Madoff and JPMorgan Chase

another JP Morgan legal settlement

Yesterday JP Morgan and the federal government announced a deal.  The bank has agreed to pay fines of $2.6 billion and to reform its operating practices, in return for not being prosecuted for offenses relating to the Bernie Madoff Ponzi scheme.

Although the press reports are a bit confusing, the offenses seem to fall into two areas:

–Madoff routinely made transfers in and out of his accounts in excess of $10,000 a day.  Chase did not report these to the government as required by anti- money laundering statutes.  At least some of these transfers were rapid-fire movements from bank to bank, designed to allow Madoff to illegally collect interest on the deposits from more than one institution (“check kiting”).

–Parts of JP Morgan refused to invest the bank’s money with Madoff on the grounds that he was running a Ponzi scheme.  Other parts of JP Morgan happily continued to service Madoff, to buy his products, and to help sell them to others. Also, In the days just before Madoff’s arrest, JP Morgan withdrew most of its own money from Madoff, apparently because of fears of fraud.  The bank notified the UK government of this, but, oddly, not the US.

my take

To me, the plea deal is more evidence of a sea change in the attitude of regulators toward the financial industry since Mary Jo White became head of the SEC.  Long overdue.

In my experience, in every company there’s a tension between politically powerful senior managers who are identified with, and benefit from, the revenues generated by someone like Madoff and the relatively junior researchers who understand the facts better and are more aware of what the law requires.  The former can put up immense resistance to fixing problems.  Their allies can simply refuse to act on, or even to read, the case for a different course of action.

I’ve seen some of the Madoff sales materials.  They assert that phenomenally high returns are to be had with virtually no risk.  No explanation of how this is possible, just a simple appeal to greed.

Current media coverage is highly favorable to government investigators.  What seems to be forgotten is that Harry Markopolos, a financial analyst whistleblower with very detailed evidence of the Madoff Ponzi scheme, repeatedly showed up at SEC offices from 2000 onward to present his case.  He was ignored every time.  (Markopolos was asked by his boss to create a clone of Madoff.  He soon realized that there were periods where no assets delivered the returns Madoff claimed.)

The most elementary checks of the phony documentation Madoff prepared would have revealed the fraud.  But in their periodic inspections, the SEC appears to have checked virtually nothing.  Madoff himself commented on how easy the SEC was to fool.

Bernie Madoff and the New York Times

a Times article

Yesterday, the New York Times published a front page article based on correspondence with, and an in-prison interview of, Ponzi-schemer Bernie Madoff.  The reporter is turning her investigation into a book.

what Madoff said

Madoff had a number of comments:

1.  Discovery of his crime has had a much more severe negative impact on his family than he expected.

2.  He has given important information to Irving Picard, the trustee appointed by the court to recover investors’ assets (despite the fact he refused to help prosecutors after he was arrested).

3.  Internal bank and investment firm correspondence he has seen while in jail convince Madoff that these partners of his deliberately failed to do due diligence before recommending him to clients.  Why?   They knew they would find fraud–and thereby kill the goose that laid the golden eggs for them.

4.  In contrast to the banks, the Wilpon-Katz family, New York real estate developers and owners of the Mets baseball team, were clueless.  Despite having a cadre of highly educated financial and legal experts, and being sophisticated investors themselves, they “knew nothing.”

5.  There is no need to pursue Madoff clients who received the assets that belong to defrauded customers.  Why?  If other lawsuits seeking punitive damages from institutions that Picard maintains were “complicit” in the fraud are successful, there will be more than enough money to pay off investors who lost part or all of their principal.

is there any reason to think Madoff is being honest?

What are we to make of this?  Is any part of it true?

We do have one indication:  …Madoff’s gloating soon after arriving in prison about how he sized up business partners and clients–and refused to have anything to do with anyone he thought might be capable of uncovering the fraud.  He wouldn’t talk to them, wouldn’t take their money.  In other words, Madoff will only speak to people he’s confident he can successfully lie to. (I realize there’s a whiff of the famous liar paradox about Madoff’s statement, but I choose to think he’s being honest here.)

If so, what does this say about the reporter, to whom Madoff seems to have given a significant amount of time?

a human tendency

More generally, it seems to me that there’s a human tendency to think of oneself as somehow special…to say, in effect, “Yes, I know he’s defrauding others, but I’m part of the “in” group.  He won’t do that to me.”  Con men cultivate this feeling and take advantage of it.

In the Madoff case, early investors seem to have believed that the superior returns he advertised came from his illegal “front running” of clients in his brokerage business (that is, buying for himself before executing orders from brokerage clients, using the client volume to push prices up).  Yet, they were happy–no, eager–to give him their money, in the belief that 1) he wouldn’t cheat them, and 2) that he was willing to gift them with some of the money he stole from others.  Sounds crazy, doesn’t it?  But that’s what a lot of people did.

my take,

for what it’s worth:

1.  Madoff gave no thought to the effect that discovery of his fraud would have on his family, so of course he’s surprised.

2.  Some of the information cited in the Picard lawsuit against the Wilpon-Katz family sounds as if it came from Madoff, or perhaps Madoff confirmed surmises Picard’s forensic accountants made, but I doubt he provided other information.  He would certainly not be a credible witness in court, even were he to choose to testify.

3.  Madoff was very clever in arranging his fee structure.  The vast majority of the hedge fund-like fees charged to customers were kept by the selling agent.  So I can imagine there was immense pressure by top managements of his business partners to look the other way.

Consider the case of GE, a blue chip company made up of decent, hard-working people.  Less than a decade ago, even parts of that corporate icon wilted under pressure from a former chairman and falsified their financial accounts, so they could be seen to be achieving earnings goals.  I’m not condoning this activity, just saying that it happens and that potential whistleblowers would likely have gotten a very frosty reception.

4.  Long-suffering Mets fans realize that the Wilpons don’t have what it takes to run a sports franchise.  We also know that Madoff spent lots of time with the Wilpons and took huge amounts of their money.  So, no matter what Madoff says, his actions tell us what he thought of them.

Nevertheless, the Wilpon family would doubtless be classified as sophisticated professional investors–and subject to the much higher standards of conduct that this entails–based on the size and breadth of their operations, their education, training and experience, and the high quality of the financial and legal staffs they employed.  Separately, the Wilpons are also apparently being sued for failure to supervise their employees’ 401k plan, virtually all of which was directed to  Madoff.

These will be interesting cases to watch.

5.  I don’t understand the logic of Madoff’s wish that customers who received money stolen from others should be allowed to keep it.  I have no idea what the law is on the matter, though.

investment implications

Two that I can see:

I think we’re all susceptible (I know I am) to the idea that our own intrinsic worth shines through so clearly in all we do that complete strangers will offer us “special” investment opportunities as soon as they meet us.  Caveat emptor is a better rule to use in investment.

I started out as an oil analyst.  One of my earliest industry contacts told me that in his experience “good” oil wells always produced continual positive surprises.  “Bad” oil wells, on the other hand, continually disappoint.  I think that’s generally true of stocks, too.  In the case of unethical conduct, a given instance may be the first you have heard of.  But it’s a very bad assumption to think that this is the first instance that has occurred, or that the negative news is limited only to the area you have identified.  In all likelihood, the opposite is true.  The instance is almost certainly not the first, and chances are it’s indicative of a corporate culture that pervades the entire enterprise.

Life is too short and there are too many good investment opportunities for us to need to bet where the odds are stacked against us like this.

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.