At the end of last week, news broke that Bernard Madoff, a former chairman of the Nasdaq -- now Nasdaq OMX Group (NASDAQ:NDAQ) -- had been heading up a $50 billion Ponzi scheme. This scandal raises numerous uncomfortable questions for regulators and professional investors who were burned. However, even though we could end up looking at the largest Ponzi scheme ever perpetrated, I can assure you that this is only the tip of the iceberg.
There will be others
We'll see several fraudulent schemes coming undone over the next 18 months. Why? Because things cannot turn out differently. Financial bubbles are always accompanied by a multiplication of frauds, and we are now unwinding one of the largest bubbles in history. In the run-up of a bubble, greed and uncontrolled enthusiasm snuff out skepticism and prudence. Such an environment is ideal for confidence men (and women) to ply their trade.
Due diligence for dummies
In this case, however, the number and prominence of the red flags is startling: silky-smooth returns over long time periods, a willingness to forsake hundreds of millions of dollars in performance fees to avoid the hassle of administering hedge funds, fund accounting provided by a "hole-in-the-wall" accounting firm -- it's all there. Descriptions of Madoff's operation read like a cheat sheet out of Investment Fund Due Diligence for Dummies.
This isn't a case in which hindsight is 20/20, either. Members of the finance community were pointing out all of these elements long before the fraud was revealed. In 1999, a finance professional named Harry Markopolos wrote in a letter to the SEC that "Madoff Securities is the world's largest Ponzi scheme." He took the words right out of Madoff's mouth!
Collateral damage
Madoff's fraud is a further blow to the financial sector's reputation. Thankfully, however, I have seen no reports that prominent U.S. companies such as Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C) or Bank of America (NYSE:BAC) have any exposure to it -- contrary to major international institutions including HSBC (NYSE:HBC), Nomura, BNP Paribas, and Grupo Santander.
Nevertheless, numerous groups will need to give an accounting of how they came to invest with Madoff to their clients and shareholders. For everyone else, the SEC owes a public explanation of how a blatant fraud of this magnitude was able to continue unhindered for so long.
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