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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Thu, 11 Mar 2010

Law, Madoff, fairness and interest rates

I would grant that there is probably no fair way for the courts to deal with the mess created by the Madoff fraud. But I am intrigued by the discussions about fairness in the ruling of the US Bankruptcy Court about the rights of the Madoff victims.

I have nothing to say about the part of the judgement which interprets the law, and will confine myself to the fairness example that the judge discusses (page 32):

Investor 1 invested $10 million many years ago, withdrew $15 million in the final year of the collapse of Madoff’s Ponzi scheme, and his fictitious last account statement reflects a balance of $20 million. Investor 2 invested $15 million in the final year of the collapse of Madoff’s Ponzi scheme, in essence funding Investor 1’s withdrawal, and his fictitious last account statement reflects a $15 million deposit. Consider that the Trustee is able to recover $10 million in customer funds and that the Madoff scheme drew in 50 investors, whose fictitious last account statements reflected “balances” totaling $100 million but whose net investments totaled only $50 million.

The judge believes that Investor 1 has no net investment “because he already withdrew more than he deposited” while Investor 2 has a $15 million net investment. Since the recovery of $10 million is 20% of the $50 million net investment of all investors put together, Investor 2 is entitled to $3 million and Investor 1 is entitled to nothing.

The court states that Madoff apparently started his Ponzi scheme (“investment advisory services”) in the 1960s. Since the fraud was exposed at the end of 2008, the Ponzi scheme went on for maybe 40 years. Let us therefore take “many years ago” in the judge’s example to mean 20 years ago.

Between 1988 and 2008, the 3 month US Treasury Bill yield averaged a little over 4% so that the present value of Investor 1’s $10 million at the risk free interest rate would be about $22 million. After the withdrawal of $15 million, there would still be $7 million left – a little less than half of Investor 2’s $15 million. If you believe in the time value of money, Investor 1 should get a little less than half of Investor 2. The judge thinks Investor 1 should get nothing.

Alternatively, if you believe that the purchasing power of money is important, then the US consumer price inflation during those 20 years averaged about 3%. The $10 million that Investor 1 put in two decades ago would be worth $18 million in 2008 dollars and Investor 1 would still have $3 million of net investment left after the withdrawal of $15 million. Yet the judge thinks he should get nothing.

Posted at 15:08 on Thu, 11 Mar 2010     View/Post Comments (0)     permanent link