Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Sun, 06 Sep 2009

Madoff and Renaissance Technologies

A short while back, I blogged about the OIG report on the SEC investigation of Madoff. One of the interesting nuggets in this report is about how the leading hedge fund, Renaissance Technologies, analysed and dealt with their Madoff exposure way back in 2003. It struck me as a good example of prudent risk management.

The first internal RenTec email about its Madoff exposure contains a brief description of the red flags, but what interests me is the risk analysis:

Committee members,
We at Meritage are concerned about our [Madoff] investment. ...

... you have the risk of some nasty allegations, the freezing of accounts, etc. To put things in perspective, if [Madoff] went to zero it would take out 80% of this year’s profits.

Sure it’s the best risk-adjusted fund in the portfolio, but on an absolute return basis it’s not that compelling (12.16% average return over [the] last three years). If one assumes that there’s more risk than the standard deviation would indicate, the investment loses it[]s luster in a hurry. It’s high season on money managers, and Madoff’s head would look pretty good above Elliot Spitzer’s mantle. I propose that unless we can figure out a way to get comfortable with the regulatory tail risk in a hurry, we get out. The risk-reward on this bet is not in our favor.

In one short email, you have several lessons in risk analysis:

What is interesting is that this email led to a flurry of emails analysing the red flags in Madoff at great length, collecting data from published sources and from conversations with market participants. At the end of it all, there was disagreement about the course of action between those who wanted to exit the position completely and those who drew comfort from the fact that Madoff had survived an SEC investigation. Finally, they decided to reduce the exposure by 50% (perhaps as a hedge fund they had the risk appetite to lose 40% of profits in a worst case scenario, when the investment looked attractive otherwise).

What is also interesting is that these smart hedge fund managers thought that the one regulator who was likely to catch Madoff was the New York Attorney General, Spitzer. Markopolos also thought that the New York Attorney General was the best financial regulator in the country (see my blog post here).

Of course, the RenTec people come across as having a self confidence bordering on hubris. At one point, they analysed Madoff’s stock trading and determined that “the prices were just too good from any mode of execution that we were aware of that was legitimate. ... And we would have loved to figure out how he did it so we could do it ourselves. And so that was very suspicious.” They finally decided that Madoff could not be doing what they were not able to do themselves: “Well, I knew it wasn’t possible because of what we do.”

I can quite imagine the RenTec people thinking that there was no way Madoff with his AS400 could do what RenTec could not do with the 60th largest supercomputer in the world.

Yet, there is no reason we should not learn from a bunch of arrogant people.

As an aside, I thought that the internal RenTec emails were the best leads that the SEC got. These were not complaints and were not even intended to be read by SEC – they just got picked up during an SEC examination of RenTec. There was clearly no motive, no hidden agenda. The SEC was peering into the unedited thinking of some of the smartest hedge fund managers in the world.

As another aside, the very fact that these internal emails got picked up as a lead for investigation of another entity conflicts with the idea that the SEC is so badly incompetent. My Hanlon’s Razor is taking some dents.

Posted at 17:42 on Sun, 06 Sep 2009     View/Post Comments (1)     permanent link

The SEC Madoff Investigation Report

Ever since the Markopolos documents became public, we have known that the SEC bungled its investigation of Madoff very badly (see my blog posts here and here). So when the SEC asked its Office of Investigations to investigate the SEC’s failure, there was only one question to answer – was it incompetence or was it something worse? We now have a 450 page report (with only minor portions redacted) describing how the SEC dealt with various complaints against the SEC.

In my first blog post last year, I wrote that:

I could not get away from the feeling that the SEC bungled this investigation very badly. But I also suspect that regulators are much more geared towards dealing with complaints from whistleblowers or other complaints with a “smoking gun” proof rather than some forensic economics that most regulators probably do not understand. Perhaps also the fact that a complaint comes from a rival automatically devalues its credibility in the eyes of many regulators.

I believe that in financial regulation, both these attitudes are completely mistaken. Forensic economics is usually more valuable than “smoking guns” and complaints by rivals and other interested parties are the best leads that a regulator can get.

By and large, the investigation report tells the same story. But I think the report pushes the incompetence story a bit too much to the point where it almost reads like a whitewash job. I counted the term “inexperienced” or “lack of experience” being used 25 times in the report and that count excludes several other similar phrases. When an investigator is a good attorney, the report complains that the person had no trading experience; when the person had trading experience, it complains about his lack of investigative experience.

I am a firm believer in Hanlon’s Razor: “Never attribute to malice what can be adequately explained by stupidity,” but the report’s furious attempt to document incompetence makes one wonder whether it is trying to cover up something worse than incompetence.

At several points in the last few years, the SEC staff appear to have been tantalizingly close to uncovering the fraud. They knew that Madoff was lying to them repeatedly, but their seniors seemed to be unwilling to let them go where the facts seemed to point them. On all occasions, the staff seem to have been intimidated by Madoff’s standing in the industry and within the SEC itself. Repeatedly, the senior staff in the SEC seemed to turn any complaint about Madoff into one on front running even when the complaint was not about front running or explicitly stated that front running was unlikely. Of course, front running was the one crime that Madoff was not guilty of!

The report gives a completely clean chit to the SEC where it really matters:

The OIG did not find that the failure of the SEC to uncover Madoff’s Ponzi scheme was related to the misconduct of a particular individual or individuals, and found no inappropriate influence from senior-level officials. We also did not find that any improper professional, social or financial relationship on the part of any former or current SEC employee impacted the examinations or investigations.

Rather, there were systematic breakdowns in the manner in which the SEC conducted its examinations and investigations ...

While Sandeep Parekh states that he is “impressed that such a self critical report was put up on the main page of the SEC’s website,” the SEC OIG report appears to me to be a report of self exoneration.

My adherence to Hanlon’s Razor remains unchanged, but this adherence is in spite of the OIG report and not because of it.

Posted at 10:52 on Sun, 06 Sep 2009     View/Post Comments (0)     permanent link