Opinion

Edward Hadas

Madoff/subprime – spot the difference

By Edward Hadas
January 15, 2014

Bernard Madoff still has some magic. The public finds anything connected to the fraudster’s case fascinating, from a prison interview to JPMorgan’s agreement last week to pay $2.3 billion for Madoff-related sins. And why not? Madoff was a grandmaster of the confidence trick. But there is more to it than that. His way of doing business was alarmingly close to the perfectly legal practices which brought down the financial system in 2008.

To see that, compare Madoff to a hypothetical pre-crisis hedge fund manager – one with a special interest in U.S. subprime residential mortgage securities. The common tale starts with a commitment to provide higher returns than the economy can safely offer to financial investors. Both Madoff and the hedgie took in funds without making any specific promises, but their investors’ expectations were lofty.

Madoff, of course, knew that he could not live up to those expectations. That makes him smarter than the hedgie, who was either foolish, if he thought American house prices would keep rising for many years; or arrogant, if he was confident that he could sell out before the losses hit.

Both Madoff and the hedgie relied on the inability of most investors to accept deep in their hearts that market skills very rarely produce portfolios that massively outperform the overall market and the economy for a long time. It is not surprising that almost no one at JPMorgan was bothered by the consistent 10.5 percent annual returns. A similar complacency about investment returns cost investors far more in subprime losses. Financial engineers got away with claims that subprime housing could be turned into financial assets that combined high rewards with low risks.

When trying to attract funds, Madoff and the fictional hedgie made similarly exaggerated claims about their strategic expertise. Madoff just lied. The hedgie had to put together the data in a way that helped them tell clients what they wanted to hear. But gullible investors are all too often looking for a story that calmer souls would consider too good to be true. They are willing to trust doubtful claims, whether Madoff’s new wrinkle in options strategy or the hedgie’s new paradigm of housing finance.

For a while, it was fun. Reported returns were excellent – over decades for Madoff, over just a few years for the hedgie. But the numbers were pumped up by an illusion. The liar Madoff was fine as long as not too many investors wanted to cash in. It was not that different for the honest hedgie. His market values were true only as long as the market was going his way. In practice, they were fictional, because prices were sure to fall fast exactly when he would have to sell out – the moment the housing market turned.

The dark days would come, but Madoff and the putative hedgie basked in high incomes and social esteem for as long as the positive cashflow lasted. Apparent success allowed them to brush off the few investors and investigators who asked hard questions.

The unravelling of the two managers was also quite similar. The game was up when there was no longer enough money flowing in – to the Madoff funds or to the subprime market. Investors then found that much of their cash had vanished: paid out, appropriated by the fund manager or vaporised in a falling market.

And yet in the end, fraud cost less than foolishness. Madoff’s investors are expected to get as much as three- quarters of their money back, thanks to a lack of bad investments and a diligent effort to recoup funds from the scheme’s former beneficiaries – including JPMorgan. Investors in almost any leveraged subprime housing fund suffered much higher losses.

I am not trying to excuse Madoff. He is a criminal who belongs in prison. The fictitious hedgie broke no laws, although he might suffer pangs of conscience for profiting while his clients suffered. Still, he is less at fault than the financial system he worked in.

The business model of banks and brokers is not designed to make finance – the gathering and disbursing of funds, primarily for investment – safe or sound. All too often, it allows investors to maintain greedy fantasies of tremendous gains. The industry’s high pay is a reward for nurturing those fantasies.

What can be done? Greed cannot be banished from human hearts, but wise rules can temper its deleterious effects on individuals and society. The current arrangements and expectations of finance are anything but wise. If supposedly sophisticated investors had been less rapacious and more realistic, and if regulators were more diligent, there would have been neither a subprime boom nor many ultra-high-fee hedge funds. There would also have been fewer opportunities in the financial mainstream for con men like Bernard Madoff.

Comments
8 comments so far | RSS Comments RSS

Hindsight is 20:20
A few years down the road from now you’d be telling the story of the big QE bubble and its duped investors.
You’d wonder how so many people could have believed that printing fictional money in a manner limited by no law, term or other formally agreed means of measuring success (or failure) could have been taken seriously.
You’d wonder how lawmakers and economists failed to see that the US was spending (wasting) millions of dollars for each new low-payed hamburger-flipping job created since 2010.

Posted by reality-again | Report as abusive
 

Reality – you are correct that hindsight is easier. But I disagree that foresight is not possible. Those who believe that the ‘world should protect investors’ while they sit back and relax are gravely mistaken. Pay attention to what you are really buying into. PAy attention to how those investors affect your country, your city, your family. If it is not clear – then don’t invest. The old way of ‘seeking out the best returns’ is now a proven method of seeking out the snake oil salesmen.

Posted by BidnisMan | Report as abusive
 

Edit: “investors affect your country” should read “investments affect your country”.

Posted by BidnisMan | Report as abusive
 

Thank you for an excellent article, Mr. Hadas. Yes, honest traders must help develop serious regulatory safeguards for investors and average Americans who entrust their hard-earned 401k money to them.

Posted by njglea | Report as abusive
 

Securitized subprime mortgages were supposedly good investments not because subprime borrowers were supposed to be good credit risks. The subprimes had low credit rating scores precisely because they are worse than average risks. Subprime mortages were supposedly good investments because the collateral (the house) that backed the mortgage was (going to be) more valuable than the loan. If and when a subprime failed to repay their mortgage, the lender could foreclose and resell the house to recoup his investment. Even if an investor believed that 10% or 20% or more of their subprime borowers would eventually default; they could limit their own investment to the senior tranches of the pool of mortgages being securitized and none of those defaults would impact their own investment.

Posted by walstir | Report as abusive
 

Securitized subprime mortgages were supposedly good investments not because subprime borrowers were supposed to be good credit risks. The subprimes had low credit rating scores precisely because they are worse than average risks. Subprime mortages were supposedly good investments because the collateral (the house) that backed the mortgage was (going to be) more valuable than the loan. If and when a subprime failed to repay their mortgage, the lender could foreclose and resell the house to recoup his investment. Even if an investor believed that 10% or 20% or more of their subprime borowers would eventually default; they could limit their own investment to the senior tranches of the pool of mortgages being securitized and none of those defaults would impact their own investment.

Posted by walstir | Report as abusive
 

It is truly frightening for me to realize I have begun to believe in the credibility of a couple of your recent articles.

Posted by EconCassandra | Report as abusive
 

Subprime along with other real estate loan categories were good speculation only so long as investors piling into it, in the search for yield, got out before reality set in. I wonder what happens when reality concerning the Fed’s pumped up speculative scheme sets in.

Posted by keebo | Report as abusive
 

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