Madoff: The loss to society is psychological, not financial

| NY Torch

Investment manager Bernard Madoff has allegedly admitted to what could be the biggest single criminal financial fraud ever, with up to $50 billion in losses. What does it mean for New York?

If this were 2006 instead of nearly 2009, one aspect of the failure would actually be comforting because it would point up how the financial world’s fragile system of checks and balances works (notwithstanding the very real tragedy of the personal losses involved).

It’s obvious, from reading newspaper accounts of competitors’ and potential investors’ scrutiny of Madoff’s firm, that this case was yet another situation in which it wasn’t difficult to protect oneself and one’s money from what many people understood, through foresight and due diligence and not through hindsight, was a murky investment.

Among the warning signs: Madoff’s indepedent auditor clearly didn’t have the resources to audit such a large, complex firm; he did not use an independent custodian that would send customers regular third-party verifications of their assets; and his smooth, predictable returns were anomalous and suspicious to many.

It’s also important to remember that customers of hedge funds that kept their assets at independent custodians at firms like Lehman Brothers did not lose their assets when those custodians collapsed (at least in America; in the UK, it’s a different story). Madoff, by contrast, managed customers’ money at his own securities firm.

While it is hard, almost impossible, to see it now, some — although obviously not all — of our regulatory and private market surveillance measures have worked, and they have protected people from real losses. In the end, when the mess is cleared away, they will provide the beginning of a public and private infratructure that will make us stronger.

The immediate problem is, though, that Madoff’s fraud came to light in a world in which people have already lost confidence in the larger financial system, so there can be no healthy flight to quality controls and investments within that system right now.

To wit: It is hard to differentiate between Madoff’s fraud and the “legal” fraud, including the fraud of self-delusion, of high return for low risk that was the financial industry’s business model for much of the past decade.

Among other things, the failure of Madoff’s firm is likely to spur a “run on the banks” at hedge funds, even those that do use independent custodians and the like. People’s brains are so filled with panic signals right now that they are unable to differentiate between gradations of risk and control, unable to trust their conclusions when they make the attempt, and unable to trust anyone — from their longstanding accountant to their veteran adviser at a surviving investment bank — to help them.

In the short term, then, Madoff’s failure is likely to exacerbate what’s already happening: hedge-fund withdrawals and more forced selling and asset-price declines.

The biggest hit, though, is likely to be psychological, not financial. It is important to point this fact out because recognizing it is necessary to recover from it. New Yorkers — from the wealthy elite who are worrying that everything they ever knew was wrong down to the immigrant in East New York who took out a subprime mortgage based on the same false premises — need to remember: yes, things are bad.

And, yes things will get better — but people have to stop being so shocked so that they can help constructively in the recovery.