- Erin Arvedlund is a journalist who has worked for Dow Jones, The Moscow Times, TheStreet.com, Barron's and the New York Times.  She is author of "Too Good to be True: The Rise and Fall of Bernie Madoff". The opinions expressed are her own. -

Where did all the money go?

After I wrote "Madoff: The Man Who Stole $65 Billion" this was probably the first question I received from almost everyone. And I am forced to tell the bizarre truth: there's probably no money left.

This is the nature of what are known as "Ponzi" schemes, or a classic pyramid scheme--Bernard Madoff constantly had to raise money from new investors to cash out the old investors, or "redeem" them, as a traditional hedge fund or mutual fund would.

But Madoff was not running a traditional hedge fund--not at all. He was running a cash-in/cash-out fraud, using the London branch of his brokerage firm as the piggy bank where he would wire money to and fro to make it look like he was trading for the hedge fund.

But there was no hedge fund, and there was no $65 billion at the end. Madoff lied about the amount of assets he was overseeing.

So where did the money go?

Remember, the $65 billion was a phantom number: that included all the phony profits from over the decades (in my book, I write that the scam probably began in the early 1960s!).

Working backwards, let's assume Madoff promised average returns of 10 percent a year, over a period of 35 to 40 years, and the true dollars invested--and therefore lost--is likely closer to between $10 billion-$20 billion.

That's still a shocking amount--but at least it's one that U.S. prosecutors and the Madoff trustee charged with cleaning up the mess and paying back investors can get their arms around.

Assume Fairfield Greenwich Group, one of Madoff's infamous "feeder" funds, took out roughly $7 billion; Jeffrey Picower, Madoff's favorite investor, took out $5 billion, and Stanley Chais, who raised money in Hollywood for Madoff, took over roughly $1 billion, and suddenly, $13 billion is accounted for.

So where is the rest?

It's possible Madoff spirited away a few percent of the billions he stole, but even whistleblower Harry Markopolos, who stalked Madoff for nearly a decade and warned the U.S. Securities & Exchange Commission multiple times, has estimated Madoff likely only kept perhaps $350 million for himself.

In short, it would have been easier for Madoff to run a true, bona fide hedge fund than to create the millions of pages of phony statements, using an antiquated computer and old letterhead.

With the guilty plea of his lieutenant Frank DiPascali, we now know Madoff did not act alone. He lied about that just as he lied for so many decades. the question is: who else will be charged?

Hedge funds wishing to demonstrate their honesty to a sceptical world can now pay for a risk assessment to show they have a low risk of fraud.

For $15,000-$20,000 Protean Fraud Risk Appraisal will use its database of every such financial crime since 1997 to see if a fund shows any suspicious characteristics.

"We've evaluated every single fraud and worked out the common areas where fraud has arisen," partner Nathan Sewell tells me.

While Sewell stresses there are no guarantees against such crimes, which are often committed by an individual or small group and can be very hard to spot, the certificate is designed to show a fund has 'a low fraud risk'.

The process, which also draws on experts from the insurance world, would have highlighted problems at the major hedge fund frauds of recent years, he claims, although he adds that it is unlikely that these funds would have called in Protean in the first place.

"Even the fact that the manager is willing to open their doors speaks volumes," he says. "Whereas Madoff wouldn't even open his doors to anyone."

(See also Fraud - a booming business and Spotting Madoff)

– James Saft is a Reuters columnist. The opinions expressed are his own –

It’s not exactly a wake, but participants at this year’s World Economic Forum have witnessed many of their most cherished beliefs being challenged, upended and sometimes ground in the mud.

Think of it as the “Davos Consensus,” a loose alignment of principles that held sway in this Swiss mountain resort and in large parts of the world over the past decade.

This consensus, which generally favoured the market over the state, “light-touch” regulation of financial services and the free flow of goods and capital across borders, is somewhere between on the defensive and in full, not always organised retreat.

What is a lot less clear is what might replace it.

It’s true that the global economic crisis and the debt bubble that preceded it did not deliver on much of the promises made by defenders of globalisation and market forces. Instead it was one of the biggest misallocation of resources in history; to housing and consumption that either wasn’t needed or really couldn’t be afforded.

Banks wiped out much of their capital base and their regulators failed spectacularly too, missing everything from the dangers of a build up in leverage to the Madoff Ponzi scheme.

Now the state is in the ascendant, both as an “investor” and regulator and as an economic force. Everywhere the talk is about stimulative government spending and although it’s intended to be a temporary measure while the economy recovers you do get the feeling that the shift in the balance between state and private enterprise might outlast the downturn.

And even though banks have not yet been widely nationalised, there is no doubt that the state is actually directing which parts of the economy get cash. The United States is buying mortgage related debt, Britain is bailing out its auto industry, and there is every chance that further investments in banks by governments will mean more control of how, where and to whom they lend.

It is too a huge contrast from last year, when the debate was about how much globalisation, in the form of sovereign wealth fund ownership of the western banking system, was tolerable. The sovereign funds aren’t buyers any more and the cash that is flowing into banking is mostly within individual states; governments ploughing funds into banks.

It’s really not too far-fetched to speculate that globalisation might have reached its high-water mark.

It is also absolutely certain that regulation of finance will be tighter.

“The ideology of the last decade was self-regulation which means no regulation,” NYU economist Nouriel Roubini told a panel discussion in Davos.

“If we don’t want a backlash against trade we have to have prudential regulation of the financial system.”

REGULATORY FREIGHT TRAIN

One tiny problem is that the stuff underlying the Davos consensus really was pretty good at doing lots of things, not least raising living standards in huge swathes of the developing world. States aren’t traditionally all that great at allocating resources either, and it is by definition impossible for them to explain when and how they will step back and let individuals pick up the ball.

Maybe most concerning is the threat of protectionism. Most governments who rescue their banks and spend money trying to stimulate their economies have a natural incentive to try and capture as much of the benefit as they can for their voters. If you are on the line for the losses of a big international bank, do you really want it to continue taking chances lending abroad? Wouldn’t it be more sensible to just go back to “basic” banking, lending to businesses you really know? That is a line we will hear more of and it is protectionism in another form.

There have also been moves in the United States to attach “Buy American” provisions to the $825 billion economic stimulus package. While it’s not exactly the Smoot-Hawley tariffs that made the Depression so much worse, it is a slippery slope. Even more regulation of financial services, needed or not, will tend to make states eager to bottle up their banks at home, the better to watch closely that they are not taking the wrong kinds of risks.

And while the move to allow judges to force loan amendments, so-called “cramdowns” on to investors makes very good economic sense, given the collapse in housing and the complexity of many mortgage securities, it raises questions about what other contracts won’t be honoured and will be repudiated by the state.

So what’s next? The consensus here is that the state will have to come in and clean up everybody’s messes but business executives don’t seem to have twigged yet that regulation is heading at them like a freight train.

Whatever the new rules are, the sooner governments can spell them out the sooner everyone else can get on with their newly diminished roles in the rebuilding.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

– Mark T. Williams, a finance professor at the Boston University School of Management, is a risk-management expert and former Federal Reserve Bank examiner.  The opinions expressed are his own. —

It looks like the oldest trick in the book was used to allegedly bilk wealthy investors, banks, charities, endowments, and hedge funds out of their money.  How could sophisticated investors have been duped by what could potentially be the largest Ponzi scheme in U.S. history?  The answer may center on their due diligence prior to signing up with the investment firm run by Bernard Madoff, accused of masterminding the massive fraud.

Due diligence is the rigorous process undertaken to evaluate the controls, credibility, and capabilities of an investment firm prior to putting money at risk.  This process doesn’t stop once a money manager is chosen, but continues over the life of the relationship.  The $50 billion in reported losses and the fact that this scheme went undetected for so long are stark reminders that there is no substitute for solid investor due diligence and ongoing monitoring.  Unfortunately, it has taken a down market to expose such fraud.

The following are 10 steps to help to reduce the chance of fraud.  (Note: Until a human fraud meter is perfected, such risk can never be completely eliminated.)

1.      Find a great money manager not a great friend.

Make sure the candidate pool is based on professional reputation, capabilities, investment track record, size of audit firm, and level of overall risk controls.  Deciding on the right money manager should be a pure business decision.  Confusing this business relationship with friendship or a person’s golfing handicap can cloud sound judgment.

2.      Conduct your own independent due diligence.

Regardless of who else might be investing with a potential money management firm (relatives, acquaintances, movie stars, or billionaires) don’t neglect your duty of completing your own thorough due diligence.  It’s dangerous to blindly assume that those that have a lot of money can also pick the most honest money managers.

3.      If you can’t do your own due diligence, hire a qualified agent to do it.

There are consultants and hedge funds with the expertise to conduct thorough due diligence.  But delegating this duty does not mean you can consider your work finished.  There must be constant monitoring, reporting, and ongoing dialogue between the investor, the agent, and the investment management firm.

4.      Remember that risk and return always goes together.

Investment returns mirror the level of risk taken, a fundamental investment management principle.  If investment returns are steady, regardless of an up or down market, it would suggest that there is a deviation from this principle.  Returns never lie and are a great “red flag” monitoring tool.

5.      Money management firms are not charities; they are commission driven.

Many good money managers who are not good marketers hire salespersons to talk up their services.  Be aware that the person selling you on an investment manager might be motivated more by their commission than any commitment to help you.  Ask to have all sales commissions put in writing.

6.      Money manager diversification is your best friend.

Large investors should consider diversifying, using more than one investment manager.  Doing so will avoid putting all your eggs in the hands of one firm and will reduce the financial consequences of fraud.

7.      Asking questions is great but getting clear answers is even better.

Investment related questions must be asked frequently with responses monitored and documented.  If questions are not being fully addressed, not provided in writing, or if the story changes over time, it might be a warning sign that it is time to take your money and run.  Examples of basic questions include:

a.      How is the money being invested?

b.      Where are the returns coming from?

c.      What are the portfolio performance benchmarks?

d.      How is the portfolio performing relative to these stated benchmarks?

e.      What is the level of portfolio risk being taken relative to expected return?

8.      Conduct on-going monitoring of the relationship.

Once money managers have been chosen, on-going monitoring is needed to insure that the firm(s) continues to act, walk, and talk as they have represented themselves.  Like fruit, people can rot over time.  You need to know when the fruit flies start appearing.

9.      Good returns do not mean due diligence can be stopped.

With all investment returns come a level of risk.  Make sure your money is not exposed to excessive risk taking.  Be suspicious of consistent returns that do not track with market fluctuations.

10.     Money managers that are highly regulated tend to have reduced levels of fraud.

Fraud can persist anywhere, but banks with investment management divisions are highly regulated at the federal and state level.  For investment clients, these extra layers of oversight can be a safety net against fraud losses.  Banks also tend to be very concerned about reputational risk events and are focused on developing tighter internal controls to minimize fraud.  As added protection, if fraud occurs, banks tend to have more assets to go after when filing legal action.  They also tend to be motivated to settle legitimate fraud based lawsuits to avoid the negative publicity.