Tuesday, February 24, 2009

Madoff's Lucky Investors

Quick quiz: Would you be better off today if you had invested a half-million dollars a year ago in: a) Bernard Madoff’s infamous Ponzi scheme or b) AAA blue chips such as General Electric, AIG, Citibank or Bank of America?
The answer is, believe it or not, a). It was supplied last week by Irving Picard, the trustee liquidating Madoff's investment firm who, after examining Madoff’s records over the past 13 years, revealed that Madoff was a total fraud who. instead of buying any securities for his victims. swindled them out of their money. This is great news for his investors since it makes them eligible to collect 100 percent of their losses from the Securities Investor Protection Corp, an exchange-backed fund, which indemnifies investors against fraud up to $500,000 per investment account. So if our hypothetical investor was lucky enough to have invested $500,000 with Madoff, he would have zero loss. If on the other hand, he had been unlucky enough to invest this nest egg in the blue chip AAA blue chip selections, he would have lost at least 80 percent of his money (or up to 95% with AIG). So he would be out at least b$400,000. Making matters worse for our blue chip investor would be his tax situation. According to the U.S. tax code, a maximum of only $3,000 a year from an "investment capital loss" can be deducted against ordinary income. So if the unfortunate investor had no investment capital gains to offset the loss, it would take him over 133 years to fully deduct it from his taxes.
On the other hand, even if an investor put more that $500,000 an account with Madoff, the loss (beyond the $500,000 the investor gets back) is, thanks to an odd feature of the US tax code, a theft loss, and can be deducted dollar for dollar from his other non-investment income at present or for the past three years. So, under almost any scenario, an investor with taxable income he would be better off swindled by Madoff than having invested in General Electric, Citibank, AIG or Bank of America. Alas. as the Bonpartist Antoine Boulay de la Meurthe famously said of the assassination of the Duc d’Enghein. "It is worse than a crime, it is a mistake."

Monday, February 23, 2009

A De Beer's Nightmare

Diamonds, alas, are not forever. I explain in my article in the International Herald Tribune how De Beer's greatest nightmare is now unfolding.

Friday, February 20, 2009

The Oscar Deception

The 81 th Academy Awards, with its scripted speeches by stars, tearful acceptances, eulogies to the rich and the dead, red-carpet celebrity fashion show, and gold-dipped statuettes, has the same mission that it did when Louis B. Mayer convinced the other studio moguls to create the event in 1927 to: "establish the industry in the public's mind as a respectable institution." Now, televised by ABC in dazzling high-definition color, the evening-long informational will further the long-standing myth that Hollywood is in the business of making great—and original—movies.
This illusion, like all successful deceptions, requires misdirecting the audience's attention from reality of how Hollywood makes its money to a few brilliant aberrations. Take this year's Best Picture nominations: Milk, Frost/Nixon , The Curious Case of Benjamin Button ,The Reader , and Slumdog Millionaire . What all of these films have in common is that they have virtually little to do with the real business of the Hollywood studios, which is global openings on 3000 or more screen of youth-oriented movies that, after a few weeks in the multiplexes, can be mass marketed on DVDs. For the Hollywood elite to choose these atypically adult movies as a public display of its virtue is as absurd as the music industry giving its grammy awards to Mozart, Bach, and Verdim or international oil companies presenting awards to avant-garde artists who happen to paint in crude. While Hollywood studios, or their wholly-owned "independent" subsidiaries occasionally make or distribute artistic and social-commentary films, their principal business is no longer about making movies. It is about creating properties—including TV programs, cartoons, videos, and games—that can serve as licensing platforms for a multitude of markets.
The confusion proceeds from the fact that for the first 20 years of the Academy Awards, the movie business was entirely about movies. In those days nearly two-thirds of Americans went to a movie in an average week, and all the studios' earnings came from the proceeds of the tickets sold at movie houses. But that was before the advent of television in the late 1940s. Once people could watch sports, game shows, and movies at home for free, most of the habitual audience disappeared. By the late 1970s, U.S. movie theaters, which had sold 4.8 billion tickets in 1948, sold only 1 billion. Hollywood, on the verge of financial ruin, had little choice but reinvent itself.
The studios simply followed their audiences home. To do this, they first repackaged the movies shown at theaters Pied Piper-style by making movies that visually appealed mainly to children and teenagers and then recycled them into home products, including DVDs, TV shows, games, and toys, which, in 2008, produced some 80 percent of their revenues. In this business model, alas, art, literary, and social-commentary movies are marginalized, since they cannot be either turned into licensing franchises or used to lure huge opening-week audiences to theaters. And, as satisfying as these more artistic films may be to directors, writers, actors, and producers, they do not lend themselves to sequels, prequels, or other licensable properties. They do, however, perform one function very well: acting as decoys at Hollywood's annual celebration of itself.

Tuesday, February 17, 2009

The Myth Of The Lost Generation

"If you delay acting," President Obama warned Congress this month, "you potentially create a negative spiral that becomes much more difficult for us to get out of. We saw this happen in Japan in the 1990s… and as a consequence, they suffered what was called 'The Lost Decade' where, essentially… they did not see any significant economic growth." Actually, Japan’s GNP grew by nearly 10 percent during the 1990s. While such growth is meager, it was only part of the story. Before the United States rushes headlong into printing several trillion new dollars, with all the risks that entails of debasing the currency it is worth considering what was really lost in Japan’s "lost decade."

On the bleak side, Japan lost jobs. Its unemployment rate during these 10 years averaged 3.6 percent which, while high for Japan it was lower than any other country in the G-5 which, like Japan, had to compete with the surge in cheap-labor exports from China in the 1990s, In 1995, the midyear of the decade, while the unemployment rate was 3.2 percent in Japan, it was 5.6 percent in the US, and well over 8 percent in Germany, Britain France. Italy, and Canada.

What Japan did uniquely lose in the "negative spiral" was the incredible price froth that accompanied the 1980a bubble. At its height in 1989, real estate in Tokyo sold for as much as $139,000 a square foot– more than 350 times as much as choice property in Manhattan. Such valuation made the land under the Imperial Palace in Tokyo notionally worth more than all the real estate in California. The Japanese stock market, with some shares selling for a thousand times their earnings, similarly skyrocketed. Indeed. In 1989, the notional value of the stocks listed on the Tokyo exchange not only exceeded all the stocks in America, but represented 44% of the value all the equities in the world. When the bubble burst– as all bubbles do– real estate lost about 80 percent of their former value, and stocks plunged about 70 percent. As a result, the banking system that had extended virtually unlimited credit on pyramids collateral based on these assets, were left, if not insolvent, paralyzed. To the extent that the heady prices of the late 1980s proceeded from a wild flight from reality, their fall represented a cruel regression to the norm.

On the bright side, Japan had no inflation during this decade. So while the Japanese could no longer relish the fantasy that the land under their Imperial palace was worth more than the state of California, they could now more easily afford to buy homes, burial plots, and golf club memberships in Tokyo. The Japanese currency also was not debased in the crises, and a strengthening yen made vacations abroad and foreign imports (including fuel) far less expensive. The Japanese also continued to save. Unlike in America, in which the personal savings declined to a mere 5 percent in the 1990s (and became negative by 2005), Japan’s personal savings rate remained over 20 percent, providing some cushion of safety during this era. And Japan’s life expectancy rose in the 1990s to over 80 years, the highest of any major country, and 5 years longer than that of the United States.

Nor did Japan lose its advantage in international trade. Its automotive manufacturers, with the help of new hybrid and other fuel-efficient engines, gradually displaced their American competitors in world markets. Its electronic manufacturers, launching DVD players, digital camera, and high-definition TVs, changed the global face of home entertainment. Its state-of-the-art robotics and machine tool industry meanwhile provided China with the technological backbone for its economic boom. So even without "significant" growth in this decade, Japan remained the second largest economy in the world.

What was really lost in the crash was a popular delusion– the assumption that something as transient as the notional price of assets had enduring value. Once this illusion was brutally shattered, not even ten government stimulus packages, which totaled more than 100 trillion yen and caused public debt to exceed 100 percent of GDP, could resurrect it.

Monday, February 09, 2009

Harvard's Casino Investing

Harvard Management Corporation (HMC), which runs the world’s largest endowment fund, has had until recently an incredible record. Over the past six years, it succeeded in more than doubling the notional value of Harvard’s wealth to a $36.9 billion in fiscal 2008 (which ended on June 30th) even after paying for about one-third of Harvard’s operating expenses. So its recent loss of $8.2 billion between from July 1 through Oct. 31 2008 came as a stunning blow . This huge loss, as staggering as it sounds, may only be the tip of the iceberg of illiquid investments. According to a source close the Harvard Management Corporation, the damage, if the fund’s illiquid investment are realistically appraised, may be closer to $18 billion.
The lack of clarity as to size of the loss proceeds from the illiquid nature of the financial exotica in which Harvard is now heavily invested. Its team of highly incentivized money managers– who themselves earned $26.8 million in 2008– adopted a strategy aimed at taking maximum advantage of an inflationary global boom in the early 2000s by shifting the lion’s share of Harvard’s money from conventional endowment assets, such as bonds, preferred stocks, Treasury bills and cash, into more esoteric investments that would presumably rise as more money chased after scarcer goods. They bought, for example, oil in storage tanks, timber forests, and farm lands. While by the proliferation of trillions of dollars worth of sub-prime mortgages further expanded the bubble, driving up the price of oil, lumber and land rose, the notional value of Harvard’s portfolio soared. The price of oil, for example, which Harvard and other speculators were storing, more than quadrupled to $153 a barrel on commodity exchanges, allowing Harvard to hugely appreciate the notional value of its portfolio. So, between fiscal 2003 and 2008, Harvard’s "real assets" showed a gain of nearly 25% annually. But even after the subprime mortgage crisis began to unfold and a number of financial institutions. Including Bear Stearns had collapsed, Harvard’s money managers persisted in focusing on countering the risk of "continued longer term inflationary pressures - exacerbated by supply/demand considerations for various commodities."
Consequently, as late as June 2008 , the fund kept no reserve of cash or treasury bills and allocated a mere 6 percent of its money to fixed interest bonds. It also borrowed over one billion dollars to amplify the returns on its less conventional investments. So, by the time the bubble burst in the fall of 2008, only a small fraction of the endowment fund investment was even under the jurisdiction of the SEC. According to the 13F holding report it filed with the SEC in September 2008, Harvard had only $2.86 billion of its funds in exchange-listed stocks, options or other derivatives. What had happened to the rest of the more than $35 billion* it had allocated to investments at the start of Fiscal 2009 (in July) 2008?*
[*- From the $36.9 it had on June 30th, it had distributed $1.6 to the University which financed one-third of its budget, and another $200 million went to pay to HMC for the costs or administration and bonuses.]
Most of the balance had been allocated to investments, which if not totally illiquid, could not be valued by market activity. The breakdown that follows illuminates how far HMC had strayed from the path of traditional endowment investing.
More than a quarter of Harvard’s funds were still sunk in "real assets"; 8% in stockpiled oil, 9% in timber and other agricultural land, and 9% in real estate participation. Then came the financial crises, and prices plunged. Oil fell to under $40 a barrel. Lumber suffered almost as badly. And, with the drying up of bank lending, the value of its real estates holding became at best, problematic. One indication of how steep the loss may be is that CalPERS, the giant pension fund of the California Public Employees’ Retirement System, which owned even more real estate acreage than Harvard, reported in this period a 103% loss on real estate deals in which, like Harvard, it had borrowed to amplify its profits.
Another huge portion of Harvard’s endowment had been farmed out to hedge funds (18%) and private equity funds (13%). While these funds provided some diversification, many of them also impose restrictions on withdrawals, including ones, like Citadel, that suffered substantial losses. To get back its money under such circumstance, it was often necessary to sell at a steep discount to a "secondary" hedge fund. One major player in the private equity business tells me that Harvard had tried this Fall to sell its private equity stakes at 30 to 35 percent discounts but find no buyers even at those prices. Even worse, the typical private-equity fund has a provision for "capital calls," requiring investors to put up another 50 cents to 75 cents for every dollar they already have committed. If so with Harvard, the $4 billion it has allocated to private equity may not only o be drastically reduced in value, but might lead to a massive drain on its remaining capital.
Harvard also allocated nearly $4 billion, or 11% of its fund, to volatile emerging markets, such as Brazil, Mexico, and Russia. Here its money managers bet both that the stocks would go up and that the local currencies would at least hold steady against the dollar, but lost on both counts. First, the thin local stock markets, which had little liquidity, collapsed in the financial crises. For example, Russian stocks, lost almost 80%, of their value in a mater of days. Then, as banks and hedge funds, got out of their currency trades, the local currencies in many of these countries also lost heavily against the dollar. The Brazilian Real, for example fell about 40% . So the endowment fund took a double hit.
Aside from emerging markets, Harvard had invested another 11 percent if its portfolio in more established foreign economies, as those of Britain, Germany, France, Italy, Australia, and Japan. But here the stock markets declined, and, with the exception of the Japanese yen, so did their currencies.
Given the true cost of getting its money out of the hedge funds and other illiquid investments, my knowledgeable source finds the claim by Harvard’s money managers that the fund only lost 22 percent at best "purely pollyannaish." But while Harvard’s money managers may chose to look through rose color glasses at the value of their portfolio , Harvard University, which relies on the interest from distribution from its endowment to fund one-third of its operating budget, needs to be more realistic. As its President, Drew Faust, noted in letter to the Harvard faculty, "We need t\o be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraint."
To be sure, Harvard Management Corporation flight to illiquid assets strategy did not occur in a vacuum. Harvard’s money managers developed their ideas taking advantage of their "connections to Harvard University researchers and professors," as they say in the 2008 annual report. Up until mid 2006, Larry Summers, a former deputy secretary of the treasury (and now the head of Obama’s Economic Council, was Harvard’s President While it is not known what, if any, direct liaison Summers had with the Harvard Management Corporation,, he seemed to endorse its strategy in 2006 at a speech at the Reserve Bank of India in Mumbai when, citing the high returns that college endowment funds then had been achieving, argued that "By investing in a global menu of assets U.S. institutions have earned substantial real returns over the years."
Nor was Harvard alone in moving from traditional investments to a more"global menu". Yale’s endowment fund, which with $22.5 billion in assets in 2008 was second only to Harvard’s, followed a similar strategy of finding alternate investments including hedge funds, private equity funds, physical commodities, and emerging markets. Its longtime manager David Swensen indeed makes the argument in his book "Pioneering Portfolio Management" that diversifications of this kind are safer than just investing traditional stocks and bonds. And during the decade preceding the present financial crises his fund actually outperformed Harvard’s. But despite his efforts at diversification, Yale lost at least 25% of its fund in the fall of 2008 if one , takes into account the plunging value of its illiquid assets.
Up until the financial crises, comparative endowment fund performance became the financial equivalent of athletic rivalries, with Yale President Richard Levin, for example, pointing to the 2007 results (which beat Harvard), bragged, "The stunning thing is how much we outperformed other endowments," While Harvard, using other yardsticks, noted in its 2008 report that its "annual outperformance... easily places Harvard in the top five percent of all institutional funds." Hoping to match Harvard and Yale’s dazzling records of multiplying the notional value of their endowment funds other universities across the country, who, followed suite, plowing much of their endowment funds into financial exotica and other illiquid assets. In 1995, endowments had less than 10% of assets in these alternative type investments; by 2008, that average had climbed to more than 30%. Consider the plight of Columbia University. As oft June 2008, 41% of its $7 billion endowment fund was in hedge funds and 40% in private equity funds, and is liable for another $1.6 billion in capital calls up until 2012 (which would wipe twice over all its stock, bond , cash other liquid investments.) The collateral damage is yet to be fully reckoned, but the damage is beginning to show. In December 2008, Berkeley Chancellor Robert J. Birgeneau warned in a letter to students and faculty, "As of today, we are already seeing that the leading private universities have experienced significant drops in the value of their endowments and are engaging in severe budget cuts." So institutions of higher education, like other speculators seeking enormous profits in what is essentially a zero-sum game, learned the sad lesson that playing for high stakes in the casino economy inexorably entailed the risk of catastrophic losses.

Was Mike Milken Right?

Michael Milken, the financier who revolutionized corporate finance in the 1980s, based his entire concept of junk bonds, on what he claimed was a "fundamental flaw" in Wall Street’s financial structure: the trust it had in the ability of three ratings services– Standard & Poor’s, s Moody's and Fitch Ratings– to evaluate the relative risk of bonds. Since SEC rules prevented anyone else from supplying bond ratings, these rating services had (and still have) what is tantamount to a global monopoly on issuing bond ratings. When one or more of these services give a triple-A rating to a corporate bond, it certifies that there is virtually no risk of default, This seal of approval allows Wall Street underwriters to sell them to insurance companies, pension plans, college endowments, and other institutions, many of which are restricted by regulations from buying bonds with a lower rating that triple-A. In other words rating services determined which corporations are eligible for institutional bond financing.
When I interviewed Michael Milken back in 1987, he railed against the rating services, zeroing-in on Triple-A rated banks such as Citibank. His scathing analysis went as follows: "What is a bank?" he asked rhetorically. "It is nothing more than a bunch of loans." " How safe are these loans?" he continued.
"They are made mainly to three groups that may never repay them in a real
economic crisis-- home owners, farmers and consumers of big ticket items." "What
guarantees these loans?" "Very little since these banks usually have $100 in loans
for every dollar of equity." He pointed out that a number of states such as California required that all home loans be non-recourse loans, which means that the only collateral is the home itself (making them little better than what would later be called sub-prime mortgages.) "Yet,their bonds get a triple-A ratings from the bond rating services." ne continued. "This is crazy" because rating services measure "the past not the future" risk.
Soon afterwards, the financial establishment trounced on Milken. Faced with endless litigation. He pled guilty to the five counts of financial transgression, and went to prison for 22 months. But his downfall did not answer the critical issues he raised about the rating services.
That was two decades ago. Since then the rating services have extended their
Triple A ratings to debt packages, such as Collateral Debt Obligations (CDOs) that
included subprime mortgages and other questionable loans. Since they get much
higher fees for rating complex debt pools than for plain vanilla corporate bonds,
this expansion into CDOs has proved incredibly lucrative for them. Moody's,
which is partly owned by Warren Buffet’s Berkshire Hathaway, raked in over $3
billion in fees from 2002 until 2006 for providing these ratings. Standard &
Poor's meanwhile escalated this race into the abyss in 2000 by extending
their top ratings to "piggy-backed" CD0s. Appropriately named, piggy-backed CDOs multiplied leverage by allowing buyers to simultaneously take out a second loan to finance the first CDO. The logic was that if the initial loan was Triple A, and there could not default, so was the "piggy-back" based on it. Other rating services followed suit, so as not to lose the rich piggy-back rating business to Standard and Poor’s. The result that CDOs were leveraged over and over again, while maintaining the triple-A rating that made
them appear to be almost as safe as a Treasury bond.
Of course, there is an obvious conflict of interest in this enterprise: the rating services are paid by the companies who issue the securities they rate. Moreover, the rating services admit in their fine print that their ratings are based on the data supplied by the companies seeking the ratings. Nevertheless, wheelers and dealers in Wall Street, London, Dubai, and other financial ports of call so leverage these rated CDOs to such an extent that by late 2008 an estimated 18 trillion dollars in marketable debt hung over what remained of the global financial markets. As we all know now. the ratings proved to be wildly out of touch with reality, and the subsequent collapse of the house of cards built upon them, sapped the global financial system of the crucial confidence necessary for it to function..
If Milken’s critique of the rating services had been taken more seriously
in 1987, we might not now be staring into this back hole today,

Buffet's Darker Side

In the Presidential debates in October, both Barack Obama and John McCain, came up with the same name to save the reeling American economy: Warren Buffet.
Buffet is the chairman of Berkshire-Hathaway, a $120 billion holding company. Known in the media the "Oracle Of Omaha," he had condemned derivative contracts as early as 2003, describing them. "as time bombs, both for the parties that deal in them and the economic system." After derivative contracts on sub-prime mortgages had delivered a near death blow to the financial system in October 2008, he told Charlie Rose in an hour-long televised interview that such derivatives were nothing short of "financial weapons of mass destruction," saying, "They destroyed AIG. They certainly contributed to the destruction of Bear Sterns and Lehman." It light of his lucid explanation of their incredible perils, it seemed gratuitous for Charlie Rose to then ask Buffet if he himself had trafficked in derivatives, If he had asked, the Buffet’s answer might have been surprising since, at the time of that interview, Buffet’s holding company not only had multi-billion dollar positions in derivative contracts but it was the largest single shareholder in one of the principal enablers of the proliferation of sub-prime mortgage derivatives.
As subsequently revealed in Berkshire Hathaway’s third quarter 10-K filing with the SEC in 2008, the Oracle turned out to be one of America’s largest seller of derivative contracts. Not only had he sold over $2.5 billion worth of credit default swaps in 2008– the same notorious derivative contracts that had brought AIG to its knees– but he had sold over $6.7 billion worth of another type derivatives, called "index put option contracts" that essentially bet stock prices would not fall here and abroad. These contracts have a duration of as long as 20 year, and, as the disclosure notes, "generally may not be terminated or fully settled before the expiration dates and therefore the ultimate amount of cash basis gains or losses may not be known for years." Even for the first nine months of 2008, Berkshire’s losses from these derivative already were $2.2 billion.
But Buffet’s involvement in the derivative casino went beyond selling credit default swaps and put options. After Moody’s Corporation, the second- largest credit-rating company, went public in 2000, he had Berkshire Hathaway buy 48 million shares in it– approximately a twenty percent stake– making it by far Moody’s largest shareholder. The role Moody’s was to play in the proliferation of sub-prime mortgage , along with that of the two other rating agencies, Standard & Poor’s and Fitch Ratings, is lucidly described by Nobel laureate economist Joseph Stiglitz in an interview with Bloomberg News: "I view the ratings agencies as one of the key culprits, They were the party that performed that alchemy that converted the securities from F- rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.''
The sad history of Moody’s race to the bottom began after it was spun off by Dun & Bradstreet Corp. in September 2000 and after Buffet had invested $499 million in it. Prior to that, Moody’s was a stodgy company in the low-profit business of evaluating credit data supplied to it largely by triple-A companies. The SEC had given it, along with S&P and Fitch’s, an effective lock on the issuance of credit ratings. So the giant corporations needed to get its top rating (AAA, meaning little or no risk) in order to sell their bonds to insurance companies, pension funds, and other regulated institutions. But with the mushrooming of mortgage-back securities, Moody's found a much more profitable business line: rating pools of mortgages called Collateralized Debt Obligations (CDOs). Working on the theory that if these CDOs were structured into different tiers, it could award Triple A ratings to the safer tiers, which, in turn, would allow underwriters to sell CDOs to institutions, Moody’s made additional money advising the underwriters how to structure their CDOs in such a way so that it could provide top ratings. Once they received these ratings they could leveraged them over and over again via so called "piggy back" loans.
Even though sub-prime mortgages accounted for about half of the collateral on CDOs, Moody's manage through this theory to assign triple A grades to nearly 75 percent of them. In August 2004, to get an even larger share of this business, it revamped its credit-rating formula in such a way that it could issue top-ratings to even a larger portion of sub-prime debt. Not to lose market share, Its chief competitor, S&P, followed suit the next week. By 2006, the market for rated CDOs had exceeded $3 trillion.
This enterprise entailed an obvious conflict of interest since Moody’s was being paid by very companies it was rating, but the profits were so enormous it was overlooked by everyone involved. By extracting almost three times the fees on structured CDOs than it got on conventional corporate debt, Moody’s took in an incredible $3 billion between 2002 and 2006. And since it had operating margins above 50 percent on its rating work, most of this new found El Dorado was profit. When Moody’s stock soared, it increased the market value of Buffet’s stake from $499 million in 2001 to $3.2 billion in February 2007. The Oracle of Omaha thus made $2.7 billion profit from the very "time bombs" he was at the time publically damning. Moody’s ratings meanwhile enabled these derivatives to spread like kudzu throughout the global financial pipelines until the entire house of cards collapsed in 2008. Moody's then had to downgrade more than 90 percent of all asset-backed CDO investments issued in 2006 and 2007, and Buffet, alas, lost a good part of the windfall
It is hardly conceivable that Buffet, who famously prides himself on the scrutiny he gives to companies in which he invests, could not have known that the heart of Moody’s money machine was certifying hundreds of billion dollars worth of CDOs for purchase by banks and other institution. If he didn’t know that, what kind of Oracle is he?

The Silver Lining To Madoff

"You can’t cheat an honest man. He has to have larceny in his heart in the first place."
– W. C. Fields, 1939

Don’t cry (yet) for investors in Bernie Madoff’s grand Ponzi scheme– or at least for those of them who pay taxes. As bad as they may have done in their calculated effort to beat the system by betting with one of the stock exchange’s major market makers, thanks to an odd feature of the US tax code they will probably wind up losing less money than ordinary investors had by buying shares in some of the largest companies on the New York Stock Exchange. If an investor has a net loss in legitimate srock investments, according to the tax code, it is considered an investment capital loss, and the maximum amount he can deduct from his other income is a piddling $3,000 annually. So if he loses a million dollars, it will take him 334 years to deduct it. If, on the other hand, an investor put that million with Bernie Madoff, he could deduct the entire million immediately from other taxes because, as far as the IRS is concerned, it proceeded from a theft, not an investment loss. If the investor was in a 50% bracket– with state and local taxes– and he had other taxable income, his bottom line loss from the million would be only $500,000. Consider, for example, if a prudent investor had bought $1 million worth of shares a year ago in such blue chip stocks as Citibank, Bank of America, AIG, Ambac, General Motors or Barclays Bank, which fell between 81 and 90 percent in value (as of January 19th), which, if he sold them, would leave him with an after-tax loss of over $800,000, or, much more than the loss he would have sustained if he had let Bernie madoff swindle him out of the million.
Even better, to the extent that Madoff’s investors paid taxes on false capital gains booked in their accounts during the prior five years, they are owed tax refunds– with interest. It also turns out that since virtually all hedge fund partners are limited partners, the entity's theft loss flows through to them, and they therefore can also take advantage of the Madoff tax credit for their personal tax returns. So as painful as it is to lose money in a Ponzi scheme is, it is more painful to lose it in a legitimate investments where the loss it is not tax deductible for centuries.
The US government stands to lose a vast amount of tax revenue through the Madoff tax credit– as investors may deduct billions of dollars worth of their loss against other income. But there is also a silver lining for the government. According to my knowledgeable source, Treasury department investigators are now discovering that a great many of Madoff’s investors funneled their money through off shore accounts without reporting them. The IRS thus will be able to level immense penalties on these tax-dodgers for hiding off shore income–even if it was fictive income. But are tax-dodgers really deserving of pity?
The real victims are the tax-exempt players, especially the legitimate philanthropies, that sunk their funds in Madoff’s Ponzi scheme. Alas, they cannot recoup any of their losses. The tragic flaw here was trust. Samuel Johnson adumbrated that danger more than two centuries ago when he wrote about the bankruptcy of merchants, that assumed the splendour of wealth only to obtain the privilege of trading with the stock of other men, and of contracting debts which nothing but lucky casualties could enable them to pay; till after having supported their appearance a while by tumultuary magnificence of boundless traffic, they sink at once, and drag down into poverty those whom their equipages had induced to trust them."