He Madoff with What?? (Very Wonky)

If you haven't heard about the extraordinary $50 billion Ponzi scheme perpetrated by Bernard Madoff, I guarantee that you don't want to read this post.  But this isn't about the scheme, the lack of SEC oversight (suitable for a whole 'nother post) or the blinding lack of sophistication among the supposed sophisticated investors.  It's also not about the joke that is the fund of funds industry, nor about how many other Madoffs are yet to be exposed.

Instead, I'm talking insurance.  Specifically, SIPC insurance.

J and I have been talking about SIPC recently.  Our hypothetical: what happens if our broker (in our case, the discount broker ETrade) were suddenly to go bankrupt.  What would happen to the small amount of investments we have that is being held by Etrade?

Well, this is a situation where SIPC would come in.  According to their website:

The Securities Investor Protection Corporation (SIPC) either acts as trustee or works with an independent court-appointed trustee in a missing asset case to recover funds. The statute that created SIPC provides that customers of a failed brokerage firm receive all non-negotiable securities that are already registered in their names or in the process of being registered. All other so-called "street name" securities are distributed on a pro rata basis. At the same time, funds from the SIPC reserve are available to satisfy the remaining claims of each customer up to a maximum of $500,000. This figure includes a maximum of $100,000 on claims for cash. Recovered funds are used to pay investors whose claims exceed SIPC's protection limit of $500,000. SIPC often draws down its reserve to aid investors. [emphasis mine]

From the SIPC annual report, the reserve fund of the SIPC comes from:

The sources of money for the SIPC Fund are assessments collected from SIPC members and interest on investments in United States Government securities.  As a supplement to the SIPC Fund, a revolving line of credit was obtained from a consortium of banks. In addition, if the need arises, the SEC has the authority to lend SIPC up to $1 billion, which it, in turn, would borrow from the United States Treasury.

As @adrigonzo has pointed out in her rant against the FDIC, this means that the SIPC reserves, like the FDIC reserve, is an accounting fiction. 

Now, the members of SIPC are: "with some exceptions, all persons registered as brokers or dealers under Section 15(b) of the Securities Exchange Act of 1934 and all persons who are members of a national securities exchange." 

The SIPC reported two days ago that it was taking over as trustee in the liquidation proceedings of Bernard L. Madoff Investment Securities LLC.

SIPC today filed an application with the United States District Court for the Southern District of New York for a declaration that the customers of Bernard L. Madoff Investment Securities LLC are in need of the protections available under the SIPA. The United States District Court for the Southern District of New York granted the application and appointed Irving H. Picard as trustee for the liquidation of the brokerage firm, and further appointed the law firm of Baker & Hostetler LLP as counsel to Mr. Picard.

Now what was interesting about Madoff's organization is that it wasn't a "hedge fund".  It was, apparently, a broker/dealer with an asset management division, which enabled it to rely entirely on itself for trading and settlement.  I am not finding information about when it started its asset management division, but what we do know is that it registered as an asset manager in 2006 (though the timing could have been related to the change in rule in February of that year requiring funds with over $30 mil of AUM (Assets Under Management) to register) and never de-registered itself when a court ruling later that same year found such required registration to not be within the statutory authority of the SEC.

According to the Form ADV (which is used by an investment advisor to register with the SEC), Madoff's investment branch only had 23 clients - I don't know what % of the investors he bilked belongs to these 23 clients, since many of his "clients" appeared to have invested in Madoff indirectly via funds of funds.  But this means that there are two potential classes of clients: those that invested directly with the asset management division, and those that invested directly through the brokerage.  Only those invested through the brokerage should be eligible for SIPC insurance.

But even then, the entire insurance enterprise seems sketchy to me. 

First, unlike normal relationships between an investor and a broker, there is no indication that any of Madoff's investors had any information on what specific investments they had with Madoff.  This was not the situation that J and I have with ETrade, where if I was to pull up my account on line, I have x number of $JPM stock and y number of $GOOG stock and z number of $COKE stock [not really, btw].  Now, brokers can be given a power of attorney to make investment decisions and therefore trade on behalf of their clients (to which they are subject to certain fiduciary duties), and this is where the grey area between being a broker and being an investment advisor comes in.  From a comment discussion I was having with @tompain at Naked Capitalism about this question, he writes: "there appears to be a gray area in the determination of when discretionary brokerage becomes investment advisory activity subject to registration. The rules provide an exemption from RIA (registered investment advisor) registration for certain firms, including broker/dealers, who engage in investment advisory activity only in an "incidental" way."

But, generally speaking, even when a broker is given such discretionary power, they should still have to report to their clients what their investment accounts look like at the end of every month/quarter or some other pre-determined period.  All the reporting to this point have said that Madoff advertised using a split-strike conversion" option strategy to achieve his returns (not relevant to this discussion, if you are interested in this strategy, there is a good podcast at Planet Money on NPR).  But the reason that warning flags were being sent up was because analysts modeling split-strike conversions were not able to achieve the same returns that Madoff was reporting.  So Madoff was either reporting to his investors that they owned the equity, puts and calls that would make up the specific split-strike conversion strategy, but then report gains that didn't match (and they never said anything); OR he was merely reporting the returns on his strategy (more likely).

There are only two possibilities of what Madoff was really doing with the money: either Madoff was actually running his strategy with some of the money, while siphoning off the rest in losing investments or paying off earlier investors, or Madoff was not really running the strategy at all, siphoning off all of the invested money.

The problem here is, it's easy to claim SIPC insurance when you have a record of what investments you actually own.  Then you would get insured for the first $500,000 (and up to $100,000 of cash) with a pro-rata share of the remaining securities assets of the brokerage.  But if you don't have a record of what investment you owned, I am hard-pressed to think that you could have a claim of owning anything, except maybe cash (subject to the much loser $100,000 cap). 

Why do I care?  SIPC is, on some level, government backed and government funded.  What I can piece together myself gives me very little confidence in SIPC's ability to somehow "straighten out" the books.  I personally think that this is going to turn into a back-door attempt by the government to bailout some very powerful and monied interests.  With taxpayer dollars. 

I hope I am wrong, but I will keep updating this post as I find out more.

update: Clusterstock has a good summary of where they think investors may turn to get some money back.  Short discussion on SIPC insurance that reaches a similar conclusion as mine.

Comments

[Adrienne]

I'm glad you got this one before I did because as soon as I heard that the SIPC would step in, I went hunting for the Fiduciary Unicorn.
Couldn't find anything that looked nearly as suspicious as the FDIC did but I have a bad feeling that all of these are financial fiction.
Imagine more will be coming out as this worsens. Great catch!