Wednesday, December 17, 2008

The Madoff fraud fallout - will it enmesh even more people (including ourselves) 

The Madoff fraud on Wall Street, all 50 thousand million US Dollars of it, may get even worse if the Bayou Fraud precedent works as some people think it does.

Basically Bayou was a pyramid scam that blew up in 2005 with a mere 450 million US Dollars wiped out for ‘investors’. In cleaning up that mess, the precedent established in US law was that people who got out of the pyramid investment before it collapsed (and so made profits) had to pay back their gains. And people who invested in those investors even if the never themselves took a cent directly out of the pyramid trough are also liable, without limit.

This is on top of the massive legal uproar around dealing with just the first visible slice of losses.

As Mark Gimein says in his 16 Dec ‘The Big Money’ column in ‘Slate’:

The Bayou precedent means that the discovery of a huge fraud leads to a whole chain of liabilities that stretches back for years and may hit investors who hadn't dealt with Madoff in a decade. A few folks who think that they've lost everything may, at the end of the process, get back some portion of their money. But many others who thought they'd escaped, or didn't even know they had any link to Madoff, will turn out to have huge losses.
The fallout from the Madoff fraud for fund managers like Tremont and Fairfield already reaches into the billions of dollars. But that's not the end of the line. Even if the funds lose all the money that they had invested with Madoff when the fraud is revealed, they could still be on the hook for any money they'd taken out in earlier years. The managers—and the parent companies, such as Oppenheimer Funds, which owns Tremont—are likely to be asked to give back any money they thought they earned for their “success” in earlier years. Meanwhile, any funds that did manage to pull their money quietly out of Bernard Madoff's safe before the scam blew up could see their current and even future investors facing demands to give it back.
And he concludes:

Now that the scam's been revealed, for Madoff, it's the end. But for the grand saga of litigation that will pit Madoff's hapless investors against each other and probably make Charles Dickens' Jarndyce vs. Jarndyce look like days in small-claims court, this is just the beginning.

The Bayou precedent may actually help explain why the regulators were so blind to the situation

On this side of the pond a shiver of apprehension – what is the state of the law on this in the UK? The Royal Bank of Scotland for example has already signalled a preliminary burn of £400 million from its dealings with Madoff– is it (and it new UK taxpayer underpinning) liable to even more calls on its funds? Possibly unlimited.

And for this Party an unwelcome legal shadow perhaps over the dirty fallout from the ‘Michael Brown donation’. Is it remotely possible that the ‘Bayou Precedent’ might be shoehorned to apply to that unhappy event?

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This case blows a massive hole in the argument that those involved in investment banking are very clever people whose cleverness is "creating wealth" and who therefore deserve huge salaries and bonuses.

As we can see, these very clever people paid huge amounts for their cleverness had no idea how this money was being made, the idea that they do detailed research and use all sorts of clever knowledge which really is "creating wealth" is nonsense. The research and intelligence they used here was nothing more than "this guy is making 10% returns, so we'll invest in him". Well, come on, we could all do that. I suggest someone whose investment skills involves looking up return rates, putting money there, and nothing else is worth the sort of salary a low level admin type would get - say £30K max.
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