Madoff: Investment Fund, or Virtual Reality Game?

It’s beginning to look like Bernie Madoff’s business model had less in common with a hedge fund or investment management firm than it did with an online virtual reality game. Sort of a Sim City for investors. The money sent in was real: everything thereafter was from Oz.

Until now, we’ve thought of Madoff’s business as another financial management operation gone crooked. Think rogue currency traders, badly hedged positions, or just pump and dump.

But the Madoff scandal may be truly unique.

Consider this, from the Boston Globe:

A federal agency that regulates brokerage firms says there is no record of Madoff’s investment funds placing trades through his brokerage operation. That leaves only two options – either he was placing trades only through other firms, which would be highly unusual, or he was not placing any trades.

"There was no evidence of the Madoff broker-dealer executing trades for the [Madoff] investment adviser," said Herb Perone, spokesman for the regulatory group, the Financial Industry Regulatory Authority [FINRA]

What are the implications?

• If there were no trades, then there were no investment gains. The “profits” he made were a myth.
• Madoff has claimed he made money only on trading commissions—but if there were no trades, then there were no commissions.
• The statements he issued to investors were truly fictitious. His “statements” were to real accounts as an avatar is to a gamer.

All an investor could know for sure was that you gave Madoff money, and you got back pieces of computer paper with ink on them.

Let’s say you sent in $1M through a feeder fund. You got back monthly “statements.” Let’s say you got a return of 15%. In five years, you “owned” $2M.

But follow the money. Your original $1M went to Madoff’s bank account. Each year, Madoff took out a few percent (“transaction fees”), and your feeder fund took 20% of your “profits.” (Neither “transaction” nor “profit,” of course, are real; the only thing real is that Madoff and the feeders took money out).

In five years, that’s about $400K. Instead of $2M, you know “own” $600K. And of course, “own” belongs in quotes too.

Even that was bupkus. Virtual reality money. Sim City money. Monopoly money. In the real world, it didn’t exist except in Bernie’s bank account and a computer program.

But it did exist, you say; people got their money back!

Close your eyes and envision Christopher Walken, in his best Balls of Fury voice, saying, “What paht of ‘Ponzi Scheme’ dint you unduhstand?”

I’ve seen some Madoff statements. They look like day-trader accounts. They show page after page of “transactions,” without any subtotals or easy way of matching buy/sell orders.

If you checked, the market prices all looked valid. They were. They just weren’t hooked up to a real account. He was in effect running an entire trading system in simulation mode—and telling everyone it was real.

If you looked at the bottom of your “statement,” you’d find Madoff’s broker-dealer firm’s name. Except—it apparently never made those trades.

Many people believe it’s impossible that one man could pull all this off. I’m not so sure.

Madoff made his reputation on building complex financial systems, covering the full range of investment management—accounts, trades, taxes, clearinghouses, balances.

All he had to do was switch the input signal from real accounts to simulated accounts. And every programmer knows what happens then: GIGO—Garbage In, Garbage Out.

Call it the Madoff Virtual Reality Trading Simulation Game.

And pay no attention to that man behind the curtain.

 

3 replies
  1. Charlie (Green)
    Charlie (Green) says:

    Some additional material.  The Reuters version of this story adds some more specificity and removes some ambiguity.  For example:

    ——-

    BOSTON (Reuters) – Bernie Madoff’s investment fund may never have executed a single trade, industry officials say, suggesting detailed statements mailed to investors each month may have been an elaborate mirage in a $50 billion fraud.

    An industry-run regulator for brokerage firms said on Thursday there was no record of Madoff’s investment fund placing trades through his brokerage operation….

    Madoff’s broker-dealer operation, Bernard L. Madoff Investment Securities, underwent routine examinations by FINRA and its predecessor, the National Association of Securities Dealers, every two years since it opened in 1960, Perone said.

    ——- 

    Every two years’ examinations by FINRA?  Mary Schapiro, the former head of FINRA, is Obama’s nominee for head of the SEC.  I suspect this story is going to do nothing to ease her nomination.

    Regarding the Madoff case itself, this information changes our view of the scandal. This is not a case of advanced chicanery–this is an out and out simple scam of the most fundamental order.  The question is not one of advanced financial literacy, but one of the simple regulatory execution. 

    A basic financial audit at its simplest level checks a few transactions against their sources.  The company shows a payment; you check with the payee to be sure the check was cashed, for the same amount, the same check number. 

    That right there would have caught Madoff, apparently.  If there were no transaction, game over. Period.  The simplest of audits.

    If you can’t pass the simplest of audit tests like that one–how in the world do you get to $50 billion of supposed transactions?

    This clearly points to regulatory failures of some kind. I just don’t see any other explanation beyond massive failure of self- or institutional regulation.

    Reply
  2. Charlie (Green)
    Charlie (Green) says:

    This story is beginning to get recognized more broadly.

    First,  Mark Cuban’s blog suggests that software developers are somehow behind Madoff’s system.  Warm, Mark–not cold, but not hot either; you’re getting closer.  That was January 18.

    Next day, the 19th, Cuban’s blog is picked up by SecuritiesDocket.com.  Good instincts, SD. 

    This post, of course, was put up on the 17th.  I’m just sayin’…

    And I do think this is going to continue to be a big story.

    Reply

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