Spot the difference

Jan 17 2014, 03:04 IST
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SummaryMadoff's way of doing business was alarmingly close to the perfectly legal practices which brought down the financial system in 2008

Bernard Madoff still has some magic. The public finds anything connected to the fraudster’s case fascinating, from a prison interview to JPMorgan’s agreement last week to pay $2.3 billion for Madoff-related sins. And why not? Madoff was a grandmaster of the confidence trick. But there is more to it than that. His way of doing business was alarmingly close to the perfectly legal practices which brought down the financial system in 2008.

To see that, compare Madoff to a hypothetical pre-crisis hedge fund manager—one with a special interest in US subprime residential mortgage securities. The common tale starts with a commitment to provide higher returns than the economy can safely offer to financial investors. Both Madoff and the hedgie took in funds without making any specific promises, but their investors’ expectations were lofty.

Madoff, of course, knew that he could not live up to those expectations. That makes him smarter than the hedgie, who was either foolish, if he thought American house prices would keep rising for many years; or arrogant, if he was confident that he could sell out before the losses hit.

Both Madoff and the hedgie relied on the inability of most investors to accept deep in their hearts that market skills very rarely produce portfolios that massively outperform the overall market and the economy for a long time. It is not surprising that almost no one at JPMorgan was bothered by the consistent 10.5% annual returns. A similar complacency about investment returns cost investors far more in subprime losses. Financial engineers got away with claims that subprime housing could be turned into financial assets that combined high rewards with low risks.

When trying to attract funds, Madoff and the fictional hedgie made similarly exaggerated claims about their strategic expertise. Madoff just lied. The hedgie had to put together the data in a way that helped them tell clients what they wanted to hear. But gullible investors are all too often looking for a story that calmer souls would consider too good to be true. They are willing to trust doubtful claims, whether Madoff’s new wrinkle in options strategy or the hedgie’s new paradigm of housing finance.

For a while, it was fun. Reported returns were excellent—over decades for Madoff, over just a few years for the hedgie. But the numbers were pumped up by an illusion. The liar Madoff was fine as long as not too many investors wanted to cash

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