BERNIE MADOFF
Bailout and Hedge-fund Regulation
Outline

Background
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Bailout?

Regulation Moving Forward

Conclusion & Ponzi Schemes Moving
Forward
Outline

Background

Bailout?

Regulation Moving Forward

Conclusion & Ponzi Schemes Moving
Forward
Gravity
World’s Largest
Ponzi Scheme
The bankruptcy court released a 162-page list naming
thousands of Madoff victims, including:
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New York University
John Malkovich
Steven Spielberg
Kevin Bacon
◊ Aozora Bank (Japan)
◊ Nordea Bank (Sweden)
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Bank Medici (Austria)
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◊ HSBC
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◊ Fairfield Greenwich
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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?
20+ Years of trickery
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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
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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
Madoff’s
Friends
International
Banks;
College
Endowments
Exclusive
Circle
Feeder
Funds
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
Long Term Capital
Management
Bernard Madoff
Investment Securities
“Tail” risk(s) that triggered
the downfall:
Asian Financial Crisis of 1997
& Russian Default of 1998
Current Financial Crisis
Counterparties:
Wall Street Banks
Feeder Funds
Prominent Management
attracted investments:
John Meriwether
Myron Scholes
Robert Merton
Bernard Madoff
Millions of Innocent parties
affected:
Approximately $4.6 Billion
loss
Approximately $50 Billion loss
LTCM v. Madoff
Long Term Capital
Management
Bernard Madoff
Investment Securities
Hedge Fund Secret:
“Secret sauce” (= profitable
arbitrage and pairs trade)
Split-Strike Strategy (but in
fact Ponzi Scheme)
Investment Strategy was
Legitimate?
Yes
No
Investor Money was …
Spread out to purchase US,
Japanese, and European
government bonds
Concentrated in Madoff’s
pocket
Economic or legal remedy
available?
No
Yes
No Bailout

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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
 Equity
investments
 Leverage and short selling
 Absolute return

Why regulate?
 Long-term
incentive alignment
 Retailization
 Systemic risk
Securities Act of 1933

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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”
 In
the 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
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Madoff: Repeated Investigations
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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
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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
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Outline

Background

Bailout?

Regulation Moving Forward

Conclusion & Ponzi Schemes Moving
Forward
In the end…
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No Bailout for Madoff victims
Regulation laws seem fine. The problem is
the people running the organization.
How to Succeed in a Ponzi Scheme
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Don’t expand too fast.
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Show bad numbers once in a while.
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Run while you’re ahead.