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Saturday, January 24, 2009

More Bernard Madoff Observations

Since his Ponzi scam was discovered, Bernard Madoff is required to give up all his property. All his bank accounts and assets were frozen. They will be sold, and the profits used to pay victims and their lawyers. (Most of the money will probably go to lawyers.)

There was an accusation that Bernard Madoff mailed more than $1M in jewelry to relatives! This is a clever way of dodging the ban that froze his assets. Instead of forfeiting $1M to creditors, he managed to save an extra $1M!

This illustrates the value of investing in gold and silver. You can give your property to other people, without the State leeching it. If it were a $1M check, Bernard Madoff could not have done it, because there'd be a paper trail. By mailing jewelry to relatives, there's no trail. He can claim he forgot what he mailed to whom!

Allegedly, investigators found a bunch of checks in Bernard Madoff's apartment that were never sent. These checks were for quite a huge sum of money. Knowing his Ponzi scam was coming to an end, Bernard Madoff was attempting to unload the remaining money in his fund. For example, if his fund had liabilities of $50B and assets of $100M, he was attempting to spend the remaining $100M before he got caught.

Also in the Madoff scandal, there's a lot of cries "Why didn't the SEC catch the fraud and stop it?" Bernard Madoff was a politically connected insider. If a SEC investigator asked too many tough questions, Bernard Madoff probably could have gotten that investigator fired.

Bernard Madoff got away with breaking many rules. For example, he was his own broker and clearing firm. Most hedge funds use a third party as broker and/or clearing firm. If you clear your own trades, that opens the door wide open for fraud. This allowed Bernard Madoff to cover up his fraud.

The Bernard Madoff scandal is a big deal, because most of his victims were relatively wealthy people. Bernard Madoff was stealing from other politically connected insiders.

The SEC has a monopoly for investigating securities/investment fraud. The SEC completely failed in the Madoff scam. There is no cry for "Abolish the SEC! Let the free market do it!" Instead, the SEC is probably going to get more powers and a bigger budget. By failing to do their job, workers at the SEC are going to get a raise and promotion!

That is one fundamental evil with the State. Whenever the State fails to do something that's explicitly its job, the answer is always more power and more resources for the State. Freed from restrictions of market competition, why should it matter if the State does a lousy job or an excellent job?

How would investment fraud be handled in a true free market? First, there would be no limited liability incorporation in a true free market. Bernard Madoff and everyone working with him would be personally liable. His accountants would be personally liable. A broker who advised people to invest would be personally liable. In the present, all these people are protected by sovereign immunity. Freed from limited liability protection, people would be eager to discover potential fraud.

In a free market, nobody would invest in a bank or investment fund unless it were backed by a reputable accounting association. The members of the accounting association would be risking their personal assets if a fraud is discovered. In a free market, asset prices should be stable. Price bubbles and busts are entirely caused by the State. With stable asset prices, it should be easier for a bank to collect on collateral in the event of a default, because the collateral would still be worth approximately the amount of the loan.

Also in a free market, there's a natural limit to how big the size of an investment pool can get. You would see many smaller banks/funds, instead of several huge funds. Then, it would be less of a crisis if one fails.

Notice that only Bernard Madoff is blamed for the fraud. The people helping him are not publicly blamed. A corrupt financial and political system is never blamed. Whenever a State employee commits a crime, the person is blamed and not a corrupt system. (Bernard Madoff is a politically connected insider, making him a State employee.)

Whenever an individual commits a crime and the bad guys want to restrict freedom, the individual's freedom is blamed and not the individual. For example, if a person labeled with a "mental illness" commits a crime, the cry is "He should be forced to take his medication!" instead of "That was a bad individual." (My good ex-therapist said that people with a "mental illness" actually have lower rates of violent crime than the general population, but whenever a "mentally ill" person commits a crime, that fact is hyped as part of the media coverage.)

Also notice that Sabarnes-Oxeley, which was supposed to prevent large-scale corporate fraud, was irrelevant in this case. Bernard Madoff's fund was not subject to that regulation. Insiders will always find loopholes for the law.

Also, Sabarnes-Oxley did not prevent the recent economic bust. Technically, none of those bank executives committed accounting fraud. They were following "generally accepted practices" for valuing illiquid "level 3 assets".

SIPC insurance is being used to cover some of the losses. SIPC insurance is like the FDIC, but for brokerage accounts. Bernard Madoff's fund was incorporated as a brokerage service and not a hedge fund. Approximately $2B of the $50B loss will be repaid by SIPC insurance. In other words, I'm paying higher taxes to compensate Bernard Madoff's wealthy victims.

I heard another weird bit. Suppose you were an investor in the Madoff fund. You smelled a rat and withdrew your money. In that case, other investors in the fund may sue you to collect damages. You don't just have to repay your investment earnings. You also have to repay any money you withdrew.

For example, suppose you invested $10M with Madoff and withdrew $15M. You can be sued for $15M and not just $5M. If other investors in the fund only got repaid 5% of their investment, then you were only entitled to withdraw $0.5M.

In this manner, the State punishes prudent investors!

Another amusing bit is the way the tax law works. Madoff was distributing phony dividend statements to fundholders. Most of them reinvested their dividends in the fund, so the fraud was not discovered. However, they had to pay income taxes on the phony dividend statements!

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