The Madoff Fall-Out...

In my Money Week column this week, I've been writing about what the long-term consequences of the Bernard Madoff affair will be for the investment industry. Here's a taster....

Not much in the financial markets can ever be stated with any real certainty. Still, here’s one prediction you can take to the bank. Bernard Madoff isn’t going to be back in the investment business any time soon.
On Monday, a New York court sentenced the world’s most accomplished fraudster to 150 years in jail. It is safe to say that he won’t ever be released.
That at least is some measure of justice. The full scale of Madoff’s fraud may never be finally known. At its peak, Madoff’s firm had $65 billion under management. In the court hearings, some allowance was made for redemptions, but it was estimated somewhere between $10 billion and $20 billion went missing. Since many of his investors came via discreet Swiss private banks, and they are likely to ever go public with the scale of their losses, we may never know exactly how much money disappeared.
His legacy won’t just be felt by the unfortunate investors who had money in the fund. It will ripple out into the entire investment industry. The Madoff affair has exposed whole swathes of the financial services industry to be built on the flimsiest of foundations, surfing on hype, promises and hot air. It has revealed often shockingly lax standards of checking and breath-taking naivety. It was the greatest Ponzi scheme in history. But it was also the greatest wake-up call, an event that is likely to shape the thinking of investors for years to come.
Fairly or unfairly, Madoff will be the lens through which anyone deciding what to do with their money will look at the financial markets. Here are five of the big, long-term changes we can expect to see as the dust settles on the Madoff affair.
One: Hedge Funds.
Madoff, of course, wasn’t really a hedge fund manager. He just banked all the money, and occasionally paid some of it back to people who asked for it. But that was how he described himself, and there is little question that he rode the boom in hedge funds over the past decade. Very few hedge fund managers are fraudsters like Madoff. Most of them are perfectly capable of losing their clients money whilst sticking scrupulously to the letter of every law. But many use similar marketing techniques. They wrap up their strategies in an air of mystery, the way Madoff did. They trade on contacts and social cachet to raise funds, just the way he did.
There is nothing fair about tarring them with the same brush – but then nobody ever claimed business was fair. In reality, the collapse of the Madoff scheme is going to make it very hard for anyone to go around claiming some secret but brilliant system for beating the markets. And that is going to make life much harder for the whole hedge fund industry.
Two: Private Banks:
It is probably no accident that much of Madoff’s money came from the private banks and the wealth management industry. For the last decade, private banking has been one of the most lucrative corners of the financial markets. Managing money for the wealthy has been an easy way for banks to lift their profits: they have more assets to play around with, and they are a lot less likely to complain about the fees.
The pitch from the private banks was that they could steer their clients through the treacherous minefields of the financial markets. That, however, is looking like a fairly ridiculous boast right now. Many steered their clients straight into Madoff’s fund, despite numerous warning signs. In the light of that, many of the wealthy are likely to decide that they can do without the fancy cheque book that comes with a private bank account. They can stick with the Bognor Regis Provident Mutual for their current account, and manage their own investments themselves – they aren’t likely to make as much of a hash of it as their private banker.
Three: Regulators:
The Securities and Exchange Commission in New York looks the most exposed from the Madoff scandal. It was warned about his firm, but failed to act. But regulators around the world are going to be studying how they missed the greatest fraud of all time for so long. The problem was clear enough: Too much box-ticking, and not enough looking under the bonnet by people who actually know how the markets work. If that lesson is learned – admittedly a big if – then the scandal could pave the way for an overhaul of the way the financial markets are regulated.
Four: Investors:
Nobody likes being ripped off. In the wake of the Madoff affair, anyone putting money into a fund is going to ask much harder questions. They’ll want to know where it’s being invested and why. Any kind of ‘too good to be true’ promise isn’t going to work.
The lesson that investors are likely to take away from the affair is that if you don’t understand it, don’t invest in it. That is going to make any kind of complex financial instrument a very hard sell.
Five: Scepticism:
Throughout the financial markets, Madoff’s overall legacy is likely to be a far greater level of scepticism. He traded on a sense of sophistication, of giving people access to a closed world, and deflected hard question with a sense that it was improper to ask too closely how the returns were generated. Right across the industry, everyone is going to be asking far harder questions, probing for weakness, and looking for potential frauds. Whether a firm is honest or dishonest, there will be far fewer places to hide.
In the wake of Madoff’s imprisonment, both investors and regulators are going to be a lot more dubious about the claims of money managers. That is no doubt a good thing. But at $65 billion, it was an expensive way to learn what should be a pretty simple lesson.