Madoff Madness: Seven Things You Might Not Know

When I was a Wall Street analyst I got to know Bernie Madoff by reputation because I covered the whole online/electronic trading industry and Madoff was a big actor in that space due to his market making operations and his constant fights with the NYSE.

Given this experience as well as the fact that I currently manage a hedge fund, I can’t resist making a couple of points that I don’t think have been widely discussed in the media so far:

1. Madoff’s investment firm was not a hedge fund, it was what’s called a “managed accounts” business in which each investor had their own separate account that was supposedly managed by Madoff.  That’s why press reports indicate the investor’s got statements that listed individual trades in their account (something you don’t get with a hedge fund).  The reason why this is important is that, like many managed accounts, Madoff only charged a relatively small flat management fee (1.5% a year according to reports) compared to hedge funds which typically charge at least a 2% management fee plus 20% of the profits.  This fee structure made Madoff’s fund very attractive to fund-of-funds because it made their “double fee, double carry” structure look a lot less onerous.  If you are wondering why so many fund-of-funds bet the farm on Madoff’s fund, look no further than this.
2. Madoff was not only the investment adviser to these managed accounts, he was also the broker, custodian, and administrator.  This is a huge red flag that anyone with even a basic understanding of investment management should have noticed immediately.  A firm structured like this is essentially a closed loop with almost no external checks and balances.  Even an outside auditor would find it difficult to uncover fraud because there’s no independent entity to verify trades, assets, etc.  It’s amazing that this kind of structure didn’t raise more alarm bells at places such as the SEC and the fund-of-funds.
3. What makes this fraud truly genius is that everyone on the street, including I suspect most of his investors, assumed all along that Madoff was a crook, in fact that’s why they invested with him in the first place!  The rumor was always that he made his money by front running the order flow from his market making business so if things didn’t add up people must have just figured, “Well of course they don’t add up, wink wink nudge nudge, because we all know this whole split strike strategy is just a lie to cover up the fact he is screwing his order flow customers”.
4. The fund-of-fund managers who invested heavily in this fund should probably go to jail before Madoff.  Not only did they invest in a firm with a operating structure that should have raised just about every due diligence red flag in the book, but it delivered amazing returns at fees that were “too good to be true”. 
5. It’s highly ironic that people are shocked a market maker would be doing something illegal.  Market makers, including Madoff, conspired for years to rig spreads on the NASDAQ market before they were caught (by two professors, not the SEC!).  To this day market makers continue to front run their customers on a massive scale (why else would they pay for order flow?).  Why anyone would trust such firms with their investments is beyond me.
6. Making the rather generous assumption that it didn’t start out as a fraud, it will be very interesting to learn just when and why the scheme crossed over from investment fund to ponzi scheme.  I am guessing that the advent of decimalization plus electronic trading (both on the equity and options exchanges) plus the rapid expansion in funds under management took most of the juice out of the original model and ultimately led to the collapse of the fund’s strategy.  If that’s the case it will be highly ironic that some of the market “improvements” that Madoff help champion ultimately undermined his firm.
7. Finally, I am sure that the government will enact all kinds of new regulations as a result of this fraud but the truth is that this could all have been prevented if investors had insisted on the most basic of check and balances including an independent broker, an external custodian, a third party administrator, and a reputable auditor.  These simple, common sense controls would have easily prevented this fraud from ever taking place.