6. The SEC is slated to start overseeing hedge funds in February 2006, yet since Bernie Madoff is not registered as a hedge fund but acting as one but via third party shields, the chances of Madoff escaping SEC scrutiny are very high. If I hadn’t written this report, there’s no way the SEC would have known to check the facts behind all of these third party hedge funds.
Potential Fall Out if Bernie Madoff turns out to be a Ponzi Scheme:
1. If the average hedge fund is assumed to be levered 4:1, it doesn’t take a rocket scientist to realize that there might be anywhere from a few hundred billion on up in selling pressure in the wake of a $20 - $50 billion hedge fund fraud. With the hedge fund market estimated to be $1 trillion, having one hedge fund with 2% - 5% of the industry’s assets under management suddenly blow up, it is hard to predict the severity of the resulting shock wave. You just know it’ll be unpleasant for anywhere from a few days to a few weeks but the fall out shouldn’t be anywhere near as great as that from the Long Term Capital Management Crises. Using the hurricane scale with which we’ve all become quite familiar with this year, I’d rate BM turning out to be a Ponzi Scheme as a Category 2 or 3 hurricane where the 1998 LTCM Crises was a Category 5.
2. Hedge fund, fund of funds with greater than a 10% exposure to Bernie Madoff will likely be faced with forced redemptions. This will lead to a cascade of panic selling in all of the various hedge fund sectors whether equity related or not. Long-short and market neutral managers will take losses as their shorts rise and their longs fall. Convertible arbitrage managers will lose as the long positions in underlying bonds are sold and the short equity call options are brought to close. Fixed income arbitrage managers will also face losses as credit spreads widen. Basically, most hedge funds categories with two exceptions will have at least one big down month thanks to the unwinding caused by forced redemptions. Dedicated Short Funds and Long Volatility Funds are the two hedge fund categories that will do well.
3. The French and Swiss Private Banks are the largest investors in Bernie Madoff. This will have a huge negative impact on the European capital markets as several large fund of funds implode. I figure one-half to three-quarters of Bernie Madoff’s funds come from overseas. The unwinding trade will hurt all markets across the globe but it is the Private European Banks that will fare the worst.
4. European regulators will be seen as not being up to the task of dealing with hedge fund fraud. Hopefully this scandal will serve as a long overdue wake-up call for them and result in increased funding and staffing levels for European Financial Regulators.
5. In the US Fairfield, Access International Advisors, Tremont and several other hedge fund, fund of funds will all implode. There will be a call for increased hedge fund regulation by scared and battered high net worth investors.
6. The Wall Street wire house FOF’s are not invested in Madoff’s strategy. As far as I know the wire house’s internal FOF’s all think he’s a fraud and have avoided him like the plague. But these very same wire houses often own highly profitable hedge fund prime brokerage operations and these operations will suffer contained, but painful nonetheless, losses from loans to some hedge funds that go bust during the panic selling. As a result, I predict that some investment banks will pull out of the prime brokerage business deeming it too volatile from an earnings standpoint. Damage to Wall Street will be unpleasant in that hedge funds and FOF’s are a big source of trading revenues. If the hedge fund industry fades, Wall Street will need to find another revenue source to replace them.
7. US Mutual fund investors and other long-term investors in main stream investment products will only feel a month or two’s worth of pain from the selling cascade in the hedge fund arena but their markets should recover afterwards.
8. Congress will be up in arms and there will be Senate and House hearings just like there were for Long Term Capital Management.
9. The SEC’s critics who say the SEC shouldn’t be regulating private partnerships will be forever silenced. Hopefully this leads to expanded powers and increased funding for the SEC. Parties that opposed SEC entry into hedge fund regulation will fall silent. The SEC will gain political strength in Washington from this episode but only if the SEC is proactive and launches an immediate, full scale investigation into all of the Red Flags surrounding Madoff Investment Securities, LLC. Otherwise, it is almost certain that NYAG Elliot Spitzer will launch his investigation first and once again beat the SEC to the punch causing the SEC further public embarrassment.
10. Hedge funds will face increased due diligence from regulators, investors, prime brokers and counter-parties which is a good thing and long overdue.
Potential Fall Out if Bernie Madoff is found out to be front-running customer order flow:
1. This would be just one more black eye among many for the brokerage industry and the NYSE and NASDAQ. At this point the reputations of both the NYSE and NASDAQ are already at rock bottom, so there’s likely little downside left for these two troubled organizations.
2. The industry wouldn’t miss a beat other than for the liquidation of Madoff Investment Securities, LLC. Figure it will be similar to REFCO’s demise only there won’t be a buyer of the firm given that they cheated customers who would all be embarrassed
