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The Inoculated Investor http://inoculatedinvestor.blogspot.


The Bernie Madoff-Goldman Sachs Parallel

Faith can be blinding. Decades of built up trust can all be lost in a single day. These are truths that investors all over
the world were reminded of the day Bernie Madoff’s $65B Ponzi scheme came to light. As a result of the magnitude
of his crimes and the resultant suffering of charities, feeder funds and investors, the investment management
industry will never be the same. I’m not insinuating that people will no longer entrust their wealth and savings to
professionals. But I do believe that the Madoff stain will not disappear anytime soon. Perhaps one day Madoff will
even replace Ponzi as the namesake of this nefarious scheme. Regardless, as a result of the lasting memory of the
Madoff affair, even if it is only a faint whisper, those of us who aspire to make a career in the investment
management business will live with more intense scrutiny and be expected to slowly re-build the trust that has
proven to be so fleeting.

Maybe this is a good thing. In fact, it was a blatant lack of scrutiny and diligence combined with the deification of
the man that allowed Madoff to perpetrate his ruse for so long. It appears that Madoff’s status along with his
penchant for secrecy and a catastrophic diffusion of responsibility among his investors dissuaded most from
questioning what stuck out as improbable returns. If you make your operations opaque enough or claim to have
some undeniable secret sauce, only the most sophisticated and vigilant investors will question the consistent results.
Madoff apparently compensated for those brave few by threatening to kick them out of his club and thus prevent
further access to an asset that came to be known as the “Jewish Bond.” That was all it took to keep those other than
a lone soldier named Markopolos quiet. In the end, all it took was the near collapse of the entire global financial
system to induce an admission of fraud and defeat. If you were ever dubious regarding the enormous power of
hope, this scandal should put any and all doubts to rest.

Specifically, what did Madoff’s investors hope? They hoped the returns were real. They hoped that nothing about his
operations were illegal. They hoped that even if he had some unfair advantage it was a result of nothing more than
something as trivial as front running. They hoped his elevated status in the financial community would shield him
from regulatory and legal scrutiny. They hoped that they could get out before it all fell apart. Human nature dictates
that we can always come up with an excuse for inaction or inertia. Just one more check and then I will get out. Just
one more year of market-beating returns and I will take my chips off the table. Just one more day as a part of this
exclusive club and I will leave the game for good. In the end Madoff’s drug proved to be too powerful for even the
most “sophisticated” investors to kick the habit.

Glancing up at the title of this discussion, you might wonder what in the world this has to do with Goldman Sachs
(GS). Well, it struck me recently that many of the elements of GS’s success are similar to those that made Madoff so
successful. Don’t worry; this is not going to be another one of these Goldman bashing pieces that have become so
ubiquitous recently. I want to it be more of a thought exercise for those who believe that what happened to Madoff’s
investors cannot happen to them. By highlighting some of the comparable mechanisms I hope to remind people of
the ever-present and inherent risks associated with any investment. Why is this so pertinent now? Well, with what
appears to be a speculative rally driven by individuals who seem to be blind to downside risk, I think any analysis
that suggests the need for caution can be very valuable.

Without further ado, here is a list of themes that seem to be present among investors in both GS and Madoff:

1. Belief in supernatural skills that led to a God-like personification

2. Comfort with the opacity of the investment strategy
3. The irreplaceable benefit of an elevated standing in the financial community
4. Widespread suspicion of wrongdoing (or at least marginally acceptable behavior) with little action by
investors to learn the truth
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Let’s start with assessing the first item on that list through some personal anecdotes regarding Madoff via

For Swiss banker Werner Wolfer, the memory of his first encounter with one of Bernard Madoff’s
emissaries nine years ago is as clear as the waters of Lake Geneva.

“It all looked so good,” says Wolfer, who has a master’s degree in economics from the University of St.

“With every year passing, the worries were a little bit less,” Wolfer says.

To hear Patrick Littaye talk, the Wall Street money manager could walk on those waters. “It was like a
religion,” Wolfer, 57, says of the promise of steady returns, which would be echoed by other acolytes.
“These people firmly believed in the story.”

Unfortunately, nothing about investing should be a story or should invoke religious comparisons. Successful money
management requires a diligent and disciplined process and any claims to have a magic formula should be looked
upon with extreme skepticism. While I am certainly not a proponent of the Efficient Market Hypothesis (EMH),
there is one aspect of it that is 100% accurate: there is no such thing as a lasting free lunch. Riskless arbitrage
opportunities, other than in extreme situations like the ones we have seen in the past year, are often closed
immediately by the market. Thus, Madoff’s investors accepted their returns without acknowledging that sometimes
substantial rewards are accompanied by extreme risks.

Similarly, the investors who have driven the share price of GS back up over $160 seem to have blind faith in the
company’s ability to profit in any market circumstances. Unfortunately, they have reason to believe this is a reality:

Goldman Sachs Group Inc. made more than $100 million in trading revenue on a record 46 separate days
during the second quarter, or 71 percent of the time, breaking the previous high of 34 days in the prior three

Trading losses occurred on two days during April, May and June, down from eight in the first quarter, the
New York-based bank said today in a filing with the U.S. Securities and Exchange Commission. The
company made at least $50 million on 58 of the 65 trading days in the period, or 89 percent of the time.

Tell me that these results do not seem to be as improbable as Madoff’s long term returns in both up and down
markets. This astonishing data means that from January to June (let’s call it 130 trading days) GS only lost money
on 10 of those days. That’s almost like a baseball player batting .920 for half a season. A player who achieved that
feat would immediately be deemed the best hitter to ever play the game. Since trading is a zero sum game, meaning
that there is a loser on the other side of each winning trade, results like this should be impossible. Unless of course,
the winner is cheating or has a skill level that is unlike that of mere mortals. Statistics like these illustrate how both
Goldman and Madoff achieved such a mystique on Wall Street. Further, when the number of days that GS not only
made a trading profit, but also made over $100M is added to the equation, the whole thing starts to look too good to
be true. Obviously, the lesson from the Madoff affair is that what appears to be too good to be true, probably is.
From the same Bloomberg article linked above:

“It’s very counterintuitive to think that they’d be able to generate this much profit and this much revenue in
the middle of an ongoing recession,” said William Cohan, a former banker at JPMorgan Chase & Co. and
Lazard Ltd. and author of “House of Cards” about the collapse of Bear Stearns Cos.
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

Next, let’s examine the parallels when it comes to the opacity of the investment strategy. We know Madoff
advertised that he used a split strike conversion strategy to generate his returns. But when pressed on the details, he
tended to be very vague or become defensive. As mentioned above, if he felt people were too inquisitive he would
threaten to return their investment. Similarly, GS does not give a whole lot of information about how it generates
such tremendous trading profits. We know for sure that it coincides with increased risk though. At the end of Q2
2009, GS’s value-at-risk (the amount the company could lose in a single day) was $245M, up from $184M in May
2008. Furthermore, GS continues to hold a huge number of what are known as Level 3 assets on its balance sheet.
These are by definition the most opaque assets. For those of you who are unfamiliar with this term, according to
wikinvest, Level 3 assets are:

Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs
that are both unobservable and significant to the overall fair value measurement…Level 3 assets trade
infrequently, as a result there are not many reliable market prices for them. Valuations of these assets are
typically based on management assumptions or expectations.

In other words, kind of like how Madoff made up his returns by printing fake trade receipts, GS gets to decide the
value of $54B of 8.7% of its total assets. Also, just as Madoff’s investors had no way of learning more about his
strategy, GS is understandably tight lipped about its Level 3 assets and trading strategy. Now this secrecy is not
unique to GS. No bank gives away information that could hurt its own positions. But the question investors have to
ask themselves is whether or not the amazing returns and the carrying value of assets are likely to be legitimate.

Next, when it comes to status there is no end to the amount of influence that GS has on policymakers and regulators.
The number of GS alumni who have held or currently hold influential government positions is very well
documented. What that leads to is the perception among investors that GS is protected, not only from legal scrutiny
but from adverse market consequences. I worked with some former Goldman guys and there was a palpable
understanding that GS would inevitably be the first one to get “the call” or a head’s up from the powers that be. If
Hank Paulson’s calls to GS CEO Blankfein during the AIG crisis are any indication, this phenomenon is not just
assumption, but a reality. Accordingly, this elevated status has the potential to lull investors to sleep. If you believe
that the government will always bail out GS or provide sufficient forewarning prior to a crisis, you will invest
without the potential downside in mind. This is what is known as moral hazard and can lead to a mispricing of risk
among investors.

Similarly, Madoff’s status had a comparable lulling effect on his investors. He was on the Board of Directors of the
National Association of Securities Dealers (NASD). He also had very close ties to Securities Industry and Financial
Markets Association (SIFMA), served as the non-executive Chairman of the NASDAQ, and was considered a
pioneer when it came to electronic trading. The positions he held led his investors to assume that there was no way
he could be doing anything illegal. Even worse, his insider status among the industry’s self regulatory body
legitimatized his returns in a way few others things could. Plus, there appears to have been an implicit expectation
that even if he was engaging in some dubious practices, his reputation would allow him to escape with only a slap
on the wrist or a stern talking to.

Finally we come to what I think is the most fascinating similarity between GS and Madoff. This particular bias
comes about when investors have an inkling that something that is not quite kosher is going on but for the most part
decide to ignore their misgivings. Apparently in Madoff’s case his investors suspected that he might be front running
trades, a practice that is illegal, but not seen as unethical as the scheme he was actually running. From The
The Inoculated Investor http://inoculatedinvestor.blogspot.com/

According to reports, some of those who put their faith in Mr. Madoff suspected that he was engaged in
wrongdoing, but not the sort that would endanger their money. They thought he might be trading illegally
for their benefit on information gleaned by a separate business within his group, which made a market in
shares. The firm had been investigated for “front-running”, using information about client orders to trade
for its own account before filling those orders.

Basically people were suspicious but they were not going to risk speaking up and killing the golden goose. I would
assume that after a number of recent incidents, this feeling has become extremely prevalent among owners of GS
shares. First off, there is the amazing trading record. I’m not sure any bank in history has achieved such astounding
results over 2 consecutive quarters. Even the most gullible person should question how these returns are possible.
Next is the perception that the government often gives GS information that the market is not privy to. At very
minimum this practice could spark complaints of conflicts of interest and lead to civil litigation, especially given the
standing of many Goldman alums. However, the SEC does have rules regarding insider trading (or at least used to)
that may have been violated during multiple occasions over the last few years. While this probably will not be a
problem while GS’s friends are in power, we know that regimes change and those who think they were invincible
suddenly find themselves on the wrong side. Although many investors are comforted by the fact that GS is
nicknamed “Government Sachs, there is no way to know when prior affiliations and actions will become liabilities.

The third piece of news that should be disturbing to investors came to light when the world learned that some of the
company’s proprietary software had allegedly been stolen. At a hearing regarding this theft the US prosecutor
explicitly said that this code could be used to manipulate the markets. Well, if that is the case, doesn’t that mean that
GS could be using it for illicit purposes? In addition, how would we know if it were? I think the Madoff case proves
that the implicit assumption that GS is not using the code to juice its profits just because it could be construed as
illegal or because of the company’s lofty reputation is very naïve. Lastly, there was a revelation in the last few weeks
that apparently GS engages in a practice called huddling in which certain clients get advanced notice of research
analysts’ stock opinions. While GS has vehemently defended this practice and has assured the market that it has
done nothing wrong, the implication that GS gives specific firms information that has not yet been published seems
a bit shady. This is especially problematic because the market often reacts sharply (for some unknown reason) to
analysts’ upgrades and price target changes.

In conclusion, I have no idea whether or not GS has crossed any legal or ethical boundaries. However, I have to
admit that some of the parallels between Madoff’s operations and those of GS are quite eye opening. It could be true
that GS is just smarter and more connected than everyone else, in which case the company is probably bulletproof.
But, I think people should remember that this is precisely what investors thought about Madoff. We now know that
premise turned out to be a once in a generation magnitude lie. So, my suggestion to those who either own shares of
GS or are contemplating a purchase is to keep all of the things I have highlighted in mind. There is no sure thing in
this world and asymmetrical rewards don’t come without risk. Most importantly, the major take away from the
Madoff fiasco is that returns that appear to be too good to be true probably are and that if you have an inkling that
some of the profits may be from dubious practices, it might be smart to take your money elsewhere. Lucky for you,
you have an easy way out that Madoff’s investors did not. All you have to do is click your mouse.

(Picture courtesy of Businessweek.com)

(Disclosure: No Positions)