This is one of those weeks where we have so many juicy stories that I truly don’t know where to begin. How about another Madoff story? At last, we have the long-awaited and so richly deserved punishment of ten years in the slammer for Peter Madoff, the brother of the Ponzi King, Bernie Madoff. Whether the two of them will end up sharing a cell remains to be seen. Regardless of whether he was stupidly criminal or criminally stupid, Peter Madoff deserves the title of the very worst chief compliance officer in the history of finance. As part of his plea deal, he has agreed to forfeit all his personal assets (the fruits of $90 million in illicit payments he received) plus an additional $143 billion (yes, billion!) just in case some hidden assets come to the surface. That breathtaking figure is based on the total number of dollars that passed through Madoff’s firm. The next shoe to drop might be Peter’s daughter, Shana Madoff Swanson, who served as a compliance director at the firm and is the target of a $15.3 million lawsuit by the Madoff bankruptcy trustee, Irving Picard. Whoever knew that compliance could pay so good?
Next up on our plate is JPMorgan’s ever-widening loss attributable to the very large and illiquid positions taken by trader Bruno Iksil, aka “the caveman” or more recently “the London Whale.” What started as a mere $2 to $3 billion loss has ballooned to a potential $9 billion according to the New York Times. Perhaps Mr. Market knew something when he docked JPM for about $13 billion of market value on the day that the $2 billion was announced by Jamie Dimon? To put it in perspective, JPMorgan’s first quarter profit was $5.4 billion, and the total profits from the London trading desk over the last three years was $4 billion. The damage that one person can do never ceases to amaze me. Here are my takeaways from this debacle:
1) “Risk management” and “risk controls” at these “too big to fail” banks are meaningless notions.
2) If it could happen at JPM, it could happen anywhere (and rest assured, it will).
3) Higher capitalization requirements are preferable to stricter regulations. These trades were well beyond the ability of the average regulator to comprehend. Sharpies like the London Whale will always be several steps ahead of the regulators.
4) End “too big to fail” once and for all, regardless of the short-term consequences.
To top it all off, we have the Securities and Exchange Commission charging billionaire hedge fund operator Philip A. Falcone and his firm, Harbinger Capital Partners LLC, for illicit conduct that included misappropriation of client assets, market manipulation, and betraying clients. The SEC also charged Peter A. Jenson, Harbinger’s former Chief Operating Officer, for aiding and abetting the misappropriation scheme. “Today’s charges read like the final exam in a graduate school course in how to operate a hedge fund unlawfully,” said Robert Khuzami, Director of the SEC’s Division of Enforcement. “Clients and market participants alike were victimized as Falcone unscrupulously used fund assets [$113 million] to pay his personal taxes, manipulated the market for certain bonds, favored some clients at the expense of others, and violated trading rules intended to prohibit manipulative short sales.” According to the Minneapolis Star-Tribune, Harbinger has suffered $23 billion in losses and investor redemptions from its peak of $26 billion in 2008 and Harbinger’s biggest investment, LightSquared Inc., filed for bankruptcy in May.
Index Funds Advisors has long advised investors to steer clear of hedge funds or as Forbes magazine dubbed them, “The Sleaziest Show on Earth.” More recent information is found in Simon Lack’s book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True. Lack showed that hedge fund investors as a group would have been better off if they had simply invested in Treasury bills, the quintessential risk-free investment. The primary reason for this dismal performance is the imbalance between fees paid to managers and returns received by investors. Lack found that since 1998, hedge fund managers have kept 84% of profits while 14% went to funds of hedge funds as fees, leaving a paltry 2% for investors. Lack himself pointed out to me that this was as of the end of 2010, so the results of 2011 essentially wiped out the remaining 2% of investor profits. While it is easy to find people like Falcone who became rich by operating hedge funds, it is difficult, if not impossible, to find someone who became rich by investing in hedge funds. Lack has an open challenge for anyone who can make this claim to come forward. It has not happened yet.