1. BERNIE MADOFF Bailout and Hedge-fund Regulation

2. Outline  Background  Bailout?  Regulation Moving Forward  Conclusion & Ponzi Schemes Moving Forward

3. Outline  Background  Bailout?  Regulation Moving Forward  Conclusion & Ponzi Schemes Moving Forward

4. Gravity

5. The bankruptcy court released a 162-page list naming thousands of Madoff victims, including: ◊ ◊ Aozora Bank (Japan) ◊ ◊ Nordea Bank (Sweden) ◊ ◊ Bank Medici (Austria) ◊ New York University ◊ ◊ HSBC ◊ John Malkovich ◊ ◊ Steven Spielberg ◊ Fairfield Greenwich ◊ Kevin Bacon ◊ World’s Largest Ponzi Scheme

6. Begs the questions 1) How could this scheme go on for so long? 2) How could so many sophisticated individuals be taken in by a fund that provided no info on how it was able to achieve consistent returns of 8-13% for many years, during both good and bad times?

7. 20+ Years of trickery  SEC did a bad job regulating. They too were caught up with the hype surrounding investors.  Split-Strike Strategy – complex with many moving parts.

8. Begs the questions 1) How could this scheme go on for so long? 2) How could so many sophisticated individuals be taken in by a fund that provided no info on how it was able to achieve consistent returns of 8-13% for many years, during both good and bad times?

9. Information Cascades  Each successive investor assumed that the previous investor did their due diligence  “Information cascades” – kind of like playing telephone.  Perhaps “sophisticated” financial institutions are NOT immune from hypes

10. Bernard L. Madoff  Professional Accomplishments:  Founder of Bernard L.Madoff Investment Securities (BMIS)  Chairman of the Board of NASDAQ  Founding Member of the International Securities Clearing Corporation in London  Board of Governors of National Association of Securities Dealers

11. Exclusive Circle: Club Madoff Bernie Madoff Ruth Madoff’s Friends Exclusive Circle International Banks; College Endowments Feeder Funds Mutual Funds

12. Outline  Background  Bailout?  Regulation Moving Forward  Conclusion & Ponzi Schemes Moving Forward

13. Yes Bailout....  Millions were affected  Not only wealthy white-collar individuals, but also blue-collar individuals with retirement funds managed by one of the feeder funds.  Hedge Fund Bailout  It’s been done before with success, i.e. LTCM.

14. LTCM v. Madoff Long Term Capital Management Bernard Madoff Investment Securities “Tail” risk(s) that triggered the downfall: Asian Financial Crisis of 1997 & Russian Default of 1998 Current Financial Crisis Counterparties:Wall Street BanksFeeder Funds Prominent Management attracted investments: John Meriwether Myron Scholes Robert Merton Bernard Madoff Millions of Innocent parties affected: Approximately $4.6 Billion loss Approximately $50 Billion loss

15. LTCM v. Madoff Long Term Capital Management Bernard Madoff Investment Securities Hedge Fund Secret:“Secret sauce” (= profitable arbitrage and pairs trade) Split-Strike Strategy (but in fact Ponzi Scheme) Investment Strategy was Legitimate? YesNo Investor Money was …Spread out to purchase US, Japanese, and European government bonds Concentrated in Madoff’s pocket Economic or legal remedy available? NoYes

16. No Bailout  Legal Remedy Available  People are already bringing lawsuits against Madoff and feeder funds.  Bailout will encourage Ponzi Schemes  If government bails out Ponzi scheme participants, then taxpayers stand to lose more money than Ponzi players. This incentivizes a rational person to partake in the next Ponzi game rather than avoid it.

17. Outline  Background  Bailout?  Regulation Moving Forward  Conclusion & Ponzi Schemes Moving Forward

18. What is a Hedge Fund?  Unregistered, privately-managed pools of capital  Equity investments  Leverage and short selling  Absolute return  Why regulate?  Long-term incentive alignment  Retailization  Systemic risk

19. Securities Act of 1933  Section 4. Exempted Transactions  Regulation D, Rule 501  “Accredited Investor”  Calculating purchasers  Regulation D, Rule 506  No more than 35 purchasers  Sophisticated purchasers

20. Securities Exchange Act of 1934  “Dealer” vs. “Trader”  In the business of buying and selling securities  Registration under 15(b)  Section 12. Registration Requirements for Securities  More than 500 holders of record, and  Assets in excess of $10M

21. Investment Companies Act of 1940  Section 3(c). Further exemptions  3(c)(1) –type hedge fund Up to 100 investors No public offerings  3(c)(7) – type hedge fund Up to 500 qualified purchasers No public offerings  “Qualified Purchaser”

22. Investment Advisors Act of 1940 Section 203(b). Registration of Investment Advisors  Fewer than 15 clients in past 12 months, and  Doesn’t hold self out as an investment advisor

23. Other  Commodity Exchange Act  FINRA  ERISA  Department of Treasury  Fraud

24. Madoff: Repeated Investigations  1999: SEC send examiners to review trading practices  2000: SEC sends examiners to review trading practices  2004: SEC investigates front running allegations  2005: NASD reviews Madoff  2005: SEC investigates front running allegations  2006: SEC investigates Ponzi Scheme allegations

25. Madoff Skeptics  Harry Markopolos  Mark Occrant  Erin Arvedlund

26. SEC: Organizational Problems  Understaffed  Lawyers not financial experts  Political influences  Little deterrent effect  GAO study – 92% of hedge funds in study were not in compliance.

27. Any Lessons Learned from LTCM?  “Unique characteristics and unlikely events”  Amount of leverage is rarely seen today  Private parties were willing to buy LTCM  Counterparties could have absorbed losses from a default

28. Outline  Background  Bailout?  Regulation Moving Forward  Conclusion & Ponzi Schemes Moving Forward

29. In the end…  No Bailout for Madoff victims  Regulation laws seem fine. The problem is the people running the organization.

30. How to Succeed in a Ponzi Scheme  Don’t expand too fast.  Show bad numbers once in a while.  Run while you’re ahead.