Madoff, the latest round

the latest round

From the point of view of Wall Street and other global stock-trading centers, that is, in the world of pricing future consensus expectations, the Bernie Madoff ponzi scheme has been “old” news for a long while. But in the real world, the economic consequences of this fraud continue to slowly work themselves out.

Occasionally, new information emerges. Like this week…

According to the Financial Times, a lawsuit filed by Irving Picard, the court-appointed trustee charged with recovering what assets of the Madoff victims he can, makes interesting new allegations regarding the role of HSBC in perpetuating the fraud. HSBC denies any wrongdoing. (The complaint runs 160-odd pages. I haven’t read it.)

The suit contends:

–a third of the funds Madoff accumulated were funnelled to Madoff from HSBC,

–HSBC commissioned KPMG to look at the Madoff operation on two occasions, once in 2006 and again in 2008. The consultant’s report warned against possible fraud but were ignored.

–irregularities in Madoff’s reporting to HSBC should have been taken by the bank when it reconciled its client records as red flags prompting further investigation, but weren’t. The reported problems include:

  1. some Madoff-reported trade settlement dates fell on days the relevant exchanges were closed
  2. some Madoff-reported trades were at prices that were either higher than the highest price achieved on the purported trade date, or lower than the lowest price.
  3. cash holdings were reported as being in placed in a specific money market fund for up to three years after the fund had changed its name.

–these red flags began to emerge seven years before the fraud was finally revealed.

–internal compliance people at HSBC put their worries about Madoff into writing annually for a number of years–presumably at considerable office-political damage to themselves—without any effect.

My thoughts

The damages sought, US$6.6 billion, amount to a bit more than 3% of the stock’s market capitalization. So they are probably too small to be of much significance in themselves as a factor in deciding whether to be a shareholder of HSBC or not.

In fact, a potential Madoff-related judgment would pale in comparison with the negative effects of HSBC’s decision a number of years ago to buy US sub-prime consumer lender, Household International, and then to purchase large chunks of other banks’ sub-prime exposure.

Makes you wonder what parts of the banking or investment management businesses the guys in charge actually understood.

What catches my eye about Madoff is the repeat hiring of KPMG to examine his product. To me, this signals a power struggle was going on inside HSBC over what to do about the firm’s large exposure to Madoff.

My picture, which I have no factual evidence to support, but which makes sense to me, is this:

Compliance people began to develop evidence that the Madoff investment results might be fraudulent and recommended that the firm stop selling the Madoff product. HSBC’s marketers of the product, who were generating $500 million in yearly revenue from Madoff, opposed doing so.

The dispute was kicked upstairs, apparently to someone who had reached a position of power in the bank who had no technical competence in the area he was supervising. He couldn’t decide, or didn’t want to alienate the marketers, who were most likely much more powerful internally than the compliance people—because they generated all that revenue and compliance generates none.

So he called in consultants, to make the decision for him, thereby deflecting any ire of the revenue generators away from him.

It would be interesting to read the consultants’ reports. According to the Picard lawsuit, HSBC ignored the KPMG warnings. But the KPMG conclusions may have been written in either ambiguous or not particularly forceful fashion.

Why do that? …to avoid offending any of the HSBC parties involved, and thereby presumably maximizing the possibility of future business.

I think it’s hard for someone who hasn’t worked for large corporations to understand the  significance of the fact that the compliance people persisted in making their position known, They did so; not only informally and orally, but also in writing. That can’t have been a very popular stance. Presumably, this persistence is why KPMG was called in a second time.

What surprises me, assuming my account is roughly correct, is how tone-deaf top management must have been to the tenor of the compliance department’s warnings. Clearly, they were committing internal political suicide again and again in delivering a message it was clear no one else wanted to hear. You’d think that would give top management pause. But–again assuming I’m reading the situation correctly–it didn’t.

I’m not sure this has any investment significance, other than to illustrate how big bureaucratic organizations can get tangled up.  Maybe it also explains why there has been so much reshuffling of HSBC top management over the past short while.