Beating Bernie

The stories about Bernie Madoff keep coming -- his cushy confinement, the conspiracy behind trading confirms, a life sentence. Many articles find common roots in one question. How did he fool so many people?

It's the wrong question.

What we really want to know is how to beat the next Bernie, the next Stanford, or the next Greenwood and Walsh -- the alleged swindlers from upstate New York. Investors won't get their cash back with answers to the past. That money is gone. It's a sunk cost. Now there's a more important question.

How do we avoid these guys going forward?

Financial stings are not going away. John Kenneth Galbraith wrote in his book, The Great Crash of 1929, there is an "inventory" of undiscovered frauds at any given time. It's a sobering thought in the wake of a $50 billion Ponzi scheme. And I believe Galbraith is right. During investment booms, Wall Street attracts talented and legitimate people with the promise of riches. Those same riches attract the criminal element. When times turn bad, as they are now, the falling markets flush out cons that flourished under the veil of prosperity. Unfortunately, the crooks return to money management when economic cycles improve. And they blend into the fabric of our capital markets.

After fifteen years in wealth management -- with both investment boutiques and brokerage houses -- I know only one foolproof way to beat fraud: separate money management from reporting. You can hire that lights-out investment manager. But keep all your assets with a custodial bank like State Street or Pershing. They report your account value, not the money manager. It's like separating church and state.

Custodians don't make investment decisions. They hold securities, process trades, and provide independent statements showing your portfolio's value. They collect dividends and bond payments. They receive wire transfers into your account or send them with your instructions. Their job is to watch your money. In the timeless words of Ronald Reagan, custodians enable you to "trust but verify" what your money managers claim.

While writing Top Producer, a novel to be published in September of this year, I studied frauds dating from Bayou Capital to Charles Ponzi. Not all were Ponzi schemes. But in every single swindle, the cons "custodied" incoming funds. Each one generated their own bogus statements, some blessed by sham auditors, some blessed by respectable firms. Had investors used separate custodians, these deceptions would have failed.

I did not study Bernie Madoff while writing my book. His scheme surfaced later, Thursday afternoon on December 11, 2008. His actions, however, fit the sordid pattern of his predecessors. He custodied investor funds. He generated fake returns. He controlled all communications. An outside custodian would have wrested these powers from him, reported the assets it held, and blown Madoff's cover.

Separating money management from reporting may inoculate you from the next Bernie. But it requires work. Consider hedge funds, funds of funds, and other commingled investments. Hedge funds combine assets in one location and publish their results. Investors see one number -- the value of their investment on the reporting date. Would insistence on a third-party custodian prevent access to the fund?

The answer was "yes" prior to 2008. It was a seller's market. Hedge funds negotiated tremendous powers, often for valid reasons. It was their way or the highway. Typically, the funds would say, "If we manage your money in separate accounts held by an outside custodian, we'll lose our purchasing power."

Maybe. Maybe not.

Economies of scale, in the context of money management, depend on the asset class. Size matters when purchasing certain bonds -- like convertibles or high-yield municipals. But size can be a non-issue when purchasing equities. Don't accept the old line about "purchasing power," without pushing money managers for explanations.

Times have changed. Your negotiating position is stronger. During the fourth quarter of 2008, investors redeemed their positions at unprecedented rates. Fees are way down. Money managers are chasing assets, trying to rebuild their businesses, "their book" in the lingo of Wall Street.

If you're putting new money into a hedge fund, ask for custodial arrangements that suit you. The funds may balk. But they're the ones cutting deals. They're wooing investors who turned skittish in response to the awful markets. It's worth asking no matter the response, yeah or nay. A third-party custodian will take delivery of your securities and report your results directly. For my money, this arrangement beats audited financials all day long.

Over the last ninety days I observed one institution (a former investment bank) accept such a change. It agreed to manage money at an outside custodian -- heresy in previous years -- because the client threatened to pull the account. Now the client receives two financial statements, one from the institution and one from the custodian. Not everyone can negotiate such arrangements. That client is extremely wealthy. But it is a sign of the times s/he was able to separate reporting from money management decisions.

With time, the markets will stabilize. I have no doubt. The appetite for risk will increase, and we'll return to economic growth. Unfortunately, the appetite for risk is exactly what crooks seek. They'll be back: strutting their investment acumen, surrounding themselves with legitimate people, and using jargon to mesmerize targets. Madoff called his ruse a "split-strike option strategy." If you can separate your money managers from the reporting function, you have taken the first step toward avoiding financial scams.