Bernard Madoff, once a respected investment adviser, may have perpetrated
one of the biggest financial scams in history. Federal authorities are now
trying to sort out what amounts to an enormous Ponzi scheme after Madoff
admitted wrongdoing to employees of his firm. The scam's price tag could be as
high as $50 billion, a staggering revelation since many rich investors actively
sought to have Madoff manage their money.
Some questioned Madoff's consistently
stellar returns years ago, but inquires by the Securities and Exchange
Commission (SEC) never turned up anything. H. Nejat Seyhun, the Jerome B. and
Eilene M. York Professor of Business Administration, teaches finance at the
Stephen M. Ross School of Business. In the following Q&A, he says the
Madoff scandal is exactly what the battered financial markets didn't need right
now. But it could result in a more responsive SEC going forward, since the
regulatory agency is under intense scrutiny for dropping the ball.
did so many people who should have known better get duped by Madoff?
Seyhun: I don't know
exactly. I think it's partly human nature. Every one of his clients wanted to
believe Madoff. He probably told some of them that they were special. I know
one investor personally who said he suspected he was getting somewhat better than
the market rate, and that he was getting it as a favor. There may have been a
lot of that. There were probably a lot of clients who thought they had a
special personal relationship with Madoff and thought he was doing them a favor
by providing some extra return for them. This reminds me of an old joke: A
finance professor secretly gives each of his students a blue bead and asks them
to keep it a secret. When students ask publicly in the classroom, Who is
your favorite student? the professor replies, The one with the blue
bead, of course. (Now you know why we get high teacher ratings!) It seems
to me that Madoff ran a blue-bead operation as well.
kind of red flags were missed?
Seyhun: There were a
lot of red flags. Obviously, you had (Boston investment adviser) Harry
Markopolos writing letters to the SEC claiming specifically that Madoff was
running a Ponzi scheme. He wrote dozens of letters over nine years and the SEC
didn't investigate carefully enough. Madoff told his investors that he was
buying put options below the market and selling call options above the market
to finance the put options. That's sort of like portfolio insurance, except
that you are paying for that insurance by selling the market's upside. This
would, exactly as Madoff claimed, smooth out returns. The only problem is that
once you do this, there's no way of getting 10 percent or 15 percent returns
year in and year out. The actual returns would be near the risk-free rate, a
Treasury bill rate.
Here's another red
flag: Madoff was purporting to actively manage up to $50 billion in this
fashion. You would have to buy and sell a lot of options, day in and day out,
so there would be a huge amount of volume wherever he traded. All the SEC had
to do was look to see whether there was such volume. There wasn't. The volume
was one-tenth of what he would have generated. So it wouldn’t take rocket
science to see something was wrong. They could have simply checked the options
volume. Furthermore, he hired a tiny, three-person audit firm (including the
receptionist) for his $50 billion operation.
The most obvious
thing people missed is that you don't get something for nothing. Here he is,
delivering incredibly smooth returns between 10 percent and 15 percent year in
and year out regardless of the market conditions. One investor said that this
year, when the market is down 35 to 40 percent, his position was up five
percent year-to-date because of Madoff's investments. That should have been a
red flag. How could anyone deliver that return in this market? Anyone who can
do that would not manage other people’s money. He (she) would just manage his
or her own money.
regulators from the SEC have been able to pick up on this?
Madoff was registered as an investment adviser. As a result, the SEC would have
the right to go through his books and investigate him. It wasn't like he was
dealing with a few qualified institutional investors. He was dealing with the
public at large. The SEC did investigate him on multiple occasions and every
time they came up short.
did he dupe the SEC?
Seyhun: That we
don't know yet, fully. We need to wait and see what details will emerge. Madoff
was chairman of Nasdaq and he had a good name. It wasn't like he was a
fly-by-night operation. He had good connections, he contributed to charity, he
had a lot of respect, and all of that might have played a role in nobody
this going to lead to a change in the financial regulatory structure?
Seyhun: I'm not sure
if it's going to change the whole regulatory structure, but it should certainly
result in more effective enforcement. If something as big as this goes on and
he's not caught, that's a problem. If they can't catch a $50 billion Ponzi scheme
before the guy effectively turns himself in, what can they catch?
I think a couple of
things are going to happen. People will question their investment advisers and
money managers more carefully and be more vigilant on their own. And the SEC
needs to be more vigilant regardless of somebody's name or their position. It also
brings this to my mind: With this going on undetected for so long, is it just
the tip of the iceberg? Are there more, smaller Ponzi schemes out there?
kinds of specific changes might we see because of this?
vigilance and more disclosures. The SEC probably will require more reporting
from entities who have never reported before. For instance, even huge hedge
funds don’t report anything about their operations at all. We might see
reporting requirements for hedge funds above a certain size. And reporting on
not just what they have, but on what the potential liabilities are. A lot of
the current problems that we're experiencing right now came not from regulated
commercial banks but from entities such as investment banks, where the Federal
Reserve did not have direct supervisory authority. Now, everybody is becoming a
bank holding company and more are under the Fed's regulatory authority. Some
have suggested these multiple regulatory bodies will be consolidated into one
agency so the right hand knows what the left hand is doing. We have different
federal authorities -- the Fed, the SEC, the Financial Industry Regulatory
Authority (FINRA), and the Commodities Futures Trading Commission (CFTC)-- dealing
with different institutions.
change I would like to see is with the settlement, clearing, and safekeeping of
securities. Currently, this is done by the Depository Trust and Clearing
Corporation (DTCC), and the ownership of the securities is registered at the
level of the brokers. The regulations need to be changed so that securities are
registered not in brokers' names but in the ultimate beneficial owners' names.
Furthermore, clients should be able to obtain a password from their brokers and
directly verify the existence of the securities in their own name at the DTCC.
We don't want to over-regulate; however, the Madoff scandal has exposed this
glaring weakness in the U.S. regulatory environment and this needs to be
corrected as soon as possible. The rest of the problems are already covered by
the regulations in existence. Unfortunately, these existing regulations have
not been sufficiently followed. Had the SEC done that, they certainly would
have caught Madoff.
this going to further shake confidence in the U.S. financial system and make
investors even more skittish than they already are?
Seyhun: I think so.
I think we're already seeing the effects. People simply do not know the extent
of their losses yet. We're waiting for the other shoe to drop. We don't know
what the aggregate losses are, and how the losses are going to be divided. If you
can't trust a well-known name like Madoff then they may simply decide not to
put their money in the stock market and these kinds of investment vehicles. And
that would have important repercussions. The cost of risk capital would be
higher, and we'd get fewer risky activities and less innovation.
this scandal actually deepen and extend the credit crisis?
Seyhun: Yes. The
current crisis we're in is also a crisis of confidence. Even though the
interest rate is nearly zero, the cost of risk capital is still quite high. So
people don't want to make loans as a result. This scandal could further
increase the risk premium. When well-known names like Citibank, Lehman, Bear
Stearns, AIG, and Madoff get in trouble, investors wonder, who is safe, who
they can deal with. Maybe nobody. So they'll put their money in T-bills and
wait the crisis out. That will make the credit crisis much worse.