Madoff allegedly provided the illusion of steady returns for years mainly by managing to recruit new investors and distributing their funds to previous clients. When the market turned down, redemptions came in and the jig was up, the news was out, etc. What everyone wants to know now is why nobody noticed what he was doing before. As the NYT story notes, "Competing hedge fund managers have wondered privately for years how Mr. Madoff generated such high returns, in bull markets and bear, given the generally low-yielding investment strategies he described to his clients." His returns were too improbably regular, according to an analyst cited in the article. And in 2001, analysts were smelling something fishy about Madoff's funds and his "split-strike strategy". Naked Shorts links to this report that now makes for very interesting reading -- Madoff defends his investment approach against skeptics, who wondered "why no one has been able to duplicate similar returns using the strategy" and "why Madoff Securities is willing to earn commissions off the trades but not set up a separate asset management division to offer hedge funds directly to investors and keep all the incentive fees for itself" -- that is, why they outsourced the recruitment of new investors to other fund managers when they could have brought them in directly and earned more money. Of course, the answer is clear now -- those intermediaries were the advance guard for Madoff's pyramid scheme. The punch line is the report's last sentence:
Madoff, who believes that he deserves “some credibility as a trader for 40 years,” says: “The strategy is the strategy and the returns are the returns.” He suggests that those who believe there is something more to it and are seeking an answer beyond that are wasting their time.
But if some investing pros had been skeptical of Madoff for at least seven years, how did he keep his pyramid scheme afloat. Sadly, one can ask the same question about our entire subprime-loan-driven economy through the housing-bubble years. That makes the "cynical" take that Paul Kedrosky cites in this post especially piquant.
While many dopey investors in Madoff's funds thought he was actually running a "split strike option" strategy (and most of those people had no idea what that meant), most of the smart investors didn't. They just thought he was using the trading order flow from his securities firm to run a lucrative insider-trading operation, and they were happy to get a piece of it.Kedrosky adds, "Imagine how pissed those wise-guy investors were when they found out that Madoff wasn't running the fraud that they thought he was. Instead, he was running a different fraud."
But it is possible to be even more cynical and figure that investors knew it was scam, but figured that as long as they got in and out early, relative to the rest of the herd. That trading strategy, if you believe Marx, is called capitalism.
Capital, which has such good reasons for denying the sufferings of the legions of workers that surround it, is in practice moved as much and as little by the sight of the coming degradation and final depopulation of the human race, as by the probable fall of the earth into the sun. In every stockjobbing swindle every one knows that some time or other the crash must come, but every one hopes that it may fall on the head of his neighbour, after he himself has caught the shower of gold and placed it in safety. Après moi le déluge! is the watchword of every capitalist and of every capitalist nation. Hence capital is reckless of the health or length of life of the labourer, unless under compulsion from society. To the outcry as to the physical and mental degradation, the premature death, the torture of over-work, it answers: Ought these to trouble us since they increase our profits? But looking at things as a whole, all this does not, indeed, depend on the good or ill will of the individual capitalist. Free competition brings out the inherent laws of capitalist production, in the shape of external coercive laws having power over every individual capitalist.At some point, capitalism compels us, by its own integral logic, to adopt unsustainable approaches that can't be generalized to include everyone -- we all can't be at the top of the pyramid. Instead we become committed to a desperate effort to keep the machine moving, to bringing in more and more into the system so it won't collapse under its own weight, and the pile of grievances it generates through its merciless functioning. The more merciless the system becomes, the more merciless, we, its agents, have to become to perpetuate it. Subprime loans were made with no real faith that they will be repaid, but with some hope that new, even more desperate and exploitative techniques would be contrived to bring in a new influx of profit and prevent their insolvency from mattering. What has happened now is that for the time being, we have lost faith in the schemes, and we can't persuade ourselves to naively believe anymore, or alternatively, we have lost the will or ability to recruit new naifs.