December 17, 2008


As we have noted, hedge funds are not only useful devices for the likes of Madoffs but also for laundering criminal monies such as hundreds of billions of dollars from the illegal drug trade. Steven Pearlstein, Washington Post - L'affaire Madoff has also revealed a dirty little secret about a corner of the hedge-fund world known as funds of funds. These are hedge funds that raise money from pension funds, university endowments and wealthy individuals and, for a fee of 1.5 percent a year, invest it in other hedge funds, which charge even higher fees. In return for paying double fees, these middlemen claim to offer investors access to the best hedge funds, which can be choosy about whose money they accept. They also offer the peace of mind that goes with knowing that the funds have been thoroughly checked out. Now it turns out that some of these funds of funds had parked billions of dollars of their clients' money with Madoff without asking how he could so consistently produce returns in up market or down, or demanding to know why his books were audited by a three-person firm that nobody ever heard of operating out of a broom closet on Long Island. Britain's Man Group, Spain's Banco Santander and Switzerland's Union Bancaire Privee all had funds of funds that lost big money with Madoff. . . It will be a while before the full story behind Madoff's scheme finally comes out. But it is already possible to see that this is just the most recent case of a financial disaster that could have been avoided if the professional gatekeepers had done their job. That was certainly the story behind the failures of Enron, WorldCom and the other blowouts from the stock market bubbles, when auditors allowed their desire to preserve lucrative consulting contracts to warp their judgment and override their concerns about how these companies were keeping their books. In the more recent fiasco involving mortgage-backed securities, collateralized debt obligations and credit-default swaps, it was the failure of the rating agencies to adequately assess the risks of complex securities that led to massive losses for investors who thought, or wanted to believe, that they were buying AAA paper. And in Madoff's case, there seems to be little doubt that competent and uncompromised auditors would have quickly discovered that the firm's investment arm was paying out returns it didn't earn. It doesn't take a PhD in finance to see the pattern here: Accounting firms and rating agencies are too easily compromised by the fact that they are chosen and paid by the management of the companies whose books they are auditing and securities they are rating. There are simply too many built-in conflicts of interest.


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