The Madoff Incident

Wednesday, December 17th, 2008
By George Leong, B.Comm. for Profit Confidential

The year is nearing a close and investors will bid it a fond farewell, hoping for better results in 2009. Yet, with stock markets down as much as 45% this year and with no solid bottom yet in place, we could see more selling to begin the New Year and in the first half. The investment climate remains extremely weak and filled with risk that cannot be pushed aside at this time.

The current market is in chaos. Former Wall Street maverick Bernard Madoff ripped off institutions and wealthy individuals for more than $50.0 billion after carrying out the most elaborate Ponzi schemes in Wall Street history. The word “Ponzi” came from Charles Ponzi, the Italian immigrant widely recognized as one of the biggest con artists in U.S. history. Madoff would use funds paid in by new investors to pay older investors higher returns. The problem was the rising redemptions, which essentially blew the scheme apart, as Madoff was broke and no new capital was coming in.

The success of the Ponzi scheme is mind-boggling considering the size of the losses. How could the SEC or other institutions not discover the fraud? Madoff used an accountant that appeared to be linked to the fraud. Madoff had built a loyal following on Wall Street after his stint as chair of the NASDAQ. He was trusted and held in such high regard that no one every questioned his business despite allegations that he was running a Ponzi scheme in 1999, which were pushed aside.

What Madoff was able to accomplish clearly shows the inter- elationships on Wall Street that have that old boys’ country club feeling. Madoff was part of that club and he bet that no one would question him. In all, it was an impressive scam that should have been uncovered years ago.

The happenings at Madoff’s company could trigger more redemptions at hedge funds and other private wealth management companies. Should this happen, we could see a run of sell orders that could drive stocks lower. With the year-end approaching, pundits expect redemption requests at hedge funds to rise as a way of reducing risk for investors, especially after the Madoff incident, In October, there was $100 billion in hedge fund redemptions. Yet we are seeing more hedge funds freeze any redemptions, as these could force funds to unwind major positions and drive companies into the ground given the lack of fresh capital flowing in.

But while it may be necessary to pursue this strategy, it also seems wrong, as it opens up major investors of hedge funds to additional risk and downside moves in the market. However, investors in hedge funds should have been aware of the risk because of the lack of financial regulation at these firms. Trust and reputation are the key elements of hedge funds. Failure to judge a fund’s manager properly could prove costly, as happened in the case of Madoff.

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George is a Senior Editor at Lombardi Financial, and has been involved in analyzing the stock markets for two decades where he employs both fundamental and technical analysis. His overall market timing and trading knowledge is extensive in the areas of small-cap research and option trading. George is the editor of several of Lombardi’s popular financial newsletters, including The China Letter, Special Situations, and Obscene Profits, among others. His trading advice on stocks and options is also found on his daily trading site, Daily Profits. He has written technical and fundamental columns for numerous stock market news web sites, and he is the author of Quick Wealth Options Strategy and Mastering 7 Proven Options Strategies. Prior to starting with Lombardi Financial, George was employed as a financial analyst with Globe Information Services.