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Madoff and the Failure of the SEC

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Few Wall Street gurus or members of the financial press, if asked on December 11, would have said that the news of Senate Republicans spurning Bush and killing the automotive bailout would not be the next day’s top headline. They would have been sadly mistaken.

News broke on December 12 that Bernard Madoff, former chairman of the NASDAQ stock market, was arrested for committing fraud. This was not in the form of some minor chicanery, but a fifty-billion-dollar scam. Lest the reader think that the word scam is too harsh, I will put it in Madoff’s own words; he referred to his operation as "all just one big lie" and "basically, a giant Ponzi scheme."

For those unfamiliar with the nature of a Ponzi scheme, it relies on funds from new investors to pay falsified, and abnormally high, returns to existing investors. As Madoff demonstrated, as long as there is sufficient money coming in, it can reach massive proportions and continue for years.

Madoff managed to lure billions of dollars away from huge charities, as well as wealthy individuals in both the United States and Europe by getting them to invest in his hedge fund. He did so by claiming extraordinary returns (generally in the low double digits). His scheme eventually reached a staggering $50 billion under "management." This all came crashing down around him after market conditions led to a considerable amount of redemptions (investors asked for their money back).

Hedge funds are different from mutual funds in many respects. Most notably, hedge funds are not burdened by the same government regulatory requirements that mutual funds are. They also generally have much different compensation structures and considerably higher barriers to entry for potential investors. Due to hedge funds’ relative freedom from excessive government intervention and regulatory burden, they are often able to generate higher returns than the average mutual fund; indeed, most mutual funds underperform compared to the S&P 500 benchmark.

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December 20, 2008

Political Theatre

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