Three Things I Think About When I Think About Bernie Madoff

The following is a guest post from Peter Passell, author of Where to Put Your Money NOW: How to Make Super-Safe Investments and Secure Your Future.

The greatest financial fraudster of all time has gone to the slammer, and isn't scheduled to be released until he reaches the age of 221. That's OK by me. Bernie Madoff, after all, was no Robin Hood. Sure, he stole from the rich (the struggling middle-class need not apply). But he stole from the poor, too, slurping up billions from the endowments of charities. And apparently the only beneficiaries of this vast involuntary transfer of wealth were family members struggling to maintain the lifestyles of the rich and infamous.

End of story? Not quite. While it's hard to imagine that anyone else is running a Ponzi scheme on this scale, I would argue the human weaknesses that made it possible for Madoff to keep the scam going for decades -- greed, gullibility, laziness, money-driven politics -- explain why most investors, most of the time get less than their money's worth. At very least, then, the Madoff fiasco should remind us all of some unhappy truths about investing in America.

Government regulation is no substitute for personal vigilance. If you rob a bank, the chances are excellent you'll be caught -- and quickly. Indeed, the clearance rate on bank heists is so high that only unshakably optimistic crooks even try. How, then, was it possible for Madoff to get away with so much bigger a crime and for so long? One important reason is that modern business depends more on cultural constraints (as in, "I'm not a thief") than on regulation (as in, "I'd never get away with the theft") to keep it honest. And, unfortunately, the investment business attracts lots of folks who aren't deterred by the injunctions they heard in Sunday school.

But surely, regulators will now be more vigilant. Don't bet on it. The sort of regulation that could reliably deter the bad guys on Wall Street would be immensely intrusive and costly. And when push comes to shove, it's not likely that either Congress, or regulators appointed with the tacit approval of big political campaign contributors, will have the stomach do what's necessary.

The bottom line: You don't always get what you pay for. If you want to invest in anything other than government-guaranteed CDs and bonds, you've got to stay on top of who's got your money and where.

If it's too good to be true, it isn't. Most investment scams are of the get-rich-quick variety -- as in "I'll double your money in three months." Madoff, by contrast, attracted big sums by offering something that seemed far more reasonable. No secret land deals in Wyoming for the former chairman of the NASDAQ stock exchange, no once-in-a-lifetime opportunities to profit from the coming boom in ruthenium (look it up, yourself . . . ). All he offered were 10-15 percent returns, year after year, regardless of the state of the stock market or the global economy.

You've got to give the devil his due here. The promise of low-double-digit profits without risk was just plausible enough to attract the sort of investment advisors who served clients by dressing well and mixing a terrific martini rather than by providing timely intelligence on matters financial. Meanwhile, Madoff was able to make the cash payouts needed to keep investors believing they were getting what they paid for as he was able to increase funds "under management" by a modest amount each year.

On closer look, though, the promise of a steady 10-15 percent was hardly more plausible than the promises of more conventional investment cons. For while plenty of investors do average annual returns in the low-double-digits, they only manage it by taking substantial risks. And the fact that Madoff never had a losing year should have been a dead giveaway.

How did he get away with it, then? Like all successful scammers, Madoff understood that almost everybody secretly feels entitled to something for nothing -- and many are ready to deny reality to get one. To paraphrase Groucho Marx: Who you gonna believe, me or your lying eyes?

The scandal isn't what's illegal, it's what's legal. Yes, I stole that line from the great pundit Michael Kinsley. And yes, what Madoff did was illegal. But his most excellent adventure should not be allowed to obscure the reality that the $50 billion or so that Madoff lost on behalf of clients over the last few decades was far less than the sums that the financial services industry takes from investors every year for nothing much in return!

How dare I, an economist and (within reason) a believer in free markets, make such an outrageous claim? Try this on for size: In 1997 the after-tax profits of financial services companies was roughly $100 billion (a record high to that date). Over the next ten years it averaged a bit more than $170 billion -- even after adjusting for inflation. So what did we get for the extra $70 billion annually? Wall Street sliced and diced a lot more "product," managing everything from a great wave of corporate mergers to the issuance of hundreds of trillions of dollars worth of old- and new-fangled financial derivatives.

But it's hard to see what extra investors got from the deal. And when you look closely, you can see what they didn't get. Corporations paid hefty fees for securities issues -- fees that never seem to go down in spite of what appears to be heavy competition for their business. Meanwhile fund investors paid humongous sums to shuffle assets in what economists call "zero-sum" games in which the gains of some came out of the pockets of others.

Bernie Madoff is gone, may he rest without peace. But the financial world that spawned Bernie is alive, and will soon be well enough to take your money with gusto.

Comments

[Jamie Stenger]

"“All great failures are moral failures,” Fred Smith www.breakfastwithfred.com. Zig Zigler’s mentor Fred Smith points out that anytime you see a great failure, it is not because of their intellect, but because of some great moral failure. The current economic crisis is a perfect example of this. Greed and instant gratification are the two primary reasons we have a crisis right now. Isn’t it morally wrong to knowingly encourage someone to take a huge risk? Isn’t it morally wrong to take a huge risk for no other reason than instant gratification?" - Seven Success Keys by Tom Zigler

[David C]

As the poet Henley once said, " A man with a briefcase can steal more money than a man with a gun".

[kitty]

david C. - this reminds me of a quote I heard. Around the time of his deportation to Italy a mobster Lucky Luciano described a visit to Wall Street. He said "A terrible thing happened. I realized I'd joined the wrong mob".

[Mike Hunt]

The one thing I don't like about the beginning of this article is that Peter, the author, seems to allude it's ok to steal from the rich. That it's somehow better than stealing from the poor.

May I remind you that a fair number of people who come here are defined as 'rich' even though they may feel like they are in the middle class. These people worked as hard to save their money and don't deserve to be scammed any more than any other group.

Maybe I over-read into this and if that's the case, please accept my apologies.

-Mike

[MC]

It all comes down to your point #2: be skeptical, very, very skeptical, of "too good to be true" and get-rich-quick schemes.

Worst financial problems I've ever seen in friends and relatives all came from them buying into some "inside information", "sure-thing", "easy-money" type deal (this includes those who took out home equity loans they couldn't pay back to buy vacations they didn't need).

A corollary: Everyone should post a sign on their bathroom mirror that says, "you are not an unrecognized financial genius!" Stop trying to outguess the market, unless you are a super-experienced, educated, linked-in, full-time fund manager. And even then, you probably won't do it for long. I wish I had a dollar for every guy at the bus stop who insists on sharing with me how he's figured it all out, and he's sure to get rich on a stock tip or his own personal market theory.

[Old Limey]

There is another factor in the Madoff scandal that doesn't get discussed and that is the ethnicity factor.

My daughter has been married for many years to a wealthy Jewish attorney and my wife and I have got to know his extended family very well. One thing that I have noticed that is not present in our own ethnicity (100% English) was that Jewish people tend to put great trust in the honesty and integrity of people from their own ethnicity and seem to prefer dealing with them whenever possible.

This is not a problem 99.99% of the time but Bernie Madoff was the proverbial "Bad Apple" in the barrel and was able to pull of his outrageous scheme because his clients trusted him implicitly, especially with his rise to fame and position in the NASDAQ and local society.

The England that I grew up in before emigrating in 1956 was made up of almost entirely white, anglo saxon, protestants (i.e WASPS) so almost everyone that you dealt with was part of that group. Since coming to America, which is of course a melting pot of people of all races and ethnicities, it's impossible for most people to steer all of their business to people from their own background, so race and ethnicity are rarely a factor in business relationships. In my case I chose Fidelity Investments to keep my financial accounts primarily because of their unblemished reputation as the oldest and largest mutual fund company. I could have just as easily gone with Vanguard, American Century, or T. Rowe Price who also have fine reputations.
Since I make all of my own investment decisions I have also never had a financial adviser choose investments for me.

The investors that I feel the most sympathy for are the ones that invested in the so called "feeder" funds that were quite legitimate but unknowingly to their investors were feeding the investments to Bernie Madoff.

Interestingly Fidelity has 19 mutual funds that have an annual compound rate of return of over 10% since 9/1/88 (when the database that I subscribe to started). However not one of these 19 funds has anything anywhere near approaching a steady rate of 10%/annum over these 21 years - in fact the maximum drawdowns of these 19 funds range between -44% and -85%. There is no investment that I am aware of that has provided a very steady return of 10%, year in and year out, with low single digit drawdowns.

The proverb I learned many years ago was "If it sounds too good to be true, then it probably is".