Tuesday, December 16, 2008

Tip of the iceberg

By Carl

I've spent a few days catching up with the Bernard Madoff story (as well as the smaller but no less spectacular Marc Dreier tale of woe). I have a couple of thoughts and observations to make.

First, this is just the beginning. As with all things financial, the first shock is never the last, as things like this ripple through the interconnected financial world. Look at how the "contained" (to use Henry Paulson's term) subprime mortgage meltdown took over the entire commercial banking system.

Before we go much further, I need to do a quick primer on what Madoff and Dreier did. It involves a term you might have heard called a "
hedge fund". A hedge fund is nothing more than a pool of money that places sophisticated bets on individual companies and/or stock indices. Usually, because the chance for profit is much higher, they will bet against a company or market by "shorting" the stock or borrowing shares from someone with the promise to pay for them later, turning around and selling them, then buying other shares back when the price drops and "paying" back the original loan. There are other, even more complex arrangements that hedge funds engage in, like derivatives and leverage, and I might cover those in later articles.

There are plenty of complications to short selling, not least of which is the possibility of unlimited losses: if the shares never go down below the "sales" price, the borrower can't earn any return. The upside is, it's about the only way to make money in a down market.

Hedge funds, therefore, spend an extraordinary amount of time looking for companies that are about to fail in some respect: revenues off, profits down, dividends cancelled. Obviously, they try to do this before the rest of the market finds out.

Hedge funds are also exempt from the very tight oversight rules of the SEC that apply to brokerages by dint of the fact that one has to be a "qualifed" or "accredited" investor (the rules are a bit complex, but suffice it to say to be either of these, you gotta have bucks). These are in effect private, invitation-only investments, and the investors are expected to have some financial sophistication, as evidenced by the fact they have $1 million or more.

As the Madoff case shows, not so much.

While the grunt work of a hedge fund relies on quantitative analysis (number crunching), the marketing work of a hedge fund relies primarily on the qualitative properties of the fund manager.

Which leads me to observation number two: there's no accounting for greed. By all accounts, Madoff should have been a successful manager. He was a chairman of the NASDAQ, which means he had an awful lot of success investing, and had credentials and contacts out the wazoo.

Time will tell us how he failed so miserably, but the clear lesson from Madoff's point of view is, he got greedy.

You see, fund managers are generally entitled to a percentage take of the profits (normally 20%) as well as a percentage of the assets in play (usually 1%) to cover administrative expenses (salaries, normally). Obviously, the higher the nut, the larger the percentage take is in real dollars. If you manage actual assets of $15 billion, as Madoff did, but can leverage these to three or four times their size, as Madoff did, you can claim $50 billion in assets and ignore the liabilities, because hey, they're going to be paid back! On paper, you've just earned $7 billion in bonuses and can claim $500 million in expenses.

Not bad, eh? So you can understand why Madoff didn't just toss the keys on the desk when his investments went sour.

Which brings me to point number three: There's no accounting for greed. (What?)

How he sold these stakes in his fund is simple: he dummied up numbers, attracted the right kind of attention and was able to practically hand out stakes in his fund. He all but promised a 12% return each year, allowing people to fill in the "promise" bit on their own. So long as he was able to expand his investment pool, the sky was the limit in terms of how much money he would control but also how long he could pay out 12% returns.

This is why hedge funds are run on the rule that the investors have to have sophistication, because the opportuinity to bilk people is too juicy. You're supposed to know to ask questions, the right questions. Apparently, enough people didn't, dazzled by doubling their money every six years.

Clearly, the SEC, which has nominal oversight over hedge funds, gave Madoff a pass, which brings me to point number four: too often, we are led by authority and don't question it. We saw it after Obama took the nomination, the number of liberals who creid foul as Obama correctly shifted to more centrist positions. We see it in the Madoff case. Hey, the guy was chairman of NASDAQ just ahead of the tech boom!

Point number five (and echoing point number one) is that hedge funds have already been responsible for the collapse of
Bear Stearns, Lehman Brothers, and Fannie Mae and Freddie Mac. Indeed, some speculation has it that hedge funds are responsible for the year long collapse of the global stock market.

Now, take that bit of information and add this bit of information: in America alone, hedge funds control 3/4's of a trillion dollars in assets. That's roughly
half of the assets under management worldwide.

Put it this way: Hedge funds as a nation would rank 8th, just ahead of Spain and just behind Germany.

Suddenly, you see that Madoff is peanuts, the tip of the iceberg, the first crack in the veneer of ice over the abyss. We're a long way from bailing out this boat.

(Cross-posted at Simply Left Behind.)

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