INVESTMENT BANKING, MADOFF STYLE!

“Misfortunes never come singly”!   Ask the Americans!   As if the economic crisis, and all the misery it entails for Americans were not enough, they have now to grapple with “the biggest investment fraud in Wall Street history”(reuters).  

Mr.Bernard Madoff, an investment banker and an ex Chair of the NASDAQ, has pleaded guilty to all the eleven criminal counts of financial fraud and related offences, leveled against him.   His sentencing is due on the 16th of June this year.

What is Mr.Bernard Madoff guilty of, and how did he carry out the frauds he is accused to have, and to which he has pleaded guilty?

This story is, perhaps, as old as the human race.   Because it has to do with the human psyche.   It has to do with human nature.   It has to do with human weakness.   It has to do with GREED.   Madoff wanted to become rich, and fast.   And so did his clients.   And in the end, greed did both the parties in.   As usual.

There are innumerable cases similar to the Madoff scam, insofar as the underlying modus operandi is concerned.   Where it differs, may be in the scope and the sheer size of it, although it involves a relatively smaller number of investors, at around5000, compared to several other such scams.  

What Madoff did was quite simple.   He offered a higher return on investors’ money compared to others, in the market.   Which means more money in a shorter time.   And as might be expected, his scheme attracted hordes of greedy, or guillible, if you prefer, investors, rubbing their palms in anticipation of a  regular, and probably unending, windfall.

Next, Madoff is said to have deposited his clients’ money in a commercial Bank, instead of investing it in the market.   Of course, this deposit in the Bank would not have fetched him the same kind of returns that he had promised his clients.   So how did he comply with his own promise to reward his clients at a higher than the accruing  rate of return from the deposits?   He simply withdrew the money from the Bank, and paid his clients, as and when due, or on demand, as the case may be!   That Simple!

In other words, Madoff paid off his first client with the money of his second one, and so on!   Naturally, his clients must have been mighty pleased with him, and congratulated themselves for having chosen the right Money Manager!   And as any marketer would tell you, word of mouth publicity is the best variety of it, and authentic cases of satisfied clients are the best source of new ones.

And so it went on, for 20 long years, according to his prosecutors.   In monetary terms, it is believed to be in the region of USD 65 billion.   That is the amount of money that should be lying in his clients’ accounts.   But in actual fact, since Madoff kept paying off his clients by digging into the Principle amount, a sizeable amount of the collections were withdrawn, leaving a fraction of the original amount in the Bank.

This dream scheme might have gone on indefinitely, but for the economic crisis.   This economic crisis has exposed the underbelly of the Western, especially the American financial services industry, and it is not a pretty sight!   Scores of the industry professionals, once revered as Demi Gods, for their steel solid integrity, as well as their divine money management skills, must be having nightmares of lynch mobs at their doorstep, waiting to have a go at them!

Coming back to the Madoff scam, which he admitted was a “Ponzi Scheme”, two issues stand out in this scam.   One, the role of the regulators, and the other the greed of the investors.

But before that, a brief look at what is a Ponzi Scheme.   Well the Ponzi Scheme is exactly what Madoff ran!   Actually, this kind of fraud is attributed to one Charles Ponzi, who is said to have migrated to the United States from Italy in the early 1900s.   He is credited of having launched an investment scheme in the United States, that raked in the Dollars, through promises of high returns that were practically not viable of compliance.   More than a century later, fraudsters continue to make money in the same fashion!   And investors continue to faithfully make the same mistakes as their previous generations!   Life goes on!

Now, the two most important issues arising from the Madoff scam.   The Regulators’ role, and the Investors’ Greed.

Ironically, the more evidence the regulators dig up against Madoff, the more they get exposed in the process!   And the more vocal the duped investors get in their criticism of Madoff, the more they expose their own greed!

As an ex top honcho at NASDAQ, Madoff knew all the loopholes in the system, and as a good psychologist, he knew how to earn the confidence of the public, enough to make them part with their money.   A devastating combination indeed!   And this unbeatable combination of inside knowledge and an intrinsic understanding of human nature, elevated Madoff to such heights, that lesser mortals, both criminal and otherwise, could only look up to, and salivate at.

Regualtion of the American, or for that matter, any other, financial services industry, is a double edged sword that requires skilful handling, to avoid casualties on either side.   A little more, or a little less, can have the same kind of comparitive, negative impact.   The experts know it.   The authorities know it.   But how to put it across to the general public, that is, in fact, part of the problem?!   For, no amount of regulation can insure the public against their own greed.    It is the investors’ greed that motivates the criminals to take the risk of committing frauds, apart, of course, from their own greed!   Demand and Supply!   Greed Demands-Greed Supplies!   An unholy tango that sends both the Investor and his Money Manager crashing to the dance floor!

Conclusion:   So how do we deal with this issue?   Is it possible to avoid such frauds?   What steps need to be taken in this direction?

The fact is that there are no easy solutions.   Precisely, because it has to do with human nature.   And human beings, being what they are, it is difficult to think of a world free of financial frauds, as much as it is difficult to think of a world free of other types of crimes.   The best that can, perhaps, be done is to minimize such incidence of fraud.

And in the matter of controlling frauds of the Madoff variety, and also the others that have bloodied Wall Street, three things need to be done.

First, outlaw and disallow esoteric investment schemes, that are based, more on mathematics, than money.   Spinning multiple transactions out of a single asset backed one(transaction), is one such example.   Any scheme that offers out of ordinary returns must attract the attention of the authorities, as much as it does, of the investors.

Second, handle the sword of regulation carefully.   “Trust But Verify”

Third, and most important, educate the public.   If only the American Government and the mass media took as much trouble in educating the American public against get-rich-quick schemes, as they do in educating the rest of the world about the virtues of the American system, perhaps, these kinds of frauds could be greatly minimised!

Investment Banking Jobs and BankingandFinanceCrossing.com