More Madoffs To Come: The Heart Of Darkness Gets Legs

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It is reasonable to wonder if Bernard Madoff was in his right mind.  Was he ever aware that what he was doing was criminally and morally wrong?  Any rational person would have known that a Ponzi scheme of such significance would certainly end badly.

Madoff also had a remarkable appreciation for justice. He did not wait to be caught for his crime. Once he knew that his deceit had run its course, he turned himself in. He saved the government huge sums in the costs of investigating and prosecuting him. Once he knew he was finished he asked for the jailer’s keys so he could lock himself away.

Madoff was a blessing for the holiday season. What would have been a glum month of rising unemployment, falling stock prices, and a poor man’s Christmas has turned into a first rate drama involving billions of dollars and people from the society pages. Madoff created an unbelievable distraction in one of the grimmest winters in most people’s memories.

Probably the part of the Madoff matter which is least discussed is that he will be followed by many more like him. None may be responsible for his colossal $50 billion disaster, but the circumstances of the times and the character of people like Madoff are in the DNA of the money system. They are the biproduct of rapidly rising wealth, narcissism, vanity, and the naïve assumption that the very smart and very rich never make bad judgments.

Several analysts have written that one-third of the 10,000 or so hedge funds will fail or be merged out of existence. That means many wealthy hedge fund managers and their clients will be losing large sums. Both the people who run the investment pools and those who invested face the deep shame of poor decisions. They will put off having to face the consequences as long as possible. That means that some will hide the results of bad investments and hope to double down and get back the money they have lost.

At some point, the kitty will be empty and it will be confession time.  Hedge fund companies will keep customers on board long after the ship is down by not disclosing the truth about their investment portfolios.  Eventually, some of these people will go to prison when the deceptions can no longer be hidden from auditors, the SEC, or their clients and criminal activity is documented.

The genes in the system required the remarkably lax regulation by the SEC which meant that the ability to commit this kind of fraud has been reasonably easy for hedge fund managers over the last several years. This lack of oversight alone has allowed many more firms which have not done as well as advertised to fly beneath the radar of detection, hoping to wait out the drop in the markets. They may still not be found out quickly if they are willing to lie unless they are hit by a run of redemptions which they cannot pay.

The other ingredient which has helped those who want to conceal how their money machines work is leverage. Borrowing, especially against lax standards, has allowed hedge funds to show results which can be quickly undermined by a flat spin in the credit markets. Great results can often turn to awful ones, and the temptation to try to use leverage to get back on top is overwhelming. But, now the access to capital is gone and people, who have made billions of dollars, on paper, will have to come clean or hide their failures as long as possible.

Madoff appears to have had the capacity to cover his own tracks, a willing auditor, and a SEC which was paying virtually no attention to some of the largest hedge funds. Without a complicit auditor, Madoff could not have hidden his bizarre financial decisions. He appears to have found the right partner to keep the books.  There is no reason to believe that other adroit financiers have not been just as lucky in their choice of auditors.

The first reaction to the Madoff matter is that he was remarkably clever, so clever that what he did could not be replicated. To the extent of its size, that may be true. But, Madoff revealed how very deeply flawed the system has been and that means that he has many others just like him in the financial community.

Douglas A. McIntyre