BERNIE MADOFFBailout and Hedge-fund Regulation

Outline

Background

Bailout?

Regulation Moving Forward

Conclusion & Ponzi Schemes Moving Forward

Outline

Background

Bailout?

Regulation Moving Forward

Conclusion & Ponzi Schemes Moving Forward

Gravity

The bankruptcy court released a 162-page list naming thousands of Madoff victims, including:

◊ ◊ Aozora Bank (Japan)

◊ ◊ Nordea Bank (Sweden)

◊ ◊ Bank Medici (Austria)

◊ New York University ◊ ◊ HSBC ◊ John Malkovich ◊ ◊ Steven Spielberg ◊ Fairfield Greenwich◊ Kevin Bacon ◊

World’s Largest Ponzi Scheme

Begs the questions

1) How could this scheme go on for so long?

2) How could so many sophisticated individuals be taken in by a fund that provided no info on how it was able to achieve consistent returns of 8-13% for many years, during both good and bad times?

20+ Years of trickery

SEC did a bad job regulating. They too were caught up with the hype surrounding investors.

Split-Strike Strategy – complex with many moving parts.

Begs the questions

1) How could this scheme go on for so long?

2) How could so many sophisticated individuals be taken in by a fund that provided no info on how it was able to achieve consistent returns of 8-13% for many years, during both good and bad times?

Information Cascades

Each successive investor assumed that the previous investor did their due diligence

“Information cascades” – kind of like playing telephone.

Perhaps “sophisticated” financial institutions are NOT immune from hypes

Bernard L. Madoff

Professional Accomplishments: Founder of Bernard L .Madoff

Investment Securities (BMIS) Chairman of the Board of NASDAQ Founding Member of the International

Securities Clearing Corporation in London

Board of Governors of National Association of Securities Dealers

Exclusive Circle: Club Madoff

Bernie Madoff

Ruth Madoff’s Friends

Exclusive Circle

International Banks;College

Endowments

Feeder Funds

Mutual Funds

Outline

Background

Bailout?

Regulation Moving Forward

Conclusion & Ponzi Schemes Moving Forward

Yes Bailout . . . .

Millions were affected Not only wealthy white-collar

individuals, but also blue-collar individuals with retirement funds managed by one of the feeder funds.

Hedge Fund Bailout It’s been done before with

success, i.e. LTCM.

LTCM v. Madoff

Long Term Capital Management

Bernard Madoff Investment Securities

“Tail” risk(s) that triggered the downfall:

Asian Financial Crisis of 1997 & Russian Default of 1998

Current Financial Crisis

Counterparties: Wall Street Banks Feeder Funds

Prominent Management attracted investments:

John Meriwether Myron ScholesRobert Merton

Bernard Madoff

Millions of Innocent parties affected:

Approximately $4.6 Billion loss

Approximately $50 Billion loss

LTCM v. Madoff

Long Term Capital Management

Bernard Madoff Investment Securities

Hedge Fund Secret: “Secret sauce” (= profitable arbitrage and pairs trade)

Split-Strike Strategy (but in fact Ponzi Scheme)

Investment Strategy was Legitimate?

Yes No

Investor Money was …

Spread out to purchase US, Japanese, and European government bonds

Concentrated in Madoff’s pocket

Economic or legal remedy available?

No Yes

No Bailout

Legal Remedy Available People are already bringing lawsuits

against Madoff and feeder funds. Bailout will encourage Ponzi Schemes

If government bails out Ponzi scheme participants, then taxpayers stand to lose more money than Ponzi players. This incentivizes a rational person to partake in the next Ponzi game rather than avoid it.

Outline

Background

Bailout?

Regulation Moving Forward

Conclusion & Ponzi Schemes Moving Forward

What is a Hedge Fund?

Unregistered, privately-managed pools of capital Equity investments Leverage and short selling Absolute return

Why regulate? Long-term incentive alignment Retailization Systemic risk

Securities Act of 1933

Section 4. Exempted Transactions Regulation D, Rule 501

“Accredited Investor” Calculating purchasers

Regulation D, Rule 506 No more than 35 purchasers Sophisticated purchasers

Securities Exchange Act of 1934 “Dealer” vs. “Trader”

In the business of buying and selling securities

Registration under 15(b) Section 12. Registration Requirements

for Securities More than 500 holders of record, and Assets in excess of $10M

Investment Companies Act of 1940 Section 3(c). Further exemptions

3(c)(1) –type hedge fund Up to 100 investors No public offerings

3(c)(7) – type hedge fund Up to 500 qualified purchasers No public offerings

“Qualified Purchaser”

Investment Advisors Act of 1940Section 203(b). Registration of Investment

Advisors Fewer than 15 clients in past 12 months,

and Doesn’t hold self out as an investment

advisor

Other

Commodity Exchange Act FINRA ERISA Department of Treasury Fraud

Madoff: Repeated Investigations 1999: SEC send examiners to review trading

practices 2000: SEC sends examiners to review trading

practices 2004: SEC investigates front running allegations 2005: NASD reviews Madoff 2005: SEC investigates front running allegations 2006: SEC investigates Ponzi Scheme

allegations

Madoff Skeptics

Harry Markopolos Mark Occrant Erin Arvedlund

SEC: Organizational ProblemsUnderstaffedLawyers not financial expertsPolitical influencesLittle deterrent effect

GAO study – 92% of hedge funds in study were not in compliance.

Any Lessons Learned from LTCM? “Unique characteristics and unlikely

events” Amount of leverage is rarely seen

today Private parties were willing to buy

LTCM Counterparties could have absorbed

losses from a default

Outline

Background

Bailout?

Regulation Moving Forward

Conclusion & Ponzi Schemes Moving Forward

In the end…

No Bailout for Madoff victims

Regulation laws seem fine. The problem is the people running the organization.

How to Succeed in a Ponzi SchemeDon’t expand too fast.

Show bad numbers once in a while.

Run while you’re ahead.