By Jane Bryant Quinn
Sunday, December 21, 2008
Why do people wind up with the Bernie Madoffs of this world? Because they've neglected one of Ronald Reagan's favorite sayings, "Trust, but verify."
When it comes to Wall Street, I'm not even sure about the "trust" part, but "verify" is where wisdom begins.
Admittedly, Bernard L. Madoff was a hard guy to be suspicious of. Former chairman of Nasdaq, pioneer in electronic trading, a reputation as a trading wizard -- why would you say anything but thanks when he took you as a client? Then he took your money, too, according to civil and criminal charges filed last week. He stands accused of running a long-standing Ponzi scheme, with losses to investors of at least $24 billion and perhaps as much as $50 billion.
Madoff played to two of our most serious weaknesses as investors and human beings.
As investors, we love to believe in market wizards who hold the secret to making serious money. In fact, there's no such secret, but admitting it is like abandoning a childhood faith. Faith propels the money-management business, despite the evidence that managers rarely beat the market indexes, over time. We especially love a fatherly wizard who's close to his children, plays golf, supports caring charities and lays expensive carpets on his office floor.
As human beings, we love status symbols and, to those who knew him, Madoff was status on wheels. Investing with him proved your wealth, position and general superiority to the poor slobs bobbing around on the fringe. His investors believed they were earning steady monthly increases of 1 percent or 2 percent, even when markets went bad. Who would dream of vetting such a prize?
Even if you tried, it might seem that Madoff would have been impossible to catch. But at least two warning signals flashed for anyone to see.
First, Madoff's accounting firm, Friehling & Horowitz in New City, N.Y., was a rinky-dink shop, as a simple Google search shows. The firm doesn't have a Web page. I found it on a junky site that lists local businesses by type and address, along with the boilerplate comment, "rated as good by a New City citizen." That's an unlikely auditor for the $17 billion that Madoff claimed to have under management. When the fraud came to light, F&H turned out to be a tiny office which, neighbors said, wasn't even open all the time. (The office didn't answer its phone.)
Second, Madoff held your securities (or what he claimed were your securities) in his own advisory firm. That's not the way reliable advisers handle publicly traded investments. The custodian should always be a large, independent financial institution that reports cash flows and trading activity to you directly. When you invest new money, you should make out the check to that account.
Even if your mother is your investment adviser, look to the quality of the oversight. You want a major accounting firm checking the books and a brand-name custodian tracking the trades and the amount of money in your account. If that's not happening, something's wrong.
Many questions have yet to be answered about Madoff's operation.
He ran his investment advisory firm separately from the brokerage house and, according to court documents, kept the records under lock and key. The advisory firm had 20 employees -- what were they doing while the money gushed through?
Where was the Securities and Exchange Commission? It has been hearing from whistleblowers since 1999, one of whom directly accused Madoff of running a Ponzi scheme. No one was able to replicate his amazing results with the strategies he said he was using. An SEC investigation as recently as 2007 was closed without bringing charges. It's a startling failure of enforcement. The congressional oversight committees need to find out what went on.
Madoff's big-league advisory money came through three feeder firms that operated funds of hedge funds and vetted managers for clients. One of them, Fairfield Greenwich Group, brags on its Web site that it offers "superior hedge funds" and "selectively identified external managers." How much did these feeder firms earn from Madoff's business? How come they didn't hire someone to trot down to New City to see who was auditing the books? Fairfield said it was "shocked and appalled by the news." I'll bet.
When the story broke, a number of hedge-fund advisers came forward to say that they had looked at Madoff's operation and warned people off. His steady-eddie returns were just as suspicious as his choice of accountants. The advisers who fell for him have a lot to answer for.
Madoff's probably won't be the last fraud to surface, as Wall Street's tide goes out. If your money is under management, you might Google its accounting firm and custodian, just in case. Move your account if anything looks wrong. The cash can sit in a money market fund while you regroup.
Also, give your ego a reality check. There's nothing more gratifying than being asked to play with the big boys, but they can lose a few million and go on. Maybe you can't. At that so-called "sophisticated" level, you get far less protection than the average Joe the Investor gets in a mutual fund.
I once asked one of America's super-rich women what the hardest thing was about managing wealth. "Avoiding fraud," she said. It never arrives in the obvious form of a carnie barker. It's always someone like, well, Bernie Madoff, solid, smiling, generous, and with an arctic heart.
Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. Alexis Leondis contributed to this column.