What Feeder Fund Managers Suspected About Madoff

It turns out that many of Madoff's feeder fund managers--the people who brought much of the money from individual investors into Madoff's Ponzi scheme--had long suspected that Madoff was engaging in illegal activity. According to Bloomberg, they just assumed that they were benefiting from the illegal activity and not being victimized by it. They thought that Madoff was using his position to "front-run" trades by his clients.

The purported mission of such feeder funds was to vet hedge funds for wealthy clients. Instead, the line between victim and perpetrator was blurred. Middlemen like Littaye funneled billions of dollars to Madoff, even, in some cases, when they suspected he was engaged in questionable trading practices. In return, they reaped hundreds of millions of dollars in client fees.

Lower Returns

Wolfer says he heard of traders trying to replicate the split-strike conversion strategy Madoff told investors he used -- buying shares of large U.S. companies and entering into options contracts to limit the risk -- and getting far lower returns. He also says he heard Littaye and other middlemen talk about how Madoff may have used the knowledge he gained from his market- making firm, New York-based Bernard L. Madoff Investment Securities LLC, to get in and out of stocks ahead of market swings.

That’s front-running, a term usually applied to brokers’ trading for their own account -- and profit -- ahead of clients.

It’s also applicable to Madoff’s purported practice, says Peter Henning, a law professor at Wayne State University in Detroit and a former federal prosecutor.

“Front-running isn’t who’s getting the benefit; it’s who’s paying the price,” says Henning, noting that Madoff’s market- making customers expected the firm to obtain the best price available when buying or selling stocks. Instead, their interests were apparently subordinated to those of Madoff’s investment clients.

Front-Running

While front-running is illegal, it didn’t horrify Madoff’s champions.

“They were convinced that the risk was only that the Securities and Exchange Commission would do something about breaches of the Chinese wall in the Madoff organization,” Wolfer says. In the worst case, he says, “what could be expected was that at a certain point the SEC could say stop.”

It was obvious to anyone who looked that something fishy was going on with Madoff's trades:

"An executive at a fund of funds that invested in Kingate says he once examined Madoff’s trading records to see whether they reflected the stocks’ publicly reported activity. He found Madoff consistently bought stocks at their lows and sold them at their highs.

The executive, who wouldn’t be identified, says he reported back to his boss that he thought Madoff was front-running his clients. He says the boss’s reply was 'Yeah, so what? That’s his edge.'"

Why did the manager's of these feeder funds turn a blind eye to what appeared to be blatantly illegal activity and take such risks with their clients' money? Answer, they were raking in huge fees in return for being Madoff's willing accomplices:

"If a fund charged its clients 1 percent of the assets under management and 20 percent of the gains, as the largest one did, that translated into $41 million in annual fees.

Assuming Madoff didn’t do any investing on behalf of his clients, as investigators now suspect, the feeder funds were, in effect, being paid out of principal, which would have been depleted after 15 years.

In other words, much of the money invested in Madoff through feeder funds wound up in the pockets of fund managers."

Barry Ritholtz of the Big Picture is right in part when he says that the Trustee should "confiscate the Funds of Fund managers’ houses, cars, watches, jets and boat — as the illegal proceeds of a crime. Auction ‘em off, put the proceeds into a fund for the scam’s victims."

But the investors don't have to wait for the Trustee to act, and many are not:

"Chais’s Brighton Co.; Bank Medici, which was taken over by Austrian regulators; Fairfield Greenwich; Merkin’s funds; and Tremont have all been sued by investors claiming the firms should have known better than to invest with Madoff."

Target Date Mutual Funds Riskier Than Thought

Poor performance this year of Target Date Mutual Funds has left many investors asking questions about their holdings. Target date funds - also known as a lifecycle or age-based funds - are designed to take decision making out of an investor's hands when it comes to figuring out how to invest for retirement. The idea is you simply put your money into a single fund linked to the approximate year in which you plan to retire. Fund companies say they'll do the rest. The funds are supposed become more conservative as the target date approaches. But many with a target date of 2010 (less than a year away) have been reeling in the market with losses ranging from 15 percent to more than 40 percent to date, according to Barbara Whelehan. Click here for full article. Some funds may have had exposure to high risk bond holdings, CMBS, Swaps and toxic derivatives. According to SmartMoney, Target-date funds are trickier to evaluate than standard mutual funds, carry unique risks, and their lack of transparency is a big problem.

Investors holding funds with a date of 2010 or 2015 with large losses should feel free to contact Sparer Law Group to discuss their investment holdings.

Did Municipalities Overpay For Swaps and Swaptions?

The S.E.C., the Justice Department, and various states' Attorneys General are investigating what may be "one of the longest-running, most economically pervasive antitrust conspiracies ever to be uncovered in the U.S."

Three federal agencies and a loose consortium of state attorneys general have for several years been gathering evidence of what appears to be collusion among the banks and other companies that have helped state and local governments take approximately $400 billion worth of municipal notes and bonds to market each year.

E-mail messages, taped phone conversations and other court documents suggest that companies did not engage in open competition for this lucrative business, but secretly divided it among themselves, imposing layers of excess cost on local governments, violating the federal rules for tax-exempt bonds and making questionable payments and campaign contributions to local officials who could steer them business. In some cases, they created exotic financial structures that blew up.

People with knowledge of the evidence say investigators are not just looking at a few bad apples, but also at the way an entire market has operated for years (emphasis added).

Banks have exacerbated the damage to many municipalities by selling them unnecessary interest rate swaps that have driven some cities and counties to the verge of bankruptcy:

The use of derivatives in connection with municipal bonds has grown rapidly in the last five years. The packages are presented as money-savers to the municipalities, which may want to protect themselves against interest rate changes. But over the last year, as turmoil spread through the credit markets, some of the derivatives have blown up, leaving local governments stuck with unexpected costs.

That happened in Alabama, where Jefferson County linked an extraordinary number of derivatives, called interest-rate swaps, to its bonds, in some cases with the help of CDR Financial. Despite publicized concerns about whether improper payments to certain officials were behind the swaps, the county insisted the swaps were saving money. Last year, the derivatives failed, leaving the county with vast bills. Jefferson County is now at risk of declaring what would be the biggest governmental bankruptcy in United States history.

Even in places where the bonds and derivatives are performing as expected, irate government officials are finding they may have overpaid for various services and have inadvertently broken federal tax rules. Again and again, proceeds from tax-exempt bonds appear to have improperly generated investment income for banks and insurers.

Among the governments that have sued these financial firms are the cities of Chicago and Baltimore; Oakland and Fresno, Calif.; the state of Mississippi; and a number of counties, school districts and at least one water and sewer district. The lawsuits were consolidated in November, in Federal District Court for the Southern District of New York (emphasis added).

Municipalities should examine prior bond offerings and interest rate swap purchases very carefully to see if they have been victimized by this scam.

Constant-Proportion Debt Obligations

Noah Millman, a blogger and Wall Street banker working in structured finance, has posted his eye-of-the-storm view of how banks and ratings agencies worked together to create products that self-evidently never merited their AAA ratings. He provides as an example the constant-proportion debt obligation, or CPDO, which Millman describes as "an ingenious little fraud of a product."

Here’s how it worked.

Some clever structurer noticed that, historically, investment-grade companies don’t default very often. Rather, they deteriorate for a while first, get downgraded to junk status, and eventually they default. That’s why the short-term ratings for relatively low-rated investment-grade companies may be reasonably high: even BBB companies are generally good for the next 90 days; if they weren’t, they wouldn’t be rated BBB. And this suggested the possibility of a trading strategy.

What if you bought a portfolio of investment-grade corporate debt and, every six months, purged it of the bonds that were downgraded to junk, replacing these with new investment-grade bonds. Obviously, you’d expect the downgraded bonds to underperform the remainder of the pool, so you’d have losses you need to make up, so assume you also sell out of a handful of bonds that have done well, and replace these with higher-yielding bonds that are still investment-grade, thus keeping your yield relatively constant. You’d still expect some losses if you wanted to keep your average rating relatively constant, though. So you need some excess yield to make up for these losses.

You find that yield by leveraging the portfolio. After all, it’s an investment-grade portfolio, very unlikely to default in the short term. You can borrow very cheaply short-term, invest in longer-term bonds, and earn the spread differential. If the bonds go against you, that’s OK, because you’re going to hold them to maturity and you’ll always be able to roll your short-term borrowing. And, if you can get a high enough degree of leverage, the excess in current yield from the differential between where you borrow and the yield on your portfolio should more than pay for the cost of rolling out of your losers every six months. And if you do that successfully, you’ve got a trading strategy that never loses principal, but has a surprisingly high expected yield. Sound good?

Well, it sounded great to the ratings agencies, who blessed this strategy by giving it a AAA rating.

How did they justify that AAA rating? By looking at the historic cost of rolling credit derivatives on indices of investment-grade corporate issuers, which generally have a high-BBB rating. These had been around for about three years when the first CPDOs were rated, and the roll had never cost more than 3 basis points. Factoring in that cost, at a leverage of 15-to-1, and using historic 6-month default rates for the portfolio (since the index would be rolled every six months), the proposed trading strategy would never lose money. Hence a AAA rating.

Let me reiterate that, just to drive the point home. The ratings agencies said: you can take a BBB-rated index, leverage it 15-to-1, and follow an entirely automatic trading strategy (no trader discretion, no forecasting of defaults or anything, just a formula-driven adjustment to the leverage ratio and an automatic roll of the index), and the result is rated AAA.

Needless to say, this worked out really well for all concerned. But that’s not really the point. The point is: the notion that you could grant a AAA based on a trading strategy for which there was at best three-years of data (three years that encompassed not a single recession, I’ll note) is mind-boggling. And, worse than that, nobody at the agencies apparently stood up and said, “wait a second: how can you turn a BBB into a AAA by leveraging it 15-to-1? That’s impossible!” Which, of course, it is.

I want to be very clear about something: we’re not talking about a CDO where the AAA investor is providing leverage, and there are subordinate investors below who bear the first risks of loss. This was a trading strategy; the investor in the AAA CPDO had first-loss risk with respect to a BBB portfolio. The trading strategy was just supposed to generate enough returns to create “virtual” subordination to justify the AAA.

When I first heard about this product, I thought: whichever agencies rated this thing have lost their minds. When people asked me whether it made sense as an investment, I said: it’s an outright fraud. You’re practically guaranteed to lose money. I never bought or sold one of these things myself, and neither did anyone else in our group. But the existence of such a ridiculous product should have been a wake-up call about just how divorced from reality the agencies were. And if they were out to lunch on something as straightforwardly absurd as the CPDO, how out to lunch were they on other products, ones that were far more significant to the markets and the economy, where the absurdity of their assumptions was less-obvious? (emphasis added).

These products were offered by, among others, ABN-AMRO. If you invested money in a CPDO, you may want to consider whether the true risks of this product was disclosed to you.

Europe’s Toxic Debt Imperils Wisconsin School District’s Finances

According to Anne Szustek, the Whitefish Bay School Board is now filing a lawsuit alleging misrepresentation against Royal Bank of Canada and Stifel Nicolaus, the companies that sold them Synthetic CDOs.

David W. Noack, an investment banker who had been giving guidance to school boards in Wisconsin for some 20 years, suggested that the Whitefish Bay school board should buy into a series of European investments that he said could only mean steep returns.

The Whitefish Bay School District and four other local school systems spent $35 million and borrowed an additional $165 million from Irish bank Depfa to buy up synthetic collateralized debt obligations, or synthetic CDOs. Synthetic CDOs are a form of insurance that guarantees corporate bonds. Should a company default on its debt, the synthetic CDO steps in to cover that loss.

The only way it would fail? “There would need to be 15 Enrons,” Noack said. It turns out that $200 million of the districts’ pooled funds were used to back $20 billion in corporate bonds. The synthetic CDOs turned out to have been toxic, and the money the Whitefish Bay School District put up is now going toward covering that debt.

Both companies being sued maintain that the school board signed documents knowing what it was getting into. Click here for full article.

New York City Sues Countrywide's Underwriters for Allegedly Helping the Home Lender Defraud Investors.

New York's city and state comptrollers and their pension funds have sued Goldman Sachs Group Inc., Citigroup Inc., JPMorgan Chase & Co. and 23 more underwriters of Countrywide Financial Corp. for allegedly helping the home lender defraud investors.

The state and city pension funds' combined losses due to Countrywide's declining stock price were as much as $100 million, according to City Comptroller William Thompson Jr.

``Investors lost millions and New Yorkers lost their homes,'' New York State Comptroller Thomas DiNapoli said in a statement. ``We need to recover the pension fund's losses and find a way to help all those families.''

Click here for full article.

Merrill Lynch & Co. probed in connection with sales of CDOs to the city of Springfield

Merrill Lynch & Co. was subpoenaed by Massachusetts regulators after the value of collateralized debt obligations the brokerage firm sold to the city of Springfield plunged 91 percent because of losses tied to subprime mortgages.

Click here for the full article.

``There are a whole range of concerns, including how the investments were presented to the city of Springfield and whether these were inappropriate investments for a city,'' Secretary of State William Galvin said. ``We don't want to pre-judge but just want to assess the information.''

The Springfield finance board said it ``believes that Merrill Lynch can and should be held fully accountable for any potential losses.''