Madoff: A Riot of Red Flags

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Greg N. Gregoriou & François-Serge Lhabitant,
Madoff: A Riot of Red Flags (Jan. 2009)
available via http://faculty-research.edhec.com/jsp/fiche_document.jsp?CODE=1234770344525&LANGUE=1 

Greg Gregoriou and François-Serge Lhabitant, finance professors from the University of Pittsburgh and EDHEC Business School in France, have produced a comprehensive account of the Bernard Madoff investment scam that includes clear, comprehensible explanations of Madoff’s purported strategy comparing it to other investment vehicles. Alarm bells should have sounded when Madoff claimed to be trading large volumes of options based on the S&P index and yet there was no indication in the market that any such volume of those trades were occurring. As the authors note, Madoff’s explanation that he was using over the counter markets was unconvincing for several reasons.

First, there are not so many counterparties that could be consistently ready to sell cheap insurance every month — and spend 17 years losing money. Second, the counterparty credit exposures for firms that could have done such trades were likely to be too large for these firms to approve. And third, some of these counterparties would have hedged their books, and there was no indication of such movements. Not surprisingly, the names of these alleged counterparties could never be confirmed, and no option arbitrageur ever saw one of Madoff’s trades. This should have suggested that Madoff could not be doing what he said he was doing.

Their overall conclusion: “All (the investors) chose faith over evidence. The reality is that the warning signals were there and the salient operational features common to best-of-breed hedge funds were missing. Let us hope that this will serve as a reminder that the reputation and track record of a manager, no matter how lengthy or impressive, cannot be the sole justification.”

No one can stop investors from choosing faith over evidence when they are determined to do so. As long as people are willing to believe stories of improbable returns, there will be people like Madoff ready to take their money. But one important lesson from the scandal surrounding Madoff is that Cayman’s regulatory structures would not have permitted him to conduct his scam directly using Cayman entities. Madoff would not have been able to get a licence in Cayman to operate a fund directly as he wasn’t using an approved auditor. Further, his choice of conservator raised red flags that would have been questioned in a Cayman Islands Monetary Authority review. As onshore regulators consider how to respond to the Madoff scandal, they might consider looking at adopting some features of Cayman’s approach.

 

Andrew Morriss
Editorial Board Member
 

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Andrew P. Morriss

Andrew P. Morriss, Chairman, is the D. Paul Jones, Jr. & Charlene Angelich Jones – Compass Bank Endowed Chair of Law at the University of Alabama School of Law. He was formerly the H. Ross & Helen Workman Professor of Law and Business at the University of Illinois,Urbana-Champaign. He received his A.B. from Princeton University, his J.D. and M.Pub.Aff. from the University of Texas at Austin, and his Ph.D. (Economics) from the Massachusetts Institute of Technology. He is a Research Fellow of the N.Y.U. Center for Labor and Employment Law,and a Senior Fellow of the Institute for Energy Research, Washington,D.C., as well as a regular visiting faculty memberat the Universidad Francisco Marroquín,Guatemala. He is the author or coauthor of more than 50 scholarly articles, books, and bookchapters, including Regulation by Litigation (Yale Univ. Press 2008) (with Bruce Yandle and Andrew Dorchak), and is the editor of Offshore Financial Centers and Regulatory Competition (American Enterprise Institute Press 2010).

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