Bad news usually bursts out in clusters. After the financial markets? meltdown and the demise of Lehman and the US auto troubles, comes the news of a $50b fraud by Bernard Madoff, former chairman of Nasdaq and founder of a brokerage firm named after him. His victims range across his own clients from European, Japanese and Spanish Banks to university endowments and a charity run by a Nobel Laureate, among others
In the last two decades, his firm offered a steady yearly return of 10-12%, no matter how the markets performed. Apparently his strategy was to combine simultaneous positions in stock and options markets, which acts like an insurance mechanism where losses from one market are outweighed by gains in the other, leaving a decent return for investors. Such a strategy, even if it worked partially in the past, proved ineffective in recent months. His company recycled capital of new investors to repay others until the scheme went flat.
The great grandfather of all such schemes was Charles Ponzi who lent his name to posterity for swindlers who faithfully treaded his path. Why are Ponzi schemes mostly uncovered when markets are falling? Why are they not detected before losses have already mounted? Can anything be done to prevent them in the future?
The first question is easy to answer. All securities issued to investors are backed by some underlying real assets like the S&P 500 index in the US for mutual fund portfolios or price of housing for the mortgage backed securities etc. As long as the prices of such underlying real assets increase, it attracts more participants in the market and a con artist can redistribute the capital of late investors to early investors to make himself look credible to future investors. But as the market sinks or the price of underlying asset falls, both early and late investors run to liquidity, making such redistribution unfeasible because the original scheme was a zero-sum game. Hence, the fact that bad news bunch together is not a co-incidence.
The other questions are more difficult to answer because financial markets and intermediaries are indispensable parts of a modern economy as together they provide liquidity in the market, pool idiosyncratic risks, create tools for proper risk management, supply finances from M&A to IPO activities and execute trades between buyers and sellers of a range of financial assets. As a result, there are hundreds of financial products tailored to suit the needs and tastes of various participants, resulting in zillions of financial transactions. Refinancing of existing claims by issuing new claims form both a part of Ponzi or related dishonest schemes as well as of genuine transactions. Early detection of every fraud is almost impossible due to the large costs associated with monitoring a huge number of transactions and the apparent similarities between honest and dishonest trades. But if the monitoring system (SEC), and internal (auditing) and external (hedge funds or pension funds investment) checks and balances are strong, many cases like Madoff can be averted.
Numerous academic studies have shown that even the most sophisticated mutual funds cannot outperform index returns consistently over time. Madoff?s company defied this prinicple time and again and yet its books were not properly scrutinised by the auditors. Last October, when the S&P index was down by 38%, a Madoff hedge fund delivered a 5.6% return and neither its auditor nor other hedge funds that had invested in it, nor the SEC uttered anything, indicating a gross failure of the entire system. Further investigations will reveal whether this is a case of incompetence or corruption or both.
Regulations in financial markets are a tricky business. Laxity of regulators will create rooms for charlatans to manipulate trades in their own favour while tougher rules will choke off honest transactions. Making auditors and CEOs directly responsible for frauds and imposing stiff penalties in the form of rigorous imprisonment and heavy fines in the event of fraud discovery could act as deterrent to future crimes and will also strengthen the system of internal checks.
?The author is reader in finance at Essex University