Wednesday, August 26, 2009

The Madoff Exception

On September 4th, 2009, the Securities and Exchange Commission’s Inspector General revealed that Wall Street’s watchdog agency failed to adequately investigate six "detailed and substantive complaints" that, if properly pursued, could have exposed Bernard Madoff’s massive Ponzi scheme. The real issue is why the SEC did not pursue these leads?
Clearly Madoff had enormous influence at the SEC. Since the 1980s, he had served on its advisory panels and was constantly consulted by its top officials on issues such as computerized trading. During one investigation of his own firm, he confided to a SEC investigator that he was on "the short list" to be the next SEC Commissioner, which would make him his boss. While Madoff was not appointed to the SEC, that investigation was, as the SEC inspector general points out, prematurely terminated Madoff had become so closely identified with the SEC by the early 2000s that a controversial SEC short-selling exception that benefitted Madoff became famously known on Wall Street as "The Madoff Exception."
Even as early as 1992, Madoff had become such a trusted figure in the eyes of the SEC officials that he was able to help them dispose of what appeared to be a possible Ponzi scheme. The alarm bells were set off when SEC investigators discovered that an unregistered investment company named Avellino and Bienes was offering "100% safe investments" . As noted in the Inspector General’s report, such "high and extremely consistent rates of return over significant periods of time to "special" customers" were viewed by at least 4 SEC examiners as "red flags" of a fraud involving over $441.9 million, which in the early 1990s was a sizable sum in the investment world. Indeed, it was reminiscent of the now infamous Charles Ponzi in the 1920s who paid the guaranteed "interest" to old investors out of the funds of his new investors. Neither Frank Avellino or his junior partner Michael Bienes had been licensed to sell securities, yet they and their associates had sold these guaranteed notes to 3100 investors between 1962 and 1992. The different rates they offered was yet another red flag. Larger investors got a guaranteed annual return of a 20 percent– which in some years was more than ten times the banks’ interest rate– while smaller investors got between 13.5 and 15 percent. Adding to the SEC’s concern, the firm was unable, or unwilling, to produce financial records with Avellino telling the court appointed auditors that he did not keep detailed records because "My experience has taught me not to commit any figures to scrutiny." He insisted that furnishing his own trading data was unnecessary since "every single dollar, it is invested in long-term Fortune 500 securities" with a single broker, who makes every investment decision/ And that broker was Bernard Madoff, with whom he had 5 accounts. To prove no money was missing, Avellino provided the SEC examiners with the most recent statements he received from Madoff. The New York Enforcement Staff Attorney handling the case did not find "Avellino and Bienes’ testimony altogether convincing." The next step was to verify the statements with Madoff. When on November 16, 1992, SEC examiners conducted an examination of Madoff’s firm "to verify certain security positions carried for the accounts of Avellino & Bienes," Madoff was well prepared for their visit/ He provided them with putative copies of records from the Depository Trust Corporation (DTC) showing that he had made the trades listed in the Avellino and Bienes accounts. Madoff’s stock record exactly matched the DTC statement. The examiners did not go any further. They concluded that there was no Ponzi scheme, and merely fined Avellino and Bienes $500,000 for their illegal brokerage business, which they closed down.
What the SEC did not do was to go to the DTC and verify that the records Madoff gave them were authentic. If its investigators had merely made a phone call to the DTC, they would have discovered in 1992 that those records were hastily forged and that the Avellino and Bienes accounts were only a small part of Madoff’s much larger Ponzi scheme.. As we now know from the testimony of Frank DiPascali, Jr , Madoff somehow knew the SEC examiners were about to descend on his office and demand these records. In his 2009 debriefing by the SEC, Dipascali specifically identified the SEC’s Avellino & Bienes investigation as an occurrence when "Madoff scrambled to ... fabricate credible account records to corroborate the purported trading in the accounts." The rush to fake the records described by DiPascalini suggests that Madoff might have had advance knowledge as to the SEC’s actions.
In any case, the SEC’s failure to verify Madoff’s records is difficult to explain in light of Madoff’s long-term relationship with Avellino’s firm. Madoff and Avellino had both worked together in the small accounting office of Madoff’s father-in-law Sol Alpern, who was deeply involved, if not the organizer, of the money-raising operation. Alpern also helped set up Madoff’s brokerage operation in 1960 by providing him with $50,000 to finance it and then funneling into it the guaranteed investments his firm sold. When Alpern retired, Avellino and his junior partner, Michael Bienes, took over the business and changed its name to Avellino and Bienes.
That Madoff’s name is not even mentioned by the SEC actions against Avellino and Bienes, even though his records were central to the quashing of the case, may be some indication of the influence he had developed at the SEC. Such influence would also explain why six subsequent complaints against Madoff himself were not fully investigated and why the SEC consistently neglected to verify Madoff’s accounts against the readily-available DTC records. But how could Madoff have such influence over his regulators? As Madoff’s dealing with the Fairfield Greenwich Group in 2006 demonstrates, he had advanced knowledge about the SEC’s moves. In that investigation, the SEC was dealing with an allegation that he was hiding his role as a money-manager for its funds. According to phone records that came to light in a lawsuit filed by the state of Massachusetts, Madoff called two of Fairfield Greenwich’s top executives in Bermuda, and informed them of the question that SEC investigators would ask them about their relation with him. He then furnished the answers that would satisfy them without revealing Madoff’s true role. As for the SEC investigators themselves, he pointed out, "They work for 5 years for the [SEC] Commission and then become a compliance manager at a hedge fund." The implication here was that SEC officials had a powerful incentive to be cooperative in this matter since their future lay with hedge funds, not the SEC.
He clearly had one or more reliable sources. The SEC kept to the Madoff script and, when it got the answered he provided, it did not pursue the investigation. Such high-value feed-back, which could have come from unwitting sources or from someone cooperating with him. In either case, it would explain how Madoff evaded SEC scrutiny. ***
[UPDATE 9/5/2009]

Thursday, August 06, 2009

Can Diamonds Survive A Free Market?

Despite its celebrated slogan "Diamonds Are Forever," De Beers, which has dominated the diamond business for over a century, is discovering that diamond profits are not forever. It reported in July that its profits for the first half of 2009 fell by no less than 99%. The problem is not that the mining giant is running out of diamonds. Its highly-efficient diamond mines in South Africa, Botswana and Namibia still supply about 40 percent of the world’s gem-sized diamonds. Nor have diamonds lost their value. They not only remain a vital part of the engagement ritual but their retail price of engagement rings has actually risen in 2009. What is killing De Beer’s profits is the prohibitive cost of running a cartel. The cartel arrangement is necessary to sustain the illusion that diamonds are rare.
Diamonds, to be sure, once were exceedingly rare. Then, in the late 19th century, huge pipes full of diamond ore were discovered in South Africa, and the diamond prices fell to less than one dollar a carat. Cecil Rhodes, who by 1890 had consolidated almost all the pipe mines into his De Beers Company. wrote in a letter that diamonds were on the verge of becoming a "frightful drug" on the market unless production was restricted. To create the balance between world supply and demand, Rhodes proposed that the annual production be limited to roughly the number of "licit relationships," as he termed engagements, in the United States., which was then the main market for diamonds. Ernest Oppenheimer, who took over De Beers after Rhodes’ death, further perfected the cartel by taking over the Diamond syndicate in London. This arm of the cartel, run by Oppenheimer’s brother Otto, gave De Beers control over the global distribution market and evolved into the innocuous- sounding "Central Selling Organization," The Oppenheimers used it to allocate the world’s rough diamonds to diamond cutters in Antwerp, Tel Aviv, and other cutting centers according to its terms. If a cutter wanted to be part of the arrangement, he had to blindly accept all the diamonds offered to him in a box by De Beers, and follow its rules. Ernest Oppenheimer wrote: "the only way to increase the value of diamonds is to make them scarce." Working through an intricate system of bankers, shell corporations, and buying agents, De Beers bought up diamonds wherever they were found, acting as the buyer of last resort, and, if necessary, adding them to its stockpile. When demand for diamonds collapsed in the great depression, Oppenheimer closed all major mines, cutting production from 2,242,000 carats in 1930 to 14,000 carats in 1933. His son Harry, who succeeded him in 1957, continued this strategy, telling shareholders that De Beers had no choice but to tightly control the global supply of diamonds because "wide fluctuations in price, which have, rightly or wrongly, been accepted as normal in the case of most raw materials, would be destructive of public confidence in the case of a pure luxury such as gem diamonds, of which large stocks are held in the form of jewelry by the general public." In other words, if prices were allowed to go down, the diamonds-are-forever illusion would shatter, and people would begin to sell their diamonds. Under his regime, when new diamond mines were discovered any place in the world, De Beers negotiated through one of its front companies to buy all those diamonds, even if it meant locking them up in its vaults in London. No distinction was made between friends and foes. At the height of the Cold War, when diamonds were discovered in Siberia, De Beers arranged with the Soviet Union to take its entire output. This deal required De Beers in the 1980s to buy from the Soviet Union 2.6 million carats a year– nearly one-quarter of the world's production– which provided Moscow with so much hard currency that the head of the Russian Diamond Administration said, "We call ourselves the country's foreign exchange department."
While this global cartel succeeded in sustaining the illusion of scarcity, by the 1990s it began to put increasing financial strain on the company’s finances. Ironically, what sealed the cartel’s fate was the Oppenheimer family’s effort to tighten its iron grip on De Beers through a leveraged buyout in 2004. Up until then, the Oppenheimers, who only owned about 8 percent of De Beers relied on a maze of interlocking companies to control it. After the buy-out, 40 percent of the company was directly owned by Oppenheimer family’s holding company and 45% was owned by the Anglo-American Corporation, in which the Oppenheimers were major share-holders. But to effect the buy-out De Beers had borrowed over $ 4 billion from banks, who imposed covenants that restricted its ability to borrow further to buy diamonds for its stockpile. "Debt drove the deal, as it always does," one shrewd London banker observed. As a result, he added "The new De Beers is not the old De Beers."
When the recession collapsed demand for diamond in 2008, De Beers could still shut down its mines– and in 2009 it reduced its production by 91%– But, given its debt burden and covenants, it could not borrow to buy the growing surplus of diamonds from other mines around the world. So it could not continue the century-old cartel arrangement. The European Union, which had found that De Beers had violated its anti-monopoly rules by stockpiling Russian diamonds, provided a convenient fig leaf for its exit strategy . Instead of renewing its deal to buy Russia’s rough diamonds in 2009, De Beers handed over the job of stockpiling surplus diamonds to the Russian-government backed diamond monopoly, Alrosa. For Alrosa to support prices, it not only had to stockpile the enormous production from the Siberian mines but after new pipe mines had been discovered in Angola, it had to negotiate a De Beers-style arrangement with the Angolan government to buy up its diamonds. "If you don’t support the price," Andrei V. Polyakov, an Alrosa official told the New York Times, "a diamond becomes a mere piece of carbon," while a top Alrosa strategist said, "We have to tell people that diamonds are valuable...We are trying to maintain the price, just as De Beers did, But what we are doing is selling an illusion." But even if the Russians fully understood the requisites of the cartel, they faced an almost intractable problem in the form of $5 to $7 billion worth of diamonds that were already in the "pipeline" that extended from the cutters and jewelry manufacturers to the wholesalers.. With the dearth of retail sales in 2008, these diamonds could only be contained in the pipe line for a limited time before the banks who had financed their purchase in 2007-8 at the height of the bubble, took action to get repaid, which would cause fire sales at the wholesale level. Alrosa has not as yet intervened to absorb these diamonds, and it may not have the resources to do so. According to a major diamond dealer affiliated with De Beers "Alrosa is not De Beers. It doesn’t have the network of connections with dealers and financiers, or experience, to control the pipe line." If so, diamond prices could go into a free fall, and finally test Harry Oppenheimer theory that the diamond illusion cannot survive the destructive price swings of a free market.