Page 2 of 2 Madoff and the folly of blind faith
By Julian Delasantellis
combinations is close to endless; just in the January 2009 contracts, there are
almost 200 individual options on Google that are listed for trading. That makes
for about 40,000 possible two-option positions just in the January Google
options market, and the options for Google go out to January 2011.
On Bernie Madoff's monthly statements, although the less-sophisticated
investors probably didn't know the name of it, was displayed an options
strategy called "split strike conversion". This involved a combination of
buying a put with an exercise, or strike, price below the current market price
of a stock you own, and
selling a call with a strike price above the current market price.
Option strategies such as split strike are frequently called collars, because
they work to limit both the potential losses and gains from a stock position.
Sometimes, a sophisticated money manager will put on a split strike before he
goes off on vacation, so that he won't have to lug a quote machine with him
down the slopes at Gstaad.
One thing that split strike won't do is make you fabulously wealthy - it's not
designed to. It's a fairly conservative strategy, much more suitable for
preventing losses than for making big gains. In this, the strategy is much like
the covered call, the play that frequently introduces new investors to options
trading.
Unsophisticated investors such as Alexandra Penny, what with her undoubtedly
spending all those long days on her back researching a new book, can be
forgiven for being too busy to read an options book that might have warned her
about the improbability that what was on the monthly statements was real. For
these victims of Madoff, the monthly statements, with all those
impossible-to-understand options trades, must have been like the thurible
emitting the clouds of incense at mass; an otherworldly symbol representing the
majesty and mystery of the god behind the altar, on the return address of the
envelope.
The sophisticated investor and money-manager class of Madoff victims will have
a harder time explaining away their idiocy. Split-strike must have been, or
certainly should have been, a question on the final paper in their MBA finance
class; even if it wasn't, they undoubtedly would have access to option
simulation software on their trading terminals that would have shown them the
limited profit potential of the strategy. If that wasn't enough, there was a
smoking gun. In 1999, physicist and math geek Daniel diBartolomeo compared
Madoff's reported returns with another firm executing split-strike trades in
exactly the same manner. No matter how many times he tried, no matter how many
regression analyses he ran, he couldn't explain away Madoff's outsized returns
from the application of Madoff's trading strategy.
In addition to the diBartolomeo revelations, the press is full of others who
had doubts, some of which were reported to the US Securities and Exchange
Commission. With all these red flags, why did the all-sophisticated investors
and money managers hold on, why did they stay in and invest until today's sorry
denouement?
If they had bailed and pulled their money out, how could they have explained it
to their investors? Madoff was still reporting fabulous returns, results that
must have looked even more impressive in today's doleful bear market. How
foolish would they have looked had they withdrawn their money from Madoff's
management to then earn market average returns, while others who stayed kept on
feasting on the fatted calf? They could have told their investors that they
doubted the actual validity of Madoff's returns, but then the investors, while
pulling their money from them to place it with another manager still riding
along with Madoff, would probably have asked what the doubting Thomas knew for
sure that the rest of the market didn't.
But it was also probably true that, along with explaining it to their
investors, the money managers internalized their perception of Madoff's deity.
Had they expressed doubts, it would have put into question the soundness of the
initial decisions to go with Madoff, both with their investors, also, more
importantly, with themselves.
The investment managers who placed money with Madoff, and earned his big
returns, earned the right to be considered among the super investment savants
of the day, true modern-day Medicis (along those lines, Bank Medici is reported
to have taken a $2 billion hit from Madoff.) They bathed in Madoff's reflected
halo - his brilliance was their brilliance.
Selling out would have denied themselves this privilege; they certainly would
have shuddered at the mere thought of being thrown down from the heavens to
land among all those pathetic mere mortals sitting at the kitchen table trying
to find a no-load market index fund with a low expense ratio. Madoff did not
collapse from people having doubts and trying to pull their money out; the
withdrawals that put Madoff in jail were necessitated by losses and margin
calls in the clients' other, non-Madoff investments. Those who kept the faith
would have stayed in until doomsday - if they could.
In July, 2007, Citigroup chief executive Charles "Chuck" Prince, noting how the
flood of liquidity was driving asset prices to record and unsustainable highs,
made this observation that may very well turn out to be the epitaph of the rise
and fall of the capitalist world in this first decade of the millennium, and is
equally applicable to Madoff.
"When the music stops," Prince said, "in terms of liquidity, things will be
complicated. But as long as the music is playing, you've got to get up and
dance. We're still dancing." Probably right up until last call late in the
night on December 10, up on Park Avenue, and all the places to where its
alleged wealth flowed, the frenetic dancing went on and on. It's the hangover
the next day that's the killer.
But it's not like I don't have any good news regarding the Madoff collapse.
Both the press and, undoubtedly, the federal investigators, are trying to
answer two big remaining questions regarding Madoff - what was the total amount
of losses, and where did the money go? Did Madoff manage to squirrel away $20
billion or $30 billion to some secretive Third World banking redoubt, whether
it be Barbados, the Bahamas, Bermuda, Bimini or Basrah?
Since I am fully aware that, while I'm still sleeping in Seattle, the first
thing that those party animals over there at the J Edgar Hoover FBI
headquarters in Washington DC do is to check Asia Times Online, I'll first tell
where all the money went - check Google Maps for the address of "Cloud Cuckoo
Land".
And what was the total amount of the Madoff fraud? Not $50 billion, $75 billion
or a zillion billion trillion dollars, it was exactly $00.00. The reason you
can't find the Madoff money is that it never really existed.
In reality, not one of the Madoff victims are one red cent poorer today than
they were on December 10. They just think they are. But in real money terms,
nothing has changed. Here, like in most of the recent past's economic
circumstances that so bedevil us today, that perception translates into a
powerful reality.
Just like the homeowner who felt himself wealthy when he saw what the houses in
his neighborhood were going for and so went out and bought a Bentley, and now
pulls back on spending when he sees local house values contracting, in the
Madoff affair, much like in the general economy itself, money was this strange,
almost ethereal construct, not dime-store play money, and not an ever-steady
and never-changing storehouse and measure of wealth, but something much more
nebulous and vaporous, ever-existing and amorphous in the nether regions in
between those two polar opposites.
I told my wife about the Chuck Prince quote about dancing while the music
plays. She told me that, when she was a teenager, dances, called "mixers",
would be organized by the local parish, and then aggressively chaperoned by the
nuns and priests. If a couple were dancing too close, a chaperone would come
over advising that they must "leave some room for the holy ghost". It's
unfortunate that, in recent times, when the world capitalist system in general,
and Bernie Madoff in particular, danced, so little room was left for the truth.
Julian Delasantellis is a management consultant, private investor and
educator in international business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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