Big news for followers of financial fraud. From the Associated Press:

Bernie Madoff, the financier who pleaded guilty to orchestrating a massive Ponzi scheme, died in a federal prison early Wednesday, a person familiar with the matter told The Associated Press.

Madoff died at the Federal Medical Center in Butner, North Carolina, apparently from natural causes, the person said. The person was not authorized to speak publicly and spoke to the AP on the condition of anonymity.

The former non-executive chairman of the Nasdaq pleaded guilty in March 2009 to securities fraud after his investment fund, estimated to have assets worth $60bn at the time, turned out to be nothing more than a simple Ponzi scheme.

Here are three lessons from the affair, which may or may not have some application today.

Beware bond-like volatility with equity-like returns

Madoff was heralded by his clients — which included several high net worth individuals such as director Steven Spielberg and actor Kevin Bacon — for the consistency of his returns. In fact, he never had a down year, while also delivering double digit returns for his clients.

Here’s what those returns look like in chart form, via Bespoke Research Group:

There’s an adage in finance that if someone delivers performance with the volatility of boring-old bonds, but the returns of equities, then something is wrong.

Which brings us to our next point . . . 

Secretive firms are often secretive for a reason

It’s fair to say that, outside of dinner parties hosted by costal elites, very few knew that Bernie Madoff actually ran money. Indeed, one of the few articles written about Madoff, in Barron’s in 2001, came with the headline “Don't Ask, Don't Tell: Bernie Madoff is so secretive, he even asks his investors to keep mum”.

Here’s an extract:

Folks on Wall Street know Bernie Madoff well. His brokerage firm, Madoff Securities, helped kick-start the Nasdaq Stock Market in the early 1970s and is now one of the top three market makers in Nasdaq stocks. Madoff Securities is also the third-largest firm matching buyers and sellers of New York Stock Exchange-listed securities. Charles Schwab, Fidelity Investments and a slew of discount brokerages all send trades through Madoff.

But what few on the Street know is that Bernie Madoff also manages more than $6 billion for wealthy individuals. That's enough to rank Madoff’s operation among the world's five largest hedge funds, according to a May 2001 report in MAR Hedge, a trade publication.

What's more, these private accounts, have produced compound average annual returns of 15 per cent for more than a decade. Remarkably, some of the larger, billion-dollar Madoff-run funds have never had a down year.

Madoff told Barron’s, and others, that the strategy was both “proprietary” and achingly simple: he bought a broad index of mega-cap stocks, and then generated the excess returns by selling call options and buying put options. The magic, apparently was in how the strategy was executed.

Which was just as well, because no options strategist could recreate his returns, including a portfolio manager at trader Rampart Investment Management named Harry Markopolos. The lesson here? Don’t just accept a fantastical claim at face value, whether its from a company promising a new form of blood testing, or a new approach to a decades old-technology problem. It helps to speak to the experts before suspending your disbelief.

Regulators are often financial archeologists

Markopolos approached the Securities and Exchange Commission with evidence that Madoff was running a fraud three times between 2001 and 2005. Three times the regulator ignored him. The evidence he presented wasn’t even particularly complicated — one of his findings was that there was simply not enough option volume at the CBOE for Madoff to execute his straddle strategy.

After the fund blew up, a 2009 investigation by the SEC found that, despite the first tip-off about Madoff being made in 1992, various examinations of his operations found nothing out of order.

Why? Well, here’s a few paragraphs from the investigation:

During the course of both these examinations, the examination teams discovered suspicious information and evidence and caught Madoff in contradictions and inconsistencies. However, they either disregarded these concerns or simply asked Madoff about them. Even when Madoff’s answers were seemingly implausible, the SEC examiners accepted them at face value.

In both examinations, the examiners made the surprising discovery that Madoff’s mysterious hedge fund business was making significantly more money than his well-known market-making operation. However, no one identified this revelation as a cause for concern.

A later paragraph goes on:

As with the examinations, the Enforcement staff almost immediately caught Madoff in lies and misrepresentations, but failed to follow up on inconsistencies. They rebuffed offers of additional evidence from the complainant, and were confused about certain critical and fundamental aspects of Madoff's operations. When Madoff provided evasive or contradictory answers to important questions in testimony, they simply accepted as plausible his explanations.

Reforms followed, with the regulator promising several actions to help fight financial crime in the future.

The lesson here is one of timing: regulators seem to only jump into action when the horse has firmly bolted. Think of the SEC’s after-the-fact actions against delisted Chinese coffee stock Luckin Coffee, or more vividly, what’s emerged about German regulator Bafin’s handling of Wirecard after it collapsed.

In short: if you’re an investor and you think the regulator is going to get ahead of a fraud, think again. As short-seller Jim Chanos remarked to the FT, regulators are “are the financial archaeologists — they will tell you after the company has collapsed what the problem was.”

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