Common Thread Between Madoff, FTX, and Theranos, Corzine.....Ponzi and Other Frauds
Ponzi's But Could Have Been Discovered
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The Madoff Documentary on Netflix is worth watching. I have some quibbles with it. My main quibble is one of the same conclusions left-wing media writers made after the financial crisis; the government didn’t have enough resources and there was a lack of regulation to combat it.
Michael Lewis and everyone else that reported or wrote about the financial crisis of 2008 said it was the bank’s fault. In truth, the banks couldn’t do what they did without Barney Frank and the implicit government guarantee of Fannie and Freddie. You should only roll the dice in Las Vegas.
There were plenty of bad actors in the private sector, rating agencies, analysts, banks, and mortgage companies on down. They never were held accountable. The government bailed them out. But, without the government, they couldn’t have done what they had done.
They should have never bailed out the banks either. I actually advised a Congressperson on how to vote before the Bailout Vote. I gave him the way I saw both sides of the coin, and was transparent about my position in the market and what I thought the bailout would do to it. That Congressperson voted against it.
It was the right vote.
But, there is a common thread between Madoff, the Financial Crisis, Theranos, and FTX. It’s diligence.
In all cases, there was a breakdown in diligence that allowed the fraud to happen. People wanted a risk-free return, a lock. Greed was involved in some cases. In some cases, the bank JP Morgan was heavily involved like they were with the Jon Corzine fraud. Madoff couldn’t have done what he did without JPM and neither could Corzine. Interestingly, the Wall Street Vampire Goldman Sachs passed on Madoff. You might hate $GS, but they make a lot of good moves.
In all cases, human nature is also at fault. Once you make a decision and you feel like you have gone through a diligence process to make that decision it is hard to admit you are wrong. Humans have an inherent need to want to trust other people. It is hardwired in us which is why fraud has been around since Adam and Eve. If only Adam could have resisted that apple. I think that is the case right now with Covid and all the malarky that surrounded it. The vaccine doesn’t work. Lockdowns didn’t work. Masks don’t work. There might be evidence that the mRNA vaccine causes other conditions like myocarditis and is hurting people. Yet, the battle lines are already dug in.
The truth is, our institutions today are corrupt. They cannot be trusted.
However, Trump Derangement Syndrome is real. People get so visibly angry when you bring up Trump. The simple fact is Joe Biden looks to be engaging in exactly what Trump was accused of but the government is building a case to stick it to Trump!
Thank goodness Elon Musk bought Twitter. It’s allowing the free flow of information. Maybe free-flowing information will help stop financial fraud too. I am glad
and others are opening up lots of cans of worms for the world to see. I doubt seriously if any of them would align politically with me, but we align in the fact that there are lots of coverups all over and they need to be exposed. Transparency and the actual truth will make us freer than any law or edict that was written on paper.I was reading an interview with Alfred Lin, the VC who led the deal for Sequoia in FTX. Here is a description of the interview.
The investment, once a source of pride for the firm, has tarnished not only Sequoia but also Lin, who led the deal on behalf of Sequoia and who was also the firm’s point of contact with CEO Sam Bankman-Fried for a year and a half. He spoke thoughtfully yesterday about how he feels today about a bet gone so wrong.
Asked, for example, whether looking back, there were signs that Lin sees now that he missed earlier, he answered after a pause: “I thought [Bankman-Fried] was very smart . . . He answers questions very logically and very succinctly. Could we have spotted any tells? I don’t know. There’s what I know today and what I knew at the time. If I knew at the time, we wouldn’t have invested. So today, I think the thing that gets me to reassess is . . . it’s not that we made the investment. It’s the year-and-a-half working relationship afterward, and I still didn’t see it. And that is difficult.”
There doesn’t seem to be any humbleness in his answers, no remorse. No learnings. When I lose money on an investment, I always look at myself first. What did I do wrong? How could I be better? What did I miss? It seems like deflection but I could be very wrong about that.
I don’t care that he spoke thoughtfully. I don’t care that SBF was smart. I have passed on plenty of ideas and deals where the person was able to efficiently answer questions and did so logically. Sequoia didn’t do any diligence on FTX that was meaningful. They failed to ask two questions that would have uncovered the fraud and would have led them to pass on the investment.
How do you clear and settle trades?
How do you pay and collect with customers?
It’s not just Lin and Sequoia. Plenty of VCs invested and screwed up. It’s clear they don’t have the bench to invest in deals like this. Just because you went to the right school, or have the right MBA doesn’t make you a jack-of-all-trades investor. I was chatting with another investor about investing the other day. In looking at my track record, there are no medical deals in my portfolio. Why? Because I don’t know how to diligence them and don’t know shit from Shinola about medical deals. I just think they are cool and thinking something is cool will cost you a lot of money, as it did Sequoia.
Years ago in 2005, I had breakfast with a Russian person who was setting up an exchange in Russia to take advantage of the new open economy. He had an MBA from Chicago Booth, so he wasn’t a dummy. Fraudsters never are. He wanted a U of C professor to be on his “advisory board” to lend credibility to the exchange. It was a nice breakfast but soon I could tell the guy was full of shit. I asked,
How are you going to clear and settle trades?
He said, “We aren’t ready for that yet.” I replied, “You aren’t ready to be an exchange then.” Fortunately, the U of C prof passed on the opportunity. I don’t think the business ever got off the ground.
No one does diligence because no one understands diligence.
Even I have been burned a couple of times. If you are an active investor, you will be too on something. Hopefully, it’s not fatal. You want to trust the person that you are working with, so people are afraid to probe too far. I have invested in startups where the founder lied to us. You can only do so much. What were we going to do, hire a forensic accountant to go through all the statements to make sure they were on point? I invested in a hedge fund where I asked what the strategy was, and the trader lied to me. When the fund lost money, guess what? He was employing the strategy that I specifically asked him about and said I wouldn’t invest in if he was using it. Man, was I pissed. Neither losses were fatal. Risk not all your eggs in one basket.
You can only do so much, and you can only spend so many resources on diligence. At some point, you have to trust your counterparty. But, you have to do clear step-by-step diligence if you want to be successful in putting money into someone else’s idea be it a real estate venture, hedge fund, or startup company to get to that point.
However, even when you do sometimes you get burned just like I did.
I remember another guy from a different MBA class at Chicago than mine was putting together some “bond scheme”. I looked at it and knew it was a fraud right away. I told one of my buddies about it to stay away and he did. It turned out, he roped in a Chicago investor. That investor was incensed when I told him it was a fraud. Turns out, a year later that same Chicago investor bounced a check to a startup for $350k. Fraudsters gonna fraud.
When someone is intent on committing fraud, or they need to keep a fraud going, they will do anything to build trust with you and still work behind your back to commit the fraud. Just like a criminal that ignores gun laws, fraudsters don’t care about how many regulations there are or what agency is in their way.
Madoff and Theranos founder Elizabeth Holmes were also psychological masters. When people engaged in diligence, they told them they didn’t want their money. Their own personal greed ate up their logic and they put money in any way. Not being able to be in the club sometimes creates enough demand that you will do anything to get in. Emotion takes over your objectivity.
The Angel Capital Association did a study years ago and found the more time you took to do diligence, the more successful the investment was. That’s why in the past few years seeing VCs throw money into deals on one meeting makes me think this cycle of funds will have bad returns. Combine that with the sky-high valuations they invested at and it will be worse.
Theranos took advantage of people that were not professional investors. They were family offices that weren’t used to investing in startups. Theranos, FTX, and Madoff were able to build a circle of trust and the imprimatur of credibility that allowed clients to implicitly believe in what they were doing and be comfortable with it. They knew the right people, on the right charity boards, on the right public/private boards, lived in the right places, and said the right things at the right moment. The existing clients brought new people to the table as well. Like a snowball, it fed on itself as it rolled downhill.
That brings me back to government agencies and regulations.
When do government agency personnel go to prison for dereliction of duty? When do they get fired? When do they pay a price? They sit protected in their Ivory Towers and are above the fray, oblivious to the suffering. You can point to many many instances over time where this is true, not just recent history.
There is a lot of noise about regulating cryptocurrency today. If only we had regulation, it would be better and make it work. That’s so untrue. The past history proves me right.
In the case of Madoff, the SEC horse was led to water several times and never took a drink. It wouldn’t have mattered how much money the SEC had in their budget, they were so stupid they couldn’t be bothered to investigate. All you had to do was look at trading volume and counterparties. If you looked at that, you knew there was a fraud.
I am worried that today, virtually all government agencies have been mobilized to find “woke” problems they are avoiding the real ones that they are supposed to find that protect us. The recent debacle on airline computer systems is an example of that. The recent example of supply chain debacles at US ports is an example of that.
The government failed us in the financial crisis too. It was the foundation that allowed the whole house of cards to be built. They also failed us in Madoff by not monitoring the private associations that were supposed to be in place to help prevent fraud.
The government didn’t fail us in FTX since crypto is mostly unregulated. However, does anyone think the SEC could have caught it? Especially after looking at all the facts in the Madoff case. Terry Duffy knew right away because he asked the right questions.
The government never seems to get in front of anything. The Fed is always behind the curve. Agencies are always behind the curve. Congress is always behind the curve. Only the free market is ahead of the curve.
One thing I learned early from a gentleman named Dennis Serio is diligence is not something to overlook. When we were putting together a consortium of midwest angel groups, one of the hugest sticking points was diligence. We agreed to not hold anyone accountable for their own diligence if it didn’t pan out. We had to trust them, and if we wanted to do more we were free to do it. If it meant missing a deal, it meant missing a deal.
Another old-time Chicago VC Bob Geras talked to me a lot about diligence. So did another old-time VC Sam Guren. Talking to old hands sometimes helps you understand where to find the holes. Trouble is, now I am starting to catch them on the old-time part.
If you are a big pool of capital or an investor that places money with someone, what do you do?
I’d ask the opposite party what their diligence procedures are. If they give you generalizations, ask deeper questions to see if you can uncover if they are really doing the work or if they are bullshitting you. I’d also ask them what their investment style is. If they don’t serve on boards and lead deals, I’d like to know exactly why and how they get information about the companies.
I’d also question how much time do they spend doing their diligence. Is it a one-day process or does it take months? If you are investing less than a million dollars, the time of diligence and the type you do will be different than if you are investing more than a million. It also depends on the underlying asset you are investing in. If you are investing in a startup, the diligence is different than a hedge fund or another type of asset. You better know what questions to ask, or know someone, or employ someone that knows the questions to ask.
You can hire all the accountants and lawyers you want after the fact. They won’t help. They might help if you hire them prior to the investment. Might. It all depends on if they know the right ways to look at data and ask the right questions.
There is always gut instinct too. Sometimes, when I meet a guy, my neck hair stands on end. You just have an intuition. But, you can’t go on intuition. You can’t go with your gut when it comes to real diligence. Your gut can only uncover questions that you have to answer for yourself with objective data. If your gut continues to bother you even though the data you come up with should calm it, then don’t make the investment.
Diligence can’t be googled. It’s hard work. As an aside, you should be using Freespoke as your search engine anyway.
If you do your diligence and still lose money, them’s the breaks of investing. It happens. There is no free lunch when you invest. There are no risk-free returns. If you are going to earn a return on investment, you have to accept the fact that you can lose on that same investment.
My favorite snippet: The government never seems to get in front of anything. The Fed is always behind the curve. Agencies are always behind the curve. Congress is always behind the curve. Only the free market is ahead of the curve.
We witness this day in and day out nowadays. The CDC and FBI are freaking clown shows.
Keep the great posts coming in 2023.
SBF apparently liked to play videogames while having discussions with potential investors. I don't see how anyone could have not viewed this as a very bad sign.