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?

Even as Ponzi king Bernard Madoff goes away to prison for the rest of his life and then some, there are still so many unanswered questions — both big and fundamental.

Were Madoff’s sons involved? What did his wife Ruth know? Were the operators of the giant feeder funds that sucked in tens of billions of dollars in investor money in on the charade?

Those questions, though important, ultimately pale when compared with the bigger ones that remain about the root causes of the worst financial crisis since the Great Depression.

Indeed, for all the misery Madoff and his Ponzi brethren have caused, none of those scam artists were the cause of the crisis that brought the financial system to the brink. If anything, it was the financial crisis that helped flush out Madoff and his scurrilous ilk, as many investors rushed for the exits at the same time.

So that’s why Congress needs to act quickly to get up and running a bipartisan commission to study the underlying causes of the financial crisis. House Speaker Nancy Pelosi likens this new 10-member panel to the Pecora Commission, the famous Depression-era investigative committee that led to passage of Glass-Steagall — the 1933 law that drove a wall between commercial and investment banking.

The 1999 repeal of Glass-Steagall contributed mightily to the current crisis by opening the door to an anything-goes mentality on Wall Street and allowing far too many banks to become too big to fail.

This new commission, armed with the power to subpoena witnesses and documents, is meant to investigate all aspects of the crisis, including regulatory lapses, Wall Street excesses and deceptive behavior by lenders and securities traders.

A first order of business for the commission should be looking at the Federal Reserve’s dereliction of duty for missing the warning signs of trouble. Congress can’t consider acting on the Obama administration’s proposal to upgrade the Fed’s status to supreme financial regulator before there’s a full accounting of its missteps.

But there are already worrying signs that this commission will lack the political nerve to tackle the tough issues, let alone ask the right questions.

Reuters reported last week that some of the people being considered for the commission include many former Congressmen, governors and familiar talking heads from Washington think tanks. Let’s hope that will not be the case because the financial system can’t truly be fixed until there’s a candid assessment of who let things get so out of control.

Sure, put some wise political statesmen on the commission. But also allow room for some longtime Wall Street critics, derivatives traders and hedge fund managers — the kind of people who know the system from the inside out.

Maybe, even include one or two people who were sharp enough to stay away from Bernie Madoff.

At first blush, it's hard to fathom why it should take this long for prosecutors to file charges, given that Stanford and two of his top associates were the subject of a civil action by the Securities and Exchange Commission nearly three months ago. One of those associates, Laura Pendergest-Holt, has even been indicted on federal obstruction of justice charges. But still nothing on Stanford.

Bryan Burroughs, in the most recent issue of Vanity Fair, does a good job detailing how just about every US investigative agency was on Stanford's tail for more than 15 years. But whether it was allegations of money laundering, or fleecing investors with the sale of dubious CDs, no one was ever able to get the goods on Stanford.

In fact, I'm told Houston and New Orleans agents from DEA and IRS even considered running an ABSCAM-style sting on Stanford in 1998. The plan called for the agencies to work together and rent a yacht and throw a party with undercover agents posing as big-time drug dealers. The agencies planned to invite Stanford and some of his cronies to the party to see if he'd be willing to do business with the drug dealers. In other words, help them hide the proceeds from their illegal trade. The sting never happened.  It's not entirely clear why.

Ironically, a year later, DEA agents in Miami would praise Stanford as being one of the good guys in agreeing to turn over money that a group of alleged drug dealers had stashed away in an account at his Antigua-based bank. Again, it's not clear if the Miami agents knew about the aborted sting the Houston agents had discussed.

Sure, a lot of the difficulty in going after Stanford stemmed from the simple fact that he kept the core of his operation in a tiny country, whose political leaders were all too cozy with the native Texan and dependent on his largess to fuel the nation's economy. But there probably also was a simple lack of will on the part of the SEC, FBI, DEA and IRS to follow things through, in part because so many of Stanford's banking customers were Latin Americans.

Or, as Burroughs describes, may be it was the aggressive lobbying by the investigative firm Kroll that tamed the authorities looking into Stanford. And, of course, don't rule out the impact of inter-agency turf battles making it difficult for anyone investigative agency to take the lead and bring Stanford to justice.

In the end, the sad part of the Stanford story will be one of missed opportunities by investigators. All those years of failing to bring a case against Stanford simply allowed him to build his empire and sell more CDs to investors wanting to believe they'd found a can't lose proposition.

It would have been nice if one of those agencies had thrown up some red flag along the way to at least warn investors to stay away.

With Congress now probing the Bernard Madoff case, some claim the SEC missed the risk because of under staffing. Even if that’s an issue, one SEC enforcement officer using basic risk-management skills, asking probing questions, searching for clear answers, and exercising timely follow up could have helped in detecting this fraud before it grew to such a staggering size.

The central flaw at the SEC is that its current oversight approach is not sufficiently risk focused. Moreover, any changes in approach have tended to be in response to a specific event instead of incorporating an overall risk-based approach across all areas under their regulatory purview.

The SEC is responsible for overseeing registered broker-dealers, transfer agents, clearing agencies, investment companies and investment advisers, yet there is not a consistent risk approach used in all of these examinations. For example, in 2003, after widespread unlawful trading practices surfaced in the mutual fund industry, the SEC took steps to take a more risk-based approach.

Yet these higher examination standards were not viewed important enough to be applied to investment advisers such as Bernard Madoff. The weakness in the SEC’s existing examination approach can be best highlighted by the fact that, in the last 16 years, while Madoff’s firm was investigated 8 times, no fraudulent activities were ever uncovered.

As part of their broad regulatory mandate, the SEC is responsible for overseeing over 10,000 investment advisers. This agency needs to adopt a “where there is smoke there is fire” approach. The SEC must become risk focused in the scope and frequency of its monitoring and surveillance operations. Given the significant number of investment advisers, even if we assume that 99 percent are low risk, that still leaves 100 that need to be closely monitored and scrutinized.

The SEC should keep a detailed list of the top risky investment advisers and use it to prioritize and set review frequency. Currently, there is no clear indication that the SEC links review frequency or scope of exam with level of perceived riskiness. Former SEC Chairman Arthur Levitt recently indicated that only 10 percent of investment advisers are examined every three years. A wealth of new fraud can be dreamed up, hatched, and perpetrated at such firms in the interim.

Instead, the SEC must develop a stronger risk filter that will quickly flag investment advisers which exhibit higher risk characteristics. Such red flags should center on corporate governance issues such as level of independence and checks and balances. For example, does the investment adviser clear its own trades or do they use an independent third-party? Who is this third-party? Are they well known and do they have a good reputation? Who is the accountant for the investment adviser and what is their reputation and size?

Other warning indicators can come in the form of formal as well as informal complaints. What is the nature and frequency of such complaints and is a particular firm being consistently implicated?

Importantly, the SEC needs to develop a better “whistleblower” framework so it can quickly identify and respond to such complaints. If managed properly, the thousands of e-mails the SEC gets annually can be a powerful risk management tool to identify and respond to potential risk.

The SEC maintains a website to collect complaints and tips. However, the fact that whistleblower tips about Mr. Madoff’s firm were received as far back as 1999 and yet they were never fully vetted speaks to the weakness in the SEC’s risk filtering and response system. The SEC must be able to quickly sort through creditable allegations. Once such allegations have been identified, they must be prioritized, investigated and resolution reached in a timely manner.

Internally, the SEC should revise policy and include a clear action plan, process, and timeframe to address whistleblower complaints and tips. This would establish immediate accountability. To further encourage SEC investigators to comply with new response policy, standards must be directly linked to annual employee performance reviews.

In 1920, long before the SEC was established, Charles Ponzi was able to keep his scam running and undetected for only eight months. Fortunately, this fraud quickly unraveled when local media began to raise and followed up on some basic risk-related questions. The Madoff case and the failure of early detections is a further indication that the SEC should move to a more risk-focused approach.

Doing so, when coupled with timely follow up and consistent risk-based examination practices will help restore market confidence that the SEC can and will protect us against investment fraud.

It was perhaps inevitable that we ended 2008, the year we learned we were up the creek, with a great financial scandal: the Madoff Ponzi case.

What is even more remarkable is the way in which the alleged fleecing of many billions of dollars from wealthy people and charities — investors who should have known better or employed people who did — serves as a mirror for the broader culture, showing how we went wrong and where we are left now that we realize our errors.

The main difference really is that Madoff’s purported victims, or enablers or co-fantasists, say they found out their wealth was illusory all of a sudden whereas for most people in the English-speaking world, this is happening little by little.

Bernard Madoff, for those of you just waking after a long winter’s nap, is accused of defrauding as much as $50 billion from investors in funds he promised would deliver a steady — suspiciously steady — 12 percent or so a year in good times or bad. But rather than a miraculous hedging strategy, authorities say Madoff has confessed to running a pretty simple Ponzi operation: paying out “earnings” to those who demanded them from new commitments of cash from those who wanted in. And of course, given that the man could “make” heady sums with no risk in all markets, the cash flowed in and the redemption calls were, for a long time, manageable.

Madoff has not appeared in court to formally answer the charges. But that there was one man, or a man with confederates perhaps, who was willing to engage in a harebrained fraud that was mathematically doomed to failure would not be that surprising, sadly. That an army of either rich sophisticated investors or their highly paid advisors played along and, seemingly, genuinely believed that they were growing rich is far more interesting.

One point, highlighted by Tim Lee of consultancy piEconomics in Stamford, Connecticut, is that the $50 billion headline figure is about as inflated as California real estate prices were a year ago. That $50 billion is likely to turn out to be not the amount lost but the amount people wrongly thought they had. It’s likely that the actual strategy followed by Madoff could return little more than Treasury notes minus fees; in other words he could make for you what you could get for yourself with no help but then pay himself handsomely for the gymnastics.

That implies that a lot — for long-time investors the vast majority — of their “money” invested and now “lost” with Madoff was about as notional as a credit default swap contract with a man you met outside the bus station downtown. Much of the money never existed, other than on the attractive and no-doubt glossy statements sent by Madoff. It was simply what people would have had if he’d been a genie.

EXTRAORDINARY POPULAR DELUSIONS

And it’s in this way that we are all Ponzi limited partners: we too thought our retirement funds and houses were growing miraculously, though ours was an illusion fueled by debt rather than fraud, and we too made plans based on those asset values that now stand in ruins.

“The financial system as a whole has had the characteristics of a Ponzi scheme if we look at it fundamentally,” said Lee, who was very early in warning about deflation.

“By this I mean that we should think about the true value of assets as being derived from the future flow of goods and services that the assets can lay claim to or produce. If market prices of financial and real estate assets rise a lot but there is no increase in the ability of the economy to provide goods and services in the future, then the apparent increase in wealth is illusory.”

That means that savings must rise and expectations about the kind of growth and income that capital can safely command must fall. The process of everyone figuring that out over the next year or so will be a continued hole in the side of the stock market and, despite the risks inherent in Treasuries due to quantitative easing and fiscal stimulus, a boon to holders of government debt.

There are a lot of individuals, pension funds and non-profits out there who have penciled in benchmarks for returns on assets that are probably too high for the coming cycle, irrespective of the losses of this year, and I am talking about people thinking of a modest 8 percent.

Those people and institutions will be forced to take steps to right that, and this time it won’t be by searching for risk or yield, it will be by saving more and cutting back on expenditure.

This will cascade through the economy and until the savings are replenished and productively deployed, higher government spending will be a balm on a burn at best.

– 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. For previous columns by James Saft, click on here. –

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.