Too Good to Be True: The Rise and Fall of Bernie Madoff by Erin Arvedlund

Too Good to Be True: The Rise and Fall of Bernie Madoff by Erin Arvedlund

Author:Erin Arvedlund [Arvedlund, Erin]
Language: eng
Format: epub, pdf
Publisher: Penguin Publishing Group
Published: 2009-07-31T04:30:00+00:00


The sudden increase in the popularity of hedge funds can be explained by a number of factors—many of them political.

In part, Congress’s 1999 repeal of the Depression-era Glass-Steagall legislation, which kept commercial depositor banks and investment banks separate, allowed the resulting supermarket financial institutions cum banks to start, seed, or lend money to hedge funds. It was more profitable for a bank to do business with hedge funds, instead of just everyday lending against their depositors’ accounts.

The Economist put it succinctly in a 1992 article: “Bank lending is inherently more expensive than securitization.” Banks employ costly specialists to monitor default risk, one human being and borrower at a time. The regulatory cost of banking was justified when banks got credit information more cheaply than investors who had no direct relationship with a borrower. But advances in technology cut the cost and enabled the mass production of risk assessment for the securities markets. “Credit-rating agencies already did the job of bank credit officers for big companies with widely traded debt. Investors had already started trading pools of credit-card loans because they believed they could judge the collective risk of default without knowing the credit-worthiness of each borrower. Banks fondly believe that small-business and personal loans are safe from the ravages of securitization,” the magazine added.

Even without the impending U.S. housing and mortgage bubble and the glut of subprime borrowers, safe lending alone by banks just didn’t pay as well. Wall Street’s newest industry of securitizing bad loans by suspect borrowers did pay; lending to wealthy clients so they could invest in hedge funds did too, as did seeding hedge funds. Commercial banks wanted in on the game.

Lending to hedge funds was a favorite new line of bank business, as was underwriting securities such as derivatives backed by American subprime borrowers. Fairfield Greenwich had a cottage industry offering leveraged notes financed by JPMorgan Chase, Nomura, and other banks; all the notes were investments in Madoff, his returns magnified a few times by borrowed money.

By 2006, the interest in hedge funds was so explosive that a few had already done initial public offerings, or IPOs, while other private capital pools like private equity giant Blackstone and AQR, a quantitative hedge fund, one that uses computers rather than human judgment to pick securities, geared up valiantly to do the same just as the stock market began to slide in the fall of 2007. AQR partner Cliff Asness went so far as to allow New York magazine inside the hedge fund’s headquarters—an obvious ploy to drum up interest in the IPO. Not long after the story ran on the cover, AQR confirmed it had filed to go public.

In truth, the bubble in hedge funds was just the latest example of excess in financial markets—the young men, and a few women, who led these hedge funds were chasing unbeatable incentives that prodded them to take risks for a potentially enormous upside. And the only downside was that they were losing other people’s money. So in essence, there was no downside—for those in charge.



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