A YouTube video showing Bernard Madoff describing, for a talk show, how the stock market works is a hoot. It’s portentous and enlightening in a retrospective way. Like watching the Titanic’s last moments. At one point, one of Madoff’s staffers is asked by the host, “just describe what the heck you do?” The cryptic answer follows and the host nods vigorously. But I wonder if he was ever the wiser?
The host apparently visited the firm’s premises and was surprised to find “it was a very quiet place”. The quiet, Madoff explained, was due to the absence of humans in the process because the execution process was automated. “Ok,” Madoff said, “let’s take the human factor out of the equation”. That was touted as a technological advance though of course that meant that there were fewer people who really understood what was going on. Later he added, “when you take the human being out of the equation you solve your regulatory problems.” But nobody got the punch line at the time.
The place became a palace of mysteries. And sad to say, there’s a section of the public that is much more inclined to believe in what they can’t understand than in what they can comprehend. That’s the allure of revelation.
The real question that strikes you when Madoff explains, in the video, that he didn’t like MIT grads programming his trading system because they “spent too much time thinking” is how the heck anybody who heard this could in their right mind turn over their life savings to him? Yet apparently many smart people did. They took him on trust. The relied upon the man. And once you trust the captain of the ship then you just sit back and relax.
But do we have any choice? In a world as complex and strange as ours has become, we’ve had to entrust many vital activities to people we don’t know and systems we don’t fully understand. We go through life, as people in Manhattan did on September 11, 2001, thinking we’re safe. But beyond that comforting assumtion, how do we know?
Individual lives from the days of Alexander and Genghis Khan were always vulnerable to far away events. Peasants in China and Mesopotamia were surprised by barbarian invaders hailing from a place so distant they did not even have rumor of it. But today the influences come from every quarter and somehow we think that someone will protect us from them. The really scary thing is that however large we make the regulators, however great the powers we give them it is possible that they cannot protect us from storms at all. Perhaps the downside of an information economy — indeed an information driven world — is that no one really knows what things mean. Perhaps our guardians are just as clueless as the hapless talk show host. He wasn’t a bad guy: just unable to deal with what he couldn’t see.
At Chicago when I was his office slave I discussed with a man who is a Nobel Laureate why we kept on building more complicated theoretical structures. His answer was “It is so that nobody looks to see if the building has a foundation.” MIT grads also have a tendency to look under the floorboards.
A friend once told me that there were two types of Business school graduates. If you hired a guy from Chicago and asked him “What do you think of XYZ corp?” he would stare at a screen and sort a pile of reports covering his desk and spilling onto the floor with his left hand while with his right he worked an old fashioned adding machine with breakneck speed. After a few minutes he would look up at you through coke bottle glasses and say “Sell.” If you hired a guy from Harvard and asked the same question he would smile pick up his phone and dial it with a pencil then he would talk while swiveling his chair to look out the window, “Teddy, hi Tiger this is Fred, hope we’re on for next Thursday. Do me a favor, about XYZ, what do you think? Thanks Buddy I owe you.” Then he’d look up and nod his head “No.”
If you’ve been in a crooked poker game for an hour and haven’t figured out who’s the sucker … you’re the sucker. Oops, I meant to say “investor”.
And here is a suggestion from today’s Wall Street Journal:
“Put Madoff In Charge of Social Security”
Methinks it is too late. Collectively, the politicians and special interest groups of DC are a Madoff.
His associate’s explanation of what he does only sounds cryptic if you don’t understand how your trade gets processed or order flow. It does accurately describe the role of the market maker.
I’ve read that Madoff had two businesses on separate floors of the lipstick building. The Broker/Dealer was regulated and by the accounts I read there were no problems there. The Hedge Fund is where all the crime happened.
…Yet apparently many smart people did. They took him on trust. The relied upon the man. And once you trust the captain of the ship then you just sit back and relax.
But do we have any choice? In a world as complex and strange as ours has become, we’ve had to entrust many vital activities to people we don’t know and systems we don’t fully understand. We go through life, as people in Manhattan did on September 11, 2001, thinking we’re safe. But beyond that comforting assumtion, how do we know?
Answer: You know what is too risky and what is a reasonable bet by doing a thorough due-diligence check and rejecting opportunities that raise flags.
Madoff raised multiple flags. He was secretive about his investment strategy, his returns were too good to be true, and competitors who were using strategies of the same general type that Madoff claimed to use could never match his returns. People invested in Madoff’s fund despite the flags, because they relaxed their guard. People were wiped out by Madoff because they relaxed their guard and didn’t diversify their investments. Investors who kept their guard up, and there were many, avoided Madoff and were unharmed.
So yes, we do have a choice other than to trust the captain. We can check the captain out, monitor his performance, and risk some of our assets to his care only as long as he meets our risk and trust parameters (and keeps making money). Madoff’s investors preferred to trust without verifying.
Of course things are different when government is the captain, because then we often have no choice but to invest (see: Social Security).
Competition and limited government go a long way to curing the ills of modernity.
RWE, I’ve already suggested Madoff be put in charge of Carbon Credit trading. He could partner with Al Gore. Don’t let those talents go to waste, I say. He can run the who shebang out of the UN.
hdgreene, took the words right out of my mouth!
ctc – made sense to me, too. As lotm noted, the Broker/Dealer was probably pretty clean (even if all the little guys whine about how their orders get filled.)
wretchard – the market is fractal, and moves in exactly the same shapes at different time frames. Think ripples on waves on swells (or 1-minute, 60-minute, daily, weekly, monthly, yearly time slices). Take the time scale off a chart and you can’t tell the chart of one timeframe from another. Market makers generally live at the very short end of that spectrum, and therefore don’t have the luxury of thinking much about a trade — they just have to pull the trigger. Hence the need for the risk manager. But this is all on the broker/dealer side, not the hedge fund side. The hedge fund side is looking at the long end of the timeframe spectrum — week, months, years. Again, since the market is fractal, no great mind is really necessary, just a few very simple trading rules, some very good money management rules, and lots of discipline to follow those rules. I read somewhere that the some of the best traders are ex-Marines.
Madoff’s (a fiction writer wouldn’t have dared to use such a name!) associate’s explanation of the herd and the effect of leverage was spot on. One of the maxims I first learned (the hard way) is, “Margin kills.” In spite of the havoc it’s wreaked, it’s comforting in a perverse way to know that the laws of the investing jungle apply to the big boys, too. It’s clear, too, that, in spite of all the computerization, the market remains solidly bound by human perceptions of what high is, what low is, and whether or not there’s another sucker left to sell to. For it is really perception that drives the market up or down, not fundamentals.
Yes, Wretchard, it is mystifying and scary that people are looking for protection from all ills and misfortune from an entity the standard of which is commonly made reference to in the cliché, “it’s close enough for government work”!
Lots of arch replies this meme has garnered.
Not an investor, at least not any more. As I understand Madoff’s schtick it worked like a pyramid con: early investors are paid off out of the funds invested by later investors. Nobody has talked about whatever printed paper Madoff handed over to investors who demanded to know what they were investing in. Is this another example of people who don’t read the fine print, or who don’t miss it when it isn’t produced?
Just asking.