Monday, December 15, 2008

Making Off With Your Money



One of the odd things about the collapse in the financial markets is all the creepy-crawlies found slithering desperately when yet another rock (or what seemed as reliable as a rock) is turned over. It's hard not to think that the free-market adulators just decided that ANYTHING the market decides to do is OK, including all sorts of fraud.

Take the Madoff (pronounced made-off) case. Madoff was running a Ponzi scheme:

Most Ponzi schemes collapse relatively quickly, but there is fragmentary evidence that Mr. Madoff's scheme may have lasted for years or even decades. A Boston whistle-blower has claimed that he tried to alert the S.E.C. to the scheme as early as 1999, and the weekly newspaper Barron's raised questions about Mr. Madoff's returns and strategy in 2001, although it did not accuse him of wrongdoing.

Investors may have been duped because Mr. Madoff sent detailed brokerage statements to investors whose money he managed, sometimes reporting hundreds of individual stock trades per month. Investors who asked for their money back could have it returned within days. And while typical Ponzi schemes promise very high returns, Mr. Madoff's promised returns were relatively realistic — about 10 percent a year — though they were unrealistically steady.

Mr. Madoff was not running an actual hedge fund, but instead managing accounts for investors inside his own securities firm. The difference, though seemingly minor, is crucial. Hedge funds typically hold their portfolios at banks and brokerage firms like JPMorgan Chase and Goldman Sachs. Outside auditors can check with those banks and brokerage firms to make sure the funds exist.

But because he had his own securities firm, Mr. Madoff kept custody over his clients' accounts and processed all their stock trades himself. His only check appears to have been Friehling & Horowitz, a tiny auditing firm based in New City, N.Y. Wealthy individuals and other money managers entrusted billions of dollars to funds that in turn invested in his firm, based on his reputation and reported returns.

The linked story recounts in great detail the S.E.C.'s attempts to investigate Madoff's firm. That all the earlier attempts failed smells funny to me. Remember that because Mr. Madoff had his own securities firm, the only sort-of outside check on his activities was the auditing firm, Friehling & Horowitz? Here's how that firm is described:

When Aksia researched Madoff last year, it learned the firm's books were audited by accountants Friehling & Horowitz, operating out of a 13-by-18 foot location in an office park in New York City's northern suburbs. One partner, in his late 70s, lives in Florida. The other employees are a secretary, and one active accountant, Aksia said.

I would love to see a careful study of what steps the earlier S.E.C. investigations took before deciding that Madoff was as pure as this new snowfall.