Thursday, January 8, 2009
The Madoff Fraud: Stupidity, Greed or Both
Today, I am going to share with my readers a letter that was published today in the oldest English Jewish weekly in America, THE AMERICAN ISRAELITE, established July 15, 1854 in Cincinnati. The letter is in response to the Madoff fraud that cost many people and organizations everything they had. Drawing on my years working with investment securities, I thought I would add my two cents to the discussion. Below is my letter to the editor.
The huge losses and tragedies that have been created by the Bernard Madoff fraud could have been avoided. No foundation, endowment or any other large portfolio of money should have ever been placed in the hands of one money manager, nor without the protection of a trustee like the trust department of a bank. If each of the investors and organizations would have diversified their portfolio among a few or several money management companies and had those moneys held in the trust department of a commercial bank, the size of the loss to each organization would have been more manageable and no one would have been completely wiped out. By using a trust department the investment securities of the foundation or the endowment would be held for the trust department at the Depository Trust Company (DTC) for safe keeping. As almost all stocks and bonds today are held in book entry form, DTC acts to facilitate the transfer of investments securities in today’s book entry world. In the old days actual paper stock and bond certificates had to be mailed to the broker and new stock certificates exchanged. This old way hardly exists today except for a few people that keep their stock certificates in a safety deposit box.
If Madoff required a minimum investment of ten million dollars to invest with him, no organization with less than 100 million should have ever even considered him or his fund for investment. No organization should put more than ten percent of their fund with one money manager, much less outside the protection of a trustee. The State of Massachusetts Employee Retirement System lost $12 million, but that is a portfolio that is in the billions of dollars. Where were the advisers to all these organizations?
I have worked in five trust departments and for one state agency where we managed several billion dollars and had over a hundred money managers from around the country. The vast majority of the investments were in stocks and bonds and were held by a bank trust department, in Columbus, that in turn used DTC in New York to facilitate the trading of all securities. A small portion of this state fund was placed in alternative investments. What is an alternative investment? Everyone has their own definition of what an alternative investment is, but for me, an alternative investment is one that does not fit into the mold of a stock or a bond, and, most importantly, the money or funds actually leave the portfolio and are no longer held by the bank trust department or DTC. Hedge funds, private equity funds and any other investment vehicle where the actual money is transferred into the hands of the money manager is an alternative investment. These types of situations are the most dangerous because control of the assets is taken away from the trust department and DTC. When the assets, the stocks and bonds, are managed by an outside money manager from the trust department where they are held, the money manager never touches the money. Trades are conducted through the trust department by the equity and fixed income traders in the trust department. By having the trust department place the trades, the foundation or endowment fund avoids the possibility of the portfolio manager “cherry picking” their stocks. This is just one more fine point that too many people do not understand. Front running is a whole other matter. The only money that the money managers get their hands on is their management fee. That fee is paid to them quarterly and is based on the market value of the assets held in the portfolio that they are managing. Without a monthly or quarterly statement from the trust department, the foundation or endowment really does not know what the value of their portfolio is. Private equity funds should be held at book value, in my opinion, and not market. Market value can over state the value of a private equity fund and thus over state the overall value of the portfolio, but on that issue I will defer to the accountants.
The private equity fund is, in my opinion, usually the safest of all alternative investments. Private equity funds require periodic draws where money leaves the trustee and is wired to the private equity fund manager. But, the private equity fund also has an annual report and there are companies that they are invested, and an annual meeting to attend and ask questions. This does not protect the investor from stupid private equity fund managers, of which there are a few. The better private equity funds are usually not that easy to get into because they have a reputation for making their investors lots of money. There is also the option of investing in a private equity fund of funds. This works well where the investment committee has little if any knowledge in evaluating private equity fund managers. I have seen some good private equity fund managers and I have seen some pretty bad ones too.
Foundations and endowments and any other charitable organization has no business investing all of their money with one money manager or in a single hedge fund. This happens because people are either stupid, greedy or both. I spent over 35 years working with investment securities. I have had considerable experience managing and trading bonds and equities. I have managed portfolios and worked as a senior investment officer to a multi billion dollar state fund, and yet in my 66 years, I have never been asked to help a board of trustees with their investment responsibilities or to sit on an investment committee. Unfortunately, people are not picked to serve on these boards for what they know, but rather for who they know or what they give in donations. I know I could have helped prevent much of the tragedy that Madoff caused, but I have never been asked. I am now just an old man living a quiet life in Northside. If any organizations would like my help, I am in the phone book.