The Curious Case of Bernie Madoff

January 5, 2009

Good morning, and Happy New Year. We are fresh off a solid three-day rally, with the SPY moving sharply up from an $86.91 on 12/29 to $92.99 on 1/2/09. The VIX has continued to slide down as well, from 43.9 on 12/29 to 39.18 on 1/2/09. Is it the start of something positive, a relief rally that the horrible investment year of 2008 is over, a celebration of the new President, or just another bear market rally? To be determined. One issue affecting us placing new money in the PIP program, and in doing the calendar type spreads we like to do, is that the implied volatility levels seem to be decreasing from the near term out. In other words, the volatility levels seem to increase the further out you go with your option selection, and is remaining stubbornly high in the out month puts we like to buy. Maybe they will come down this week.

I have had a lot of emails and calls asking for my predictions for the market this year, and I have been listening to everyone else’s constantly on TV or reading about them. Is it true that the more you scowl and the more serious you sound giving your prediction (or the larger and more prestigious the firm you cite) the greater chance it has of being a good one? Will anyone remember anyway? As you can tell, my opinion is that predictions are like bad relatives, everyone has at least one. For what it is worth, I think the market hopefully will seesaw around for the year and end up positive in the 10% range. If, however, no bottom in the personal income disaster we are seeing begins to form by mid-year the consequences (in terms of states and cities going BK, small businesses falling in droves) will begin to affect the market very negatively. For me, my prediction does not matter. My job is to protect my clients if the market continues to go sour, but be out of the way as much as possible if it starts to go up significantly. A solid ally this year should be continued high call option premium, and the possibility for a very solid year for PTI clients is certainly there. A solid winning year would be nice, after all a very good way to increase money under management by 15% is to earn 15%.

What about Bernie Madoff, and the scam of the century? First of all, we have 91 years left in the century (if we do not totally wreck the place) and I am perfectly confident that someone will produce a larger scam somewhere in those 91 years. Having said that, this is a pretty serious one in terms of size and bravado, and clearly has had a particularly concentrated impact in the Jewish community and in Jewish Charities. It is also incredible given the education and sophistication of many of the victims. There have been constant calls for the heads of those in the SEC, umbrage about where were the Regulators; you name it, but very little real information as to the role of the SEC in all this, or how the Madoff thing all started.

First of all, what about the SEC? From what I understand Madoff used a hedge fund structure, which by definition is outside (maybe currently) the purview of the SEC. What I mean is this. If several of us, with a prior business relationship, decide to pony up some money for a business we are certainly free to do so. It is when we decide to expand that sphere and solicit money from other people the SEC enters the picture, and they do so through powers granted them (initially) by the Securities Acts of 1933 and 1934. Without getting too deep, these Acts provide for registrations, perspectives, and rules about solicitations across state lines, etc. A hedge fund, on the other hand, is essentially a carve out from those Acts. That carve out says, in brief, that when you are dealing with sophisticated clients only (and there is a laundry list of what that means) people are free to solicit without the usual provisions of the Acts. It also means that the people running the funds (Madoff, in this case) are free to be paid a percentage of the fund’s profits. That is why you may hear a hedge fund fees as being quoted 2 and 20. That means the fund manager would be paid 2% of the funds assets in fees (in any case) plus 20% of any profits made by the fund. A regular Investment Advisor (like PTI) is not able to participate in any profits made by our clients. I certainly feel for these people, they were robbed, but to blame the SEC for problems in a structure designed to circumvent the SEC is certainly interesting. I understand there were some complaints to the SEC, and if any of those complaints had to do with improper solicitation, or whether the fund members really were sophisticated investors, now that would be a different story (not real clear, is it?).

I do, however, have a real problem with the SEC and Bernie Madoff, and it has to do with how the whole mess started and the incompetence of the SEC in general. In the early 1990’s I was on the Board of the CBOE. At that time the investment world was a lot different, the NYSE was very dominant in trading securities listed on that Exchange, brokerage commissions were a lot higher, and the minimum bid-ask spread for a stock on the NYSE was $.125 (an eighth). The regional Exchanges (Midwest, Philly, P-Coast, Cincy) were around, but did mainly crossing business with some retail thrown in. What Bernie did was expand the Cincinnati Exchange (then owned almost totally by the CBOE) to become a preferencing Exchange. What does that mean? Before Bernie, if you sent an order to your brokerage firm, that firm would (in virtually all cases) execute that order on the NYSE. The NYSE charged a fee for that order, and the broker (or the specialist) charged brokerage to do that trade, but you as customer often (estimates were in the 35-40% range) were filled at a price better than the quoted bid-ask spread. For example, IBM might be quoted 90-90 ¼. In a significant percentage of the time your retail order to buy or sell might be filled at 90 1/8, meaning you would save $125 off the quoted price on a thousand shares, a savings maybe way more than you paid in brokerage.

Enter Bernie Madoff. Bernie devised a system on the Cincy Stock Exchange where if the firm were to send that order to the Cincy he would guarantee you the NY published bid-ask spread, and in return the brokerage firm would receive payment (kick-back) of around a penny a share. What a deal for the brokerage firm! You pay no more NYSE fees (don’t remember if there was a Cincy fee), no floor brokerage, and you receive a nice kickback. The only problem is that you, the customer, did not have a broker on the floor working for you (even though you were probably still paying for him) and the instances of you getting filled at better than the listed prices were eliminated or reduced sharply.

Legitimate firms were outraged at this, and the SEC was clearly aware of this slight of hand. Arthur Levitt, Chairman of the SEC at the time (friend of Bernie), could never really deal with this blight on the industry. They kept being tied up by ridiculous comparisons between real kickbacks and soft money stuff like giving clients free research, and came down on the side of disclosure rather than just a common sense prohibition. The disclosure, however, never took the real direction it could have, such as “Please be advised that even though you have paid for your order to go to the NYSE your order has been routed to the Cincinnati Stock Exchange instead, where you have no chance of price improvement, and we, your brokerage firm, have received a kickback for doing this to you.” The disclosure was more like a pile of legalize on the back of your confirm saying in very general terms that the firm may get paid from time to time and that trades go various places. Nothing as jolting as “You personally just got robbed on this particular trade.”

Why does this matter? It matters because Arthur Levitt, unwilling or unable to stop this absurd practice, went on to actually appoint Bernie to various Committees as an “expert” on electronic stock trading and eventually he became Chairman of the NASD. The SEC, led by his buddy Arthur Levitt, totally legitimized the guy, in no small way responsible for him being perceived as a legitimate person. The large early returns were, no doubt, due to the kickback scheme that should have been stopped immediately. The combination of the early returns and the persona the SEC created about him are hugely responsible for the carnage we are seeing. It is so disgusting I may decide to join the NRA, because I am convinced that our idiots (regulators) in charge will never figure out the connection or their complicity in this mess.

Enough of that. We will continue to place additional funds in the market as the volatility in the long term puts eases. We also continue to talk to those that may be interested is some of the fixed income opportunities that are available. Again, if you have any interest in municipal bonds, corporate bonds, or preferred stocks, please give us a call.

I will make one serious prediction. PTI clients will have a solid 2009, and we will continue to keep you apprised of what is happening in these crazy, but opportunity laden, markets.