December 26, 2008

The Madoff Scandal

Mother Economy not content with the bankruptcy of multi-billion dollar banks in the U.S, has unleashed the latest scandal to hit an already staggering Wall Street. Madoff’s Hedge Fund Scandal. Bernard L. Madoff, the former chairmen of the Nasdaq Stock Market, ran a hedge fund that turned out to be a fraudulent Ponzi’s scheme that racked up to $50 billion. The ripples of the scandal are already being felt with banking giants HSBC holdings of Britain and Santander of Spain losing $1 billion and $3 billion each.

Other major victims are Royal Bank of Scotland Group losing $595 million, hedge fund Man Group losing up to $360 million, France's BNP Paribas losing $466.9 million and Japan's Nomura Holdings losing $302 million.

Another major player who lost money in the scheme is the Abu Dhabi Investment Authority (Adia), the world’s largest sovereign wealth fund which has indirectly invested up to $400 million with Madoff through Fairfield Sentry. Speaking of which, Fairfield Sentry, a part of Fairfield Greenwich Group is the single largest loser of this scandal, has invested $7.3 billion solely in Madoff.

The list doesn’t stop here. It goes on with other victims being charity groups, small time investment managers and real estate groups. As of the latest update, a French investor Thierry de la Villehuchet, the co-founder of Access International which had invested €1.5 billion into Bernard Madoff’s fraud-hit scheme was found dead in his New York office afraid his clients might turn against him in court.

The scandal couldn’t have come at a worse time what with U.S on the verge of a recession and Wall Street giants looking towards a bleak future because of a financial crisis which experts believe might be the worst ever since the Great Depression of the 1930’s.

Now, let’s skip the sad, dull part of the scam and take a look at the interesting part of it.
To begin with, let’s take a look at hedge funds.

When the economy of a nation does good, the prices of stocks in the stock market goes up and they call it a “bull market”. When the economy goes down, so does the prices of the stocks and they call the market a “bear market”. People generally buy shares in a bear market or bull market and sell it in a bull market. Investors generally panic and sell shares during a bear market to stave off any further damage. This is a wrong strategy. You can buy more shares in a bear market for lower prices than you can in a bull market. The best thing to do in these circumstances is wait and see how the market turns up and then decide what to do. For instance, companies like Reliance Industries limited generally perform consistently well until and unless during a financial crisis like the one we have right now. Selling off shares of these companies during a bear market is big mistake. On the other hand, it would be wiser to buy more shares of such companies in a bear market, since it would be cheaper than normal, and then wait for the stock market to go up (It most certainly will. A stock market can fall only so much! Even if it does, it will rebound in a few months, except if there is a financial crisis like the one we have right now in which case it will take a year or two!) and then sell it.

The bull and bear market places a lot of restriction while trading in a stock market. People generally tend to trade only when the stock market does well. What if you want to make money even if the economy is failing?

Hedge fund is the solution. Hedge fund is like betting. There are two basic positions in hedging: going long and going short.

Going long: It is the strategy of buying an asset in the hope that the asset price will rise. For instance, let’s say person enters into a contract to purchase 50 shares of a company, say Microsoft for 10 $ each. Thus, the contract would have a price of $500. The strategy in this is to wait for the share price to go up and then sell the contract early for a profit. Let’s say for instance the market value goes up by 3 $ a share. The value of the contract goes from $500 to $650. The person can sell the contract early thereby making a profit of $150.

Going short: Let’s take the Microsoft example. For instance, a person enters into a contract to sell 50 shares of Microsoft for $10 each. The strategy in this is to sell the borrowed shares immediately, wait for the share market to fall and buy back the shares again for a lower price. The hedge fund manager must immediately sell the shares for $500.If the share price of Microsoft falls down by $3 a share, the fund manager can later buy the 10 shares back for just $350 thereby making a profit of $150.

The problem is you never know for sure if the stock market will fall or rise. Let’s say you enter into a contract for going long. Taking the Microsoft example into account, if the shares prices fall instead of rising, then you end up selling a contract for less money than it's actually worth. Let’s say the share price rises to $8, and then you end up getting $400 for a contract worth $500 thereby incurring a loss of $100!

This is why hedge fund is considered to be very risky. When it comes to dealing with shares in thousands and millions, the loss incurred can be staggering because of why hedge fund managers are paid very high.

Apart from going short and going long, there are many other strategies in hedge fund like, Convertible Arbitrage, Emerging Markets, Dedicated Short, Event Driven (Special Situation), Fixed Income Arbitrage, Global Macro, Managed Futures and Fund of Funds.

This is what Bernard L. Madoff’s hedge fund was all about. At least, this is what he said it was while it turned out to be a giant fraudulent Ponzi’s scheme all the while!

What actually happens in a Ponzi scheme is that that the schemer pays of the capital and returns of investors from the investment of other investors! Confused? It’s quite simple. You must have heard of people say “..Do you want to earn money in a very easy way? Minimum investment and maximum returns? Just sit at home and earn money? Then my scheme is the solution!" The moment you hear this, you can be 100 % sure that the schemer is fraud and you will never get your investment back.

Let’s say you invest. Looking at you, a lot of other people will also do so. You might (If the schemer is happy with his initial set of investors then you might not even get your first installment because he has already absconded with the money) get your capital back with returns. You will then be tempted to invest more and seeing how wonderful the scheme is you will recommend the scheme to your friends too who will also be tempted to invest. This is when the actual fraud kicks in. The money earned from one investment will be used to pay back the returns of another investor. In simple words, the money is just being rotated among the investors. Investment from new investors will be used to pay back returns and capitals of old investors. The scheme will be exposed when investors stop getting their returns. And when does this happen? When there are no new investors.

A scheme similar to this is the Pyramid Scheme.

Madoff’s scheme was a typical Ponzi’s scheme. And it is the most successful and high racked fraudulent scheme ever. The reason why Madoff was able to pull it off was perhaps because of the fact that he was the former chairman of the Nasdaq Stock Market and was able to win the trust of people easily using that as leverage.

What ever the case, it most certainly isn't "MERRY" Chritmas for Wall Street. While everyone in the U.S were hoping Santa would shower them with gifts that might help resurrect the ailing economy, this was totally uncalled for. The impact of this scandal is already being felt, but the full scale consequence is yet to be seen.

1 comment:

  1. Great ! A simple yet clear explanation bout the most talked about fraud. Keep up the good work!


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