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SEC not alone in ignoring warnings: The Madoff collapse shames us all

There is no doubt that managers of funds of hedge funds and other professional managers of client money lost in this case should hang their heads.

Five years ago, Euromoney was catching up over lunch with a senior figure at a large European bank. Something was troubling him. His private bankers were reporting that emissaries from a large US-based hedge fund had been approaching wealthy European clients telling them that they had unearthed a secret formula to extract regular, risk-free returns from the stock markets.

Against all common sense, some wealthy clients seemed to be falling for this outrageous pitch.

Euromoney asked around the hedge fund community and got a similar response from several sources: are you sure this isn’t Bernie Madoff they’re talking about?

Madoff’s reputation was long established. The most troubling aspect of the alleged fraud is that the warning signs were there for years for investors, risk managers, regulators and journalists to see. Euromoney wasn’t the only news organization to try to nail the story, only to fail when no iron-clad proof could be produced of wrongdoing and when sources that were happy to assert on background that it was going on wouldn’t stand up on the record.

Everyone knew that something odd was happening but no one did anything about it. The strange relationship of the broker-dealer to the hedge fund being run, apparently, out of a corner office on the side; the incredible returns, graphed in a smooth line running from bottom left to top right and undisturbed by the volatility of returns evident in other long/short equity funds; the lack of oversight even following SEC registration and the absence of high-profile accountants or custodians: all should have flashed warning signs.

In the febrile atmosphere that followed the dotcom crash and the corporate accounting scandals, amid the rapid growth of hedge-fund style absolute-return investing and the early inflation of the Greenspan bubble, the market failed to see, or chose not to see, the obvious.

OK, something didn’t look right about Madoff but instead of insisting on answers, market participants sought to rationalize and concoct possible explanations of their own. Sure, it was impossible to produce the kinds of returns that were being reported from the stated strategy but perhaps the explanation was fairly innocent. If the supposed long/short equity fund was really just a way of capitalizing the broker dealer’s market-making business – itself growing amid the expansion in trading that accompanied the emergence of high-velocity hedge fund trading strategies – was that such a bad thing really?

The worried European banker Euromoney lunched with five years ago is one of the many to have been forced out of the business in 2008. His bank is, surprisingly, one of those strong ones, including HSBC, Santander and BNP Paribas, to have disclosed substantial losses on loan exposures to collapsed Madoff funds.

SEC chairman Christopher Cox has confessed that credible and specific allegations regarding Madoff’s alleged financial wrongdoing, going back to at least 1999, were repeatedly brought to the attention of SEC staff. Despite all the rumours, with the SEC registering the firm, and in the age of financial complexity, almost no one was prepared publicly to shout “Ponzi scheme”. Such schemes typically grow fast and collapse quickly, driven by their own ever-gathering momentum. This one went on for a frightening length of time. Many questions remain.

But there is no doubt that managers of funds of hedge funds and other professional managers of client money lost in this case should hang their heads. Today, investors are reaping the consequence for a complete breakdown in due diligence. Euromoney recalls asking many of those running funds of hedge funds back in 2003 and 2004 about how much checking they were doing on the backgrounds and credentials of hedge fund managers. The answer often was none: the scramble was on to get into any hedge fund with any renowned figure behind it. No-one could afford to wait, investigate and risk not getting in.

Madoff’s won’t be the only Ponzi scheme these collapsing markets reveal. Let’s hope it is the biggest. Iconic figures are queuing up to be symbols of the market excess and disastrous collapse. We don’t need any more.

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