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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Sat, 20 Dec 2008

Madoff, Markopolos and the SEC

The Wall Street Journal has a bland story (subscription required) about the efforts made by a rival hedge fund manager named Markopolos to convince the SEC back in 2005 that Madoff was running a Ponzi scheme. Much more interesting are two documents that the WSJ has put up on its public pages (no subscription required) on this subject: Markopolos’ nineteen page submission to the SEC describing all the red flags about the Madoff operation and extracts from the SEC’s Case Opening Report and Case Closing Recommendation.

I found the Markopolos submission extremely persuasive and well argued. It appears to me to be a good example of forensic economics – the difference being that this is done not by academics (like the Nasdaq market making study) but by one of Madoff’s rivals.

Markopolos’ theoretical argument that Madoff’s alleged option trading strategy would deliver T-bill like returns is absolutely correct. This is what we teach in all derivative courses.

Markopolos also makes a valid argument about the open interest in the exchange traded options being too small to support Madoff’s alleged strategy given the large funds under management. He also points out that OTC option trades on this scale would breach counterparty limits and therefore explicitly requests the SEC to seek trade confirmation directly from the trading and operations teams at the counterparty.

What I found most interesting is Markopolos’s analysis of why Madoff did not set up a hedge fund himself but instead chose to be a white label agent for hedge fund of funds. Markopolos argues that it does not make sense for Madoff to give up the attractive 2/20 fees of a hedge fund unless he has something to hide. He also argues that the arrangement is best described as Madoff borrowing money at 16% interest. It is worthwhile understanding this part of the submission in detail, because the moment one accepts this analysis, it becomes clear that it can only be a Ponzi scheme.

Why then did the SEC miss all this? 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. Regulators should perhaps hire some PhDs in market microstructure and derivative pricing in their surveillance and enforcement departments. Under normal times, PhDs in these fields would probably not want to work in these departments of a regulator, but these are unusual times.

Posted at 19:33 on Sat, 20 Dec 2008     View/Post Comments (4)     permanent link