BERNIE MADOFF

Bailout and Hedge-fund Regulation

Outline
 Background

 Bailout?

 Regulation Moving Forward

 Conclusion & Ponzi Schemes Moving

Forward
Outline
 BackgroundANTECEDENTES

 Bailout?rescate

 Regulation Moving Forward

 Conclusion & Ponzi Schemes Moving

Forward
Gravity
 World’s Largest
Ponzi SchemeESQUEMA PONZI
The bankruptcy court TRIBUNAL DE
QUIEBRASreleased a 162-page list naming
thousands of Madoff victims, including:
◊ ◊ Aozora Bank (Japan)
◊ ◊ Nordea Bank (Sweden)
◊ ◊ Bank Medici (Austria)
◊ New York University ◊ ◊ HSBC
◊ John Malkovich ◊
◊ Steven Spielberg ◊ Fairfield Greenwich
◊ Kevin Bacon ◊
Begs the questions SUSCITA
PREGUN
1) How could this scheme go on for so long?

2) How could so many sophisticated

individuals be taken in by a fund that
provided no info on how it was able to
achieve consistent returns of 8-13% for
many years, during both good and bad
times?
20+ Years of trickeryENGAÑO
 SEC did a bad job regulating. They too were
caught up with the hype surrounding investors.

 Split-Strike Strategy – complex with many

moving parts.
Begs the questions
1) How could this scheme go on for so long?

2) How could so many sophisticated

individuals be taken in by a fund that
provided no info on how it was able to
achieve consistent returns of 8-13% for
many years, during both good and bad
times?
Information Cascades
 Each successive investor assumed that the
previous investor did their due diligence

 “Information cascades” – kind of like

playing telephone.

 Perhaps “sophisticated” financial

institutions are NOT immune from hypes
 Bernard L. Madoff
 Professional Accomplishments:
 Founder of Bernard L .Madoff Investment
Securities (BMIS)
 Chairman of the Board of NASDAQ
 Founding Member of the International
Securities Clearing Corporation in London
 Board of Governors of National
Association of Securities Dealers
 Exclusive Circle: Club Madoff
Bernie
Madoff

Ruth Exclusive
Madoff’s Circle
Friends

International Feeder
Banks; Funds
College
Endowments

Mutual
Funds
Outline
 Background

 Bailout?

 Regulation Moving Forward

 Conclusion & Ponzi Schemes Moving

Forward
 Yes Bailout . . . .

 Millions were affected

 Not only wealthy white-collar
individuals, but also blue-collar
individuals with retirement funds
managed by one of the feeder funds.
 Hedge Fund Bailout

 It’s been done before with success, i.e.

LTCM.
 LTCM v. Madoff
“Tail” risk(s) that triggered
the downfall:
Counterparties:
Prominent Management
attracted investments:
Millions of Innocent parties
affected:
Long Term Capital Bernard Madoff
Management Investment Securities
Asian Financial Crisis of 1997 Current Financial Crisis
& Russian Default of 1998
Wall Street Banks Feeder Funds
John Meriwether Bernard Madoff
Myron Scholes
Robert Merton
Approximately $4.6 Billion Approximately $50 Billion loss
loss
 LTCM v. Madoff
Long Term Capital
Management
Hedge Fund Secret: “Secret sauce” (= profitable
arbitrage and pairs trade)
Investment Strategy was Yes
Legitimate?
Investor Money was … Spread out to purchase US,
Japanese, and European
government bonds
Economic or legal remedy No
available?
Bernard Madoff
Investment Securities
Split-Strike Strategy (but in
fact Ponzi Scheme)
No
Concentrated in Madoff’s
pocket
Yes
No Bailout
 Legal Remedy Available
 People are already bringing lawsuits against
Madoff and feeder funds.
 Bailout will encourage Ponzi Schemes
 If government bails out Ponzi scheme
participants, then taxpayers stand to lose more
money than Ponzi players. This incentivizes a
rational person to partake in the next Ponzi
game rather than avoid it.
Outline
 Background

 Bailout?

 Regulation Moving Forward

 Conclusion & Ponzi Schemes Moving

Forward
What is a Hedge Fund?
 Unregistered, privately-managed pools of
capital
 Equityinvestments
 Leverage and short selling

 Absolute return

 Why regulate?
 Long-term incentive alignment
 Retailization

 Systemic risk
Securities Act of 1933

 Section 4. Exempted Transactions

 Regulation D, Rule 501
 “Accredited Investor”
 Calculating purchasers

 Regulation D, Rule 506

 No more than 35 purchasers
 Sophisticated purchasers
Securities Exchange Act of 1934
 “Dealer” vs. “Trader”
 Inthe business of buying and selling securities
 Registration under 15(b)

 Section 12. Registration Requirements for Securities

 More than 500 holders of record, and
 Assets in excess of $10M
Investment Companies Act of 1940
 Section 3(c). Further exemptions
 3(c)(1) –type hedge fund
 Up to 100 investors
 No public offerings

 3(c)(7) – type hedge fund

 Up to 500 qualified purchasers
 No public offerings

 “Qualified Purchaser”
Investment Advisors Act of 1940
Section 203(b). Registration of Investment Advisors
 Fewer than 15 clients in past 12 months, and

 Doesn’t hold self out as an investment advisor

Other

 Commodity Exchange Act

 FINRA

 ERISA

 Department of Treasury

 Fraud
Madoff: Repeated Investigations
 1999: SEC send examiners to review trading
practices
 2000: SEC sends examiners to review trading
practices
 2004: SEC investigates front running allegations
 2005: NASD reviews Madoff
 2005: SEC investigates front running allegations
 2006: SEC investigates Ponzi Scheme allegations
Madoff Skeptics
 Harry Markopolos
 Mark Occrant
 Erin Arvedlund
SEC: Organizational Problems

 Understaffed
 Lawyers not financial experts

 Political influences

 Little deterrent effect

GAO study – 92% of hedge funds in

study were not in compliance.
Any Lessons Learned from LTCM?
 “Unique characteristics and unlikely events”
 Amount of leverage is rarely seen today

 Private parties were willing to buy LTCM

 Counterparties could have absorbed losses

from a default
Outline
 Background

 Bailout?

 Regulation Moving Forward

 Conclusion & Ponzi Schemes Moving

Forward
In the end…

 No Bailout for Madoff victims

 Regulation laws seem fine. The problem is

the people running the organization.
How to Succeed in a Ponzi Scheme

 Don’t expand too fast.

 Show bad numbers once in a while.

 Run while you’re ahead.