To Err Is…

Story Highlights:

• Last week, esteemed Wall Street regulator and ex-NASDAQ chairman Bernard Madoff confessed his investment advisory company was merely a giant Ponzi scheme and has been insolvent for years.
• Madoff's larger victims include many big-name financial services firms from around the world, and some worry the repercussions from the scandal could be extensive.
• However, the Financials sector and the markets are not unfamiliar with scandal. There will always be crooks (in any industry), and now is the archetypal time they typically surface.
• Though some may see this as a big market event, its effects will likely be short-lived and relatively trivial.

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Challenging times can strip away superficialities and reveal one's true nature. Sometimes, that truth showcases man's darker side. Last week, the investment advisory arm of his company, Bernard L. Madoff Investment Securities LLC ("Madoff Securities"), was merely a giant and has been insolvent for years. In reports to the SEC, Madoff estimated the company's losses at $50 billion.

The company was founded in 1960 to handle stock trades for banks and investment houses and later expanded into investment advisory services. Bernard Madoff's esteemed reputation on Wall Street and a track record of steady 10-15% annual returns (even in down markets) drew wealthy individuals, hedge funds, and institutions as clients. Madoff used a split-strike conversion strategy to manage client assets—a strategy that buys a basket of stocks closely correlated to an index while concurrently selling call options on the index, and then buying put options against the index.

This strategy, known as a "collar," hedges against declines and establishes above-market sale prices for the stocks. Though this strategy is plausible, it's to possess the timing and execution needed to successfully generate consistent returns over several years using it. Unfortunately for Madoff's clients, the returns proved too good to be true—Madoff allegedly paid returns to investors not from investment gains, but from new client assets.

As of mid-November, Madoff Securities had $17 billion in assets under management, according to regulatory records. Madoff's many big-name financial services firms from around the world. Now, they either face millions of dollars in losses directly through investments with Madoff Securities or indirectly through loans to clients who invested with Madoff. Some worry the repercussions from the scandal could be extensive and would deal another tough blow to the already weakened Financials sector.

However, the sector and the markets are not unfamiliar with scandal. Markets ended up last week despite the revelation of the Madoff scandal. History is littered with crooks like WorldCom's Bernie Ebbers and the Enron executives, and though they often exemplify the corruption marking those time periods, they ultimately weren't the reason why things were bad.

Madoff's plight also usefully contrasts with the failure of Long Term Capital Management (LTCM). They are different in almost every way. LTCM was a hedge fund with many billions in leverage, and at the time, it was feared LTCM's forced deleveraging of debt would create a vicious cycle of further deleveraging by other firms, and the Federal Reserve Bank of New York quickly organized its bailout.

In Madoff Securities' case, there is likely no unraveling of positions—at least none that would create a chain reaction like LTCM, and not nearly on the same scale. The Madoff fallout seems to be limited to a few billion and not enough to jar global financial markets for long. Compared with the financial crisis and ensuing government rescue plans (now well into trillions in cost), this is a relatively contained event.

This scandal revealed as much a business practice breakdown as a regulatory system breakdown. The US financial regulatory system is muddled and full of gaps and inefficiencies. Unfortunately for the scandal's victims, this event only supports that belief. Red flags were raised throughout the company's years of operation—not the least its remarkably consistent returns. Other red flags included housing client assets in Madoff Securities' own broker/dealer operation, a lack of third party oversight, and a very small accounting firm (three people) for the size of its operations. It's not yet certain how much of investors' assets will be recovered, and there will likely be more fallout. Still, markets and sound institutions have recovered from scandals before. Though some may see this as a big market event, its effects will likely be short-lived.

There will always be crooks (in any industry), and now is the archetypal time they typically surface. In good times, investors are sometimes blinded by exuberance and optimism. In bad, sparks of suspicion cause the typically faulty foundations to combust. For years, Madoff Securities' strategy and its consistent (and ultimately unnatural) returns, but the company managed to evade regulatory investigation. The company's fraud was only revealed when investors sought to redeem investments from this year's volatile markets—forcing Madoff to admit his errors and empty promises.