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	Madoff and the Folly of Blind Faith By Julian Delasantellis Asia Times December 22, 2008 http://www.atimes.com/atimes/Global_Economy/JL23Dj06.html My wife was born and raised in one of those old, insular industrial towns of the US northeast, one of those places that headed off down the road to extinction following the 1973 oil embargo. Growing up among Irish-Americans, Polish-Americans, Italian-Americans, Portuguese-Americans and others, there was a remarkably high degree of respect for all manners and forms of diversity, all the various rainbow colors of race, creed and faith - as long as that creed was Roman Catholic. My wife's family had her totally onboard with the program, from baptism through confirmation to high-school graduation from St Patrick's. She's told me that following graduation she had no knowledge of such historical personages as Cicero, Tom Paine or Archduke Franz Ferdinand, but she was absolutely, positively sure that Martin Luther was still down there roasting away in the hottest circle of hell. When the sexual abuse by Roman Catholic priests scandal germinated in Boston in 2002 and then metastasized across North America, I asked her if she was surprised by the revelations of perfidious ecclesiastical pederasty. "Not really," she told me. She said that it was pretty common knowledge among the kids at school that some of the private "spiritual instruction" conferences with a few specific priests in the parish involved some pretty strange doings. When I asked her if the kids protested or complained to their parents, she said that was unthinkable. To begin with, the kids had been kept so in the dark on matters of human sexuality that they had no real way to determine what was aberrant or not. The perpetrators frequently swore their victims to secrecy, and with the kids being told over and over again that the priests were Jesus' eyes and ears on Earth, these were no easy oaths to break. Besides, even if the kids had told their parents, it would not have made much of a difference. They never would have been believed. The institutions of the Roman Catholic faith, and the clerics who were its avatars, were marbled into the community like fat on a prime rib, present and officiating at the birth, death and all the other life-passage events in between of almost everyone in town. In much the same way that the French philosopher Michel Foucault, in his 1975 book Discipline and Punish, argued that modern societies exercise power not through gendarmes and bayonets, but by having each citizen under power's control internalize his submission within himself, by accepting the role, rule and legitimacy of the church over them, the parents unwittingly acquiesced and enabled the violation of their children. Now, the God is money, its governing credenda is Alpha, finance-speak for above market-average investment returns, and Bernard Madoff was one of the faith's high priests. When you ask how the people who have lost millions, or billions, could have been so foolish, think of the betrayed parents. Even if they had doubts, how could they reject the faith, in Madoff's case, a faith that was delivering to them, in both good markets and bad, a supposedly safe, steady and secure 10% gain a year? In the 1997 movie The Devil's Advocate, high-powered lawyer John Milton (played by Al Pacino, portraying, well, you can guess who he's supposed to be with a name like "John Milton") describes any current scandal de jour in the media-sodden Big Apple as a "Class A New York style pig f**k." If that's the case, passion's squeals and oinks were particularly loud in Manhattan last week. Starting with lurid coverage in both of New York's major tabloid newspapers, from Rupert Murdoch's New York Post (which on one cover called Madoff "The Most Hated Man in New York") to the New York Daily News of Mortimer Zuckerman (whose charitable trust is reportedly out US$30 million in this) , to only slightly less gaudy, but equally breathless ink in The Wall Street Journal and New York Times, to a media scrum following a Madoff bail hearing last week that made an English soccer riot look like a debutante cotillion, New Yorkers and the worldwide finance community are alike obsessed with the story of Bernie Madoff, the man who ruled the world, the man who had it all, if not for the fact that, in reality, he had just about nothing. On Thursday, December 11, agents of the Federal Bureau of Investigation (FBI) and the US Attorney's office for Southern Manhattan arrived at the Park Avenue apartment of Bernard L Madoff, former chairman of the NASDAQ stock exchange, and founder and principal of Bernard L Madoff Investment Securities LLC, arresting him on charges of securities fraud. An FBI agent on the raid, Theodore Cacioppi, described his fateful encounter with Madoff in an affidavit filed with the Federal Court. I spoke to BERNARD L MADOFF, the defendant. After identifying myself, MADOFF invited me, and the FBI agent who accompanied me, into his apartment. He acknowledged knowing why we were there. After I stated, "We're here to find out if there's an innocent explanation," MADOFF stated, "There is no innocent explanation." MADOFF stated, in substance, that he had personally traded and lost money for institutional clients, and that it was all his fault. MADOFF further stated, in substance, that he "paid investors with money that wasn't there". MADOFF also said that he was "broke" and "insolvent" and that he had decided that "it could not go on", and that he expected to go to jail. In the charging document filed by the US Attorney's office, more details are revealed. On December 10, 2008, MADOFF informed the Senior Employees, in substance, that his investment advisory business was a fraud. MADOFF stated that he was "finished", that he had "absolutely nothing", that "it's all just one big lie", and that it was "basically, a giant Ponzi scheme". MADOFF stated that the business was insolvent, and that it had been for years. MADOFF also stated that he estimated the losses from this fraud to be at least approximately $50 billion. Press coverage of the Madoff scandal has focused on two factors, one of which is the prominence of many of those allegedly defrauded in the worlds of society, the media and charity. My colleague Spengler noted last week (see The devil and Bernard Madoff, Asia Times Online, December 19, 2008), the fecklessness of those, such as Dreamworks Studios co-founders Steven Spielberg and Jeffrey Katzenberg, in falling victim to the scheme, but in a list of over 80 purported victims published in The New York Times, a list The Times promises will be "updated regularly as more clients are identified in the case", one is struck by how many of the victims were not elderly Palm Beach society doyennes or ditzy film stars, but some of the great houses of finance, which presumably should have known much better. From Ascot Partners, a hedge fund run by General Motors Acceptance Corp chairman Ezra Merkin, to Sumitomo Life Insurance of Japan and the Union Bancaire Privee of Switzerland, the list is filled with those who will never be believed should they try to defend their actions to their principals by claiming that they were just innocent rural rubes who had the wool pulled over their eyes by shifty dealing city slickers. Press reports have it that among the victims left destitute by these events is Alexandra Penny, author of 1981's How to Make Love to a Man sex manual. Hope she still remembers. The other main focus of the press coverage has been the sheer enormity of this crime; from the US Attorney's office complaint comes the $50 billion (at least, according to the complaint) total amount of the fraud here. Not only is this the greatest Ponzi scheme ever; it will likely go down as the greatest single financial fraud of all time - the subprime scandal may eventually tip the scales at around three or four trillion dollars, but that required a whole worldwide industry of crooked bankers, realtors, securitizers, rating agencies and appraisers to pull it off. For a definition as to what a Ponzi, sometimes known as a pyramid, scheme, actually is, I could do a lot worse than rely on what was reported by FBI agent Cacioppi, in that Madoff told him that he "paid investors with money that wasn't there". What a great job it is to be a money manager - having people give you money all day long. The fly in the ointment comes when the people want the money back, preferably along with the added extra percentages of gain you promised you would earn for them through the application of your purported investment prowess. Charles Ponzi, who emigrated from Italy to Boston in 1903, found a way to solve this problem. In 1918, he set up an investment scheme involving the purchase and sale of postal International Reply Coupons, in essence, stamps. Since Ponzi promised his investors a 50% return in 45 days, his offering was wildly popular. People re-mortgaged their homes and dedicated their life savings to his scheme; then, after 45 days, they doubled up and did it again and again. Of course, there was never any great riches to be had in International Reply Coupons. Ponzi's returns, much like Madoff's, were all fictional. His claim that he was making fabulous returns kept people from pulling their money out, and if someone did, to deal with a death in the family or family emergency, there was always enough new money coming in to deal with what little was going out. At his high point, Ponzi was taking in $250,000 (and that's 1920 dollars) a day, but a series of investigative articles in the Boston Post toppled the pyramid. Ponzi did 12 years in jail, was deported and died in poverty in Italy. So how did Bernie Madoff do it? What were his postal coupons? Every month, clients of BMIS, much like clients of most brokerage houses, received in the mail statements detailing the stock trades done in the funds that they had interests in. However, along with the standard faire, like "BUY 100 shares GOOG", or "SELL 1,000 shares GM", clients noted a large number of option trades, frequently in options of the stocks BMIS was trading and owned. I sometimes tell people who want investment advice that there are two things they should do - one easy, one hard. The easy thing is to buy a really good book on stock option trading. The hard thing is to read and understand it. Options books are heavy on jargon and math, light on easy-to-understand language. Although you can get any number of software programs and spreadsheet plug-ins to do the math for you once you understand the concepts, first you have to understand the concepts. Options are particularly powerful when used either in combination with other options, or in combinations with other options and positions, whether long or short, in the underlying stock that the option is based on. With proper utilization of an option-based strategy, an investor can finely hone his portfolio as to how much risk he desires to carry in order to earn a specific return; if he wishes, a $1 rise or fall in the underlying stock can be turned into a profit of from 10 cents to $1,000. The number of possible option combinations is close to endless; just in the January 2009 contracts, there are almost 200 individual options on Google that are listed for trading. That makes for about 40,000 possible two-option positions just in the January Google options market, and the options for Google go out to January 2011. On Bernie Madoff's monthly statements, although the less-sophisticated investors probably didn't know the name of it, was displayed an options strategy called "split strike conversion". This involved a combination of buying a put with an exercise, or strike, price below the current market price of a stock you own, and selling a call with a strike price above the current market price. Option strategies such as split strike are frequently called collars, because they work to limit both the potential losses and gains from a stock position. Sometimes, a sophisticated money manager will put on a split strike before he goes off on vacation, so that he won't have to lug a quote machine with him down the slopes at Gstaad. One thing that split strike won't do is make you fabulously wealthy - it's not designed to. It's a fairly conservative strategy, much more suitable for preventing losses than for making big gains. In this, the strategy is much like the covered call, the play that frequently introduces new investors to options trading. Unsophisticated investors such as Alexandra Penny, what with her undoubtedly spending all those long days on her back researching a new book, can be forgiven for being too busy to read an options book that might have warned her about the improbability that what was on the monthly statements was real. For these victims of Madoff, the monthly statements, with all those impossible-to-understand options trades, must have been like the thurible emitting the clouds of incense at mass; an otherworldly symbol representing the majesty and mystery of the god behind the altar, on the return address of the envelope. The sophisticated investor and money-manager class of Madoff victims will have a harder time explaining away their idiocy. Split-strike must have been, or certainly should have been, a question on the final paper in their MBA finance class; even if it wasn't, they undoubtedly would have access to option simulation software on their trading terminals that would have shown them the limited profit potential of the strategy. If that wasn't enough, there was a smoking gun. In 1999, physicist and math geek Daniel diBartolomeo compared Madoff's reported returns with another firm executing split-strike trades in exactly the same manner. No matter how many times he tried, no matter how many regression analyses he ran, he couldn't explain away Madoff's outsized returns from the application of Madoff's trading strategy. In addition to the diBartolomeo revelations, the press is full of others who had doubts, some of which were reported to the US Securities and Exchange Commission. With all these red flags, why did the all-sophisticated investors and money managers hold on, why did they stay in and invest until today's sorry denouement? If they had bailed and pulled their money out, how could they have explained it to their investors? Madoff was still reporting fabulous returns, results that must have looked even more impressive in today's doleful bear market. How foolish would they have looked had they withdrawn their money from Madoff's management to then earn market average returns, while others who stayed kept on feasting on the fatted calf? They could have told their investors that they doubted the actual validity of Madoff's returns, but then the investors, while pulling their money from them to place it with another manager still riding along with Madoff, would probably have asked what the doubting Thomas knew for sure that the rest of the market didn't. But it was also probably true that, along with explaining it to their investors, the money managers internalized their perception of Madoff's deity. Had they expressed doubts, it would have put into question the soundness of the initial decisions to go with Madoff, both with their investors, also, more importantly, with themselves. The investment managers who placed money with Madoff, and earned his big returns, earned the right to be considered among the super investment savants of the day, true modern-day Medicis (along those lines, Bank Medici is reported to have taken a $2 billion hit from Madoff.) They bathed in Madoff's reflected halo - his brilliance was their brilliance. Selling out would have denied themselves this privilege; they certainly would have shuddered at the mere thought of being thrown down from the heavens to land among all those pathetic mere mortals sitting at the kitchen table trying to find a no-load market index fund with a low expense ratio. Madoff did not collapse from people having doubts and trying to pull their money out; the withdrawals that put Madoff in jail were necessitated by losses and margin calls in the clients' other, non-Madoff investments. Those who kept the faith would have stayed in until doomsday - if they could. In July, 2007, Citigroup chief executive Charles "Chuck" Prince, noting how the flood of liquidity was driving asset prices to record and unsustainable highs, made this observation that may very well turn out to be the epitaph of the rise and fall of the capitalist world in this first decade of the millennium, and is equally applicable to Madoff. "When the music stops," Prince said, "in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing." Probably right up until last call late in the night on December 10, up on Park Avenue, and all the places to where its alleged wealth flowed, the frenetic dancing went on and on. It's the hangover the next day that's the killer. But it's not like I don't have any good news regarding the Madoff collapse. Both the press and, undoubtedly, the federal investigators, are trying to answer two big remaining questions regarding Madoff - what was the total amount of losses, and where did the money go? Did Madoff manage to squirrel away $20 billion or $30 billion to some secretive Third World banking redoubt, whether it be Barbados, the Bahamas, Bermuda, Bimini or Basrah? Since I am fully aware that, while I'm still sleeping in Seattle, the first thing that those party animals over there at the J Edgar Hoover FBI headquarters in Washington DC do is to check Asia Times Online, I'll first tell where all the money went - check Google Maps for the address of "Cloud Cuckoo Land". And what was the total amount of the Madoff fraud? Not $50 billion, $75 billion or a zillion billion trillion dollars, it was exactly $00.00. The reason you can't find the Madoff money is that it never really existed. In reality, not one of the Madoff victims are one red cent poorer today than they were on December 10. They just think they are. But in real money terms, nothing has changed. Here, like in most of the recent past's economic circumstances that so bedevil us today, that perception translates into a powerful reality. Just like the homeowner who felt himself wealthy when he saw what the houses in his neighborhood were going for and so went out and bought a Bentley, and now pulls back on spending when he sees local house values contracting, in the Madoff affair, much like in the general economy itself, money was this strange, almost ethereal construct, not dime-store play money, and not an ever-steady and never-changing storehouse and measure of wealth, but something much more nebulous and vaporous, ever-existing and amorphous in the nether regions in between those two polar opposites. I told my wife about the Chuck Prince quote about dancing while the music plays. She told me that, when she was a teenager, dances, called "mixers", would be organized by the local parish, and then aggressively chaperoned by the nuns and priests. If a couple were dancing too close, a chaperone would come over advising that they must "leave some room for the holy ghost". It's unfortunate that, in recent times, when the world capitalist system in general, and Bernie Madoff in particular, danced, so little room was left for the truth. Julian Delasantellis is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at juliandelasantellis@yahoo.com.
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