Madoff meets Lehman

Posted by: Matthew Goldstein on December 19, 2008

It’s not a lot of money compared to the estimated $3 billion that a fund managed by The Tremont Group has lost in the Bernard Madoff scandal. But the same Tremont fund also claims it lost $25 million when Lehman Brothers went bust in September.

In October, Tremont’s Rye Select Broad Market fund filed a lawsuit alleging that it was owed some $25 million on a derivatives contract that permitted it to borrow money from a Lehman subsidiary. The derivative contract enabled the Rye fund to leverage its investment in Madoff’s firm by a factor of 3 to 1—a move that enabled Tremont to generate higher returns and justify the fees it was charging investors.

Tremont’s Rye fund was one of a handful of “feeder’’ funds that marketed Madoff’s fund under its own independent brand name. The Rye fund’s marketing literature said it allocated “substantially all of its assets to one manager.’’ That manager, of course, was Madoff, who federal prosecutors allege may have engineered one of the biggest Wall Street scams ever.

Madoff, the former Nasdaq stock market chairman with more than four decades of trading experience, relied on funds like Rye to attract new money to his enterprise. If Madoff was indeed running a Ponzi scheme, as he himself admits, bringing in new money was essential to its success. The key to a Ponzi scheme is attracting new investors to pay-off older investors who seek to redeem either all, or a portion of their money.

Tremont also operates a separate so-called hedge fund of funds that made a much smaller investment with Madoff. Tremont says it always marketed the Rye fund as a “single-manager’’ investment, even though it had the option to invest with other hedge funds. In the wake of the Madoff scandal, investors in funds like Rye and other funds of funds have alleged that the managers should have done a better job of due diligence. The funds of funds operators dispute that notion, alleging they were deceived like everyone else.

Tremont has sent a letter to investors saying as much: “We believe Tremont exercised appropriate due diligence in connection with the Madoff investments.”

But the deal between Lehman and the Rye fund offers a glimpse into the way many funds of funds had come to operate in recent years. In order to justify an extra layer of fees, on top of the ones charged by the underlying hedge fund managers, funds of funds managers had to amp-up returns. And the only way to do that was by getting leverage from a bank.

In fact, much of BNP Paribas’ more than $400 million exposure to Madoff stems from loans it made to funds of funds that invested with Madoff. The same is true with many of the other European banks that claim to have lost billions in the Madoff scandal. That’s why the estimated losses have already surpassed the $17 billion in assets Madoff claimed to manage at the beginning of the year. In many ways, much of the money that Madoff managed was levered 3 to 1.

In short, the Madoff mess is once again showing the dark side of all the leverage that worked into the financial system during the past two decades.

Reader Comments

Peter

December 19, 2008 12:33 PM

It baffles me why rich sophisticated investors would invest in hedge funds where they are shaken down at every level. Heads I win,tails you lose. Warren Buffet and his index fund will win the bet.

Omaha Native

December 19, 2008 12:54 PM

It is so sad to know that these people which are now shown as stealing OUR money are the very same people that, earlier this year at the start (or is it the start of the end) of the major financial crisis, said "You are not smart enough to understand what is going on in the financial markets!"

No. We are smart enough. We suspected then that the ever-so-highly-paid "smart" managers were lying.

I now know exactly why my grandfather, who lived during the first Depression, said all bankers are legal crooks. To this day, Grandmother is still finding money he had hidden away in the house. Bad investment? Hah, she still has their money, which is more than I can say for my 70 yo father's decimated 401k. Luckily, he also stashed cash.

Hartley Lord

December 19, 2008 1:51 PM

When Cornfeld first created the original "Fund of Funds", over 45 years ago, The SEC would not approve marketing it in the USA because of the second layer of fees. Do these fancy yahoos, including plenty of Wasp's, un zip their fly different from Cornfeld?

Every one of them should do time, including the son-in-laws.

mark

December 19, 2008 2:14 PM

I can't really feel sorry for the "Palm Beach" crowd that put all of their money in with this guy. Some took out mortgages and gave that to him as well. I'm a small investor. What I have in the market wouldn't pay a month's electric bill for some of their mansions. But even that is with two mutual funds. I do feel badly that some philanthropic funds will be wiped out. Good causes will suffer. The hearts behind these donations were in the right place. Their minds, however were not.

Mike

December 19, 2008 2:24 PM

They say love is blind, I say greed is just as blind. These folks probably did not care as long as the money was coming in. One man may have been the confedence man with alot of other people doing work they thought was legit. This is going to make one hell of a movie, and the people who were used to living the high life in palm beach how must they feel wow and the rest of us, we should question our investments

AMERICAN EAGLE

December 19, 2008 2:43 PM

hang em high, China style!

bob sage

December 19, 2008 3:44 PM

Let's put this in perspective. If Madoff's investors had put their money in the S&P, they would have lost 50% of it anyway. So Madoff to start with cost them 50% of their money, not 100%. Secondly, those investors made 10% on their money for 10 years when they should have been making, what, 2%, with a safe investment. So the total amount of money they had invested with Madoff included these, shall we say, ill-gotten profits. You can't say they lost that money either, because they wouldnt have thought they had it if it weren't for Madoff.

Finally, anyone who shoots for a 10% return on investment has to know that that kind of return involves risk, precisely the risk that came to pass, that of losing all the money.

This, of course, does not pardon Madoff or make the people who lost money feel any better about what happened. He did rip them off. He just didn't rip them off for as much as people are saying. Maybe he ripped them off for 25% or so of the amount.

Enzo

December 19, 2008 4:04 PM

I've been saying for a long time that the stock market is rigged, manipulated by crooks from Wall Street, and with the help of the PPT at the Fed. After Madoff's fiasco (and many others), do you believe me now? If not, the crooks on Wall Street are waiting for your sheeple money, so they can fleece you to pay for expensive escorts and a luxurious lifestyle. To all of you feeling sorry for Madoff's "victims", I have one thing to say: schadenfreude. It's well known that Madoff's investors were bragging and rubbing on everyone else's face how they were getting high returns while the rest of the commoners were hurting. Who's hurting now, geniuses? And you know what you can do with your private country clubs, don't you? I even have the Vaseline here for all of you. My portfolio isn't sexy and I don't need country clubs or to be a bootlicker of conman from the Chabad to feel special. However, I'm getting a 7% return for the last 3 years. I say don't invest anything for a long while to let those crooks on Wall Street (and Washington) to starve to death. And always remember this: IT'S ALL RIGGED!

Bernie Good Madoff

December 19, 2008 5:22 PM

All financial money managers are in fact Ponzi operators! If you didn't this way, you are dumb naive person. They are preying on wealth but still GREEDY people. If you are honest nice fellow, there's nothing you have to concern about, other than the impact on real economy. They cause havoc on real economy as we are expericing now!

Bernie Good Madoff

December 19, 2008 5:24 PM

All financial money managers are in fact Ponzi operators! If you didn't think this way, you are dumb naive person. They are preying on wealthy but still GREEDY people. If you are an honest nice fellow, there's nothing you have to concern about, other than on the impact on real economy. They cause havoc on real economy as we are expericing now!

George

December 19, 2008 6:52 PM

Bob Sage, why are you comparing Madoff's investments to S&P? The main reason that people invested with him is because of his bond-like volatility and chances are that if they weren't invested with him, they would be in bonds which are down only slightly. You agree with this by saying they should have been making 2% in a safe investment (and at this point you throw your S&P comparison out the window). Madoff showed only 5 negative months in 20+ years which is stunning. Second point is that after a bear market is over, stocks generally make up most their losses within 2-4 years. Madoff's victims will never be able to do this.

boca chic

December 19, 2008 7:02 PM

Larry Leif was on CNN describing how he lost it all. 8 million to Madoff. He deserved to loose it. He is an abuser of people especially women. He talked other people into investing with Madoff He always bragged I have the best investments. He would actually talk about how rich he was all the time.His investor Madoof would not take everyones money.He is so special.
I saw that CNN clip on victims. It was this mans karma "So sad too bad" You lost it all you greedy man!!!! GREED GREED GREED

Elisa

December 19, 2008 8:21 PM

This year, in light of my stock loses and the many failing brokerage firms, the Tremont's Rye Fund presentation, with consistent, not extravagant past and present performance, was alluring.
Don't belong to any rich Contry Club nor I mingle with the famous. By all accounts, I'm just a solid citizen looking for proven, safe investments
Furthermore, my investment took place this year and didn't redeem any money, thus, for me, it's a total and complete loss
Hope I helped provide the readers with another view of the victim's spectrum

Elisa

December 19, 2008 8:21 PM

This year, in light of my stock loses and the many failing brokerage firms, the Tremont's Rye Fund presentation, with consistent, not extravagant past and present performance, was alluring.
Don't belong to any rich Contry Club nor I mingle with the famous. By all accounts, I'm just a solid citizen looking for proven, safe investments
Furthermore, my investment took place this year and didn't redeem any money, thus, for me, it's a total and complete loss
Hope I helped provide the readers with another view of the victim's spectrum

chas

December 19, 2008 9:51 PM

These Palm Beachers and Fund Managers are hamging the blame on Chris Cox and the SEC so they can class action against the Federal Gov't (honest taxpayers of America). Look for a 50 Billion reimbursement to come from YOU to THEM for SEC watchdog negligence.

Paul K

December 21, 2008 9:08 AM

In a way, the entire stock market is one big Ponzi scheme. One investor buys in now, hoping someone else will buy from him at a higher price later, and then someone else will come along and buy at an even higher price. So we really just give money from later investors to earlier investors.

adam brower

December 21, 2008 10:45 PM

right, Paul K. but why bother with halfway measures? do the full reductio ad absurdum: "Property Is Theft!"

easan

December 24, 2008 4:10 PM

Twenty years ago I decided to always keep money manager and asset custodian separate, so have avoided the Bernies of the world. A useful rule.

More details here:

https://knol.google.com/k/easan-katir/one-useful-rule/3aj02efkxrgh8/7#

Peter

January 2, 2009 2:11 PM

This is an answer to Bob Sage's remarks. I invested in a company called the Spectrum Fund LLC through my financial adviser. I had no idea the money went to Tremont and than to Madoff. Your statement that I would have lost 50% in the S&P 500 might be true, however, at least that money would still have a chance of coming back when the market goes back up! The investment I made is gone forever so your analysis is way off base. I also only invested in Spectrum in October of 2008 so I never received a dime from my investment. Again, a fallacy in your logic. I trusted my adviser who placed my money with Spectrum and now it is lost. At least I am not the Lone Ranger and find myself in very good company.

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Bloomberg Businessweek’s Ben Steverman focuses on the latest moves in financial markets and emerging trends in stocks, bonds, and funds, always with an eye toward giving readers a better understanding of the sometimes confusing and often chaotic world of money. Standard & Poor’s senior index analyst Howard Silverblatt will also provide his take on companies’ finances and the markets. Voted one of the “Top 100 Finance Blogs” in 2007.

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