Monday, December 15, 2008

Red flags of Madoff Investment

On Wall Street, traders started picking apart Mr. Madoff's strategy based on client statements -- which they said raised several red flags that should have been obvious to the banks and investment firms that promoted Mr. Madoff. Several concluded that while Mr. Madoff's stated investing strategy was valid, it would have been impossible to execute with the amount of money he was managing. Mr. Madoff told clients he was using a fairly common options-trading strategy to generate modest but steady returns for more than two decades. The strategy involved buying stocks, while also trading options -- which grant the right, but not the obligation, to buy or sell securities at pre-established prices and dates -- in a way designed to limit losses on the shares. People who analyzed client statements said Mr. Madoff's firm couldn't have bought and sold the options he claimed because those totals would have outstripped total trading volume those days. A typical account statement provided to clients by Mr. Madoff's firm showed him buying shares of blue-chip companies such as Intel Corp., AT&T Inc. and IBM Corp. and also trading options on the Standard & Poor's 100-stock index, which tracks the movements of the market's very largest stocks. Then, at the end of each month, all of the stocks are sold, and the cash put into Treasury bills. That was another red flag, because the options strategy he used, when practiced by others, typically held its investments for longer periods, says Millicent Holmes of Crowe Wealth Management, who had researched Mr. Madoff's firm as a possible investment but ultimately steered clear. Mr. Madoff's option-trading technique is known as "split-strike conversion strategy," and it is designed to earn income off a stock portfolio while protecting against big declines in the market. Experts say it would be a difficult investing strategy to pull off with the immense amounts of money Mr. Madoff's firm was managing. For example, a client statement reviewed by The Wall Street Journal for last month showed that on Nov. 12 Mr. Madoff moved $500,000 out of U.S. Treasury bills, as well as $1,460 out of a Fidelity Investments money-market account. That cash was invested in nearly three dozen stocks, such as Exxon Mobil Corp., Proctor & Gamble Corp. and Microsoft Corp. That same day Madoff bought 11 "put" option contracts on the S&P 100 for $19,591 and sold 11 "call" option contracts on the S&P 100 which took in $17,369. During this time, the stock market was in a steep decline. By Nov. 19, when the firm next did a trade, the S&P 500 fell nearly 10%. On Nov. 19, Mr. Madoff closed out those particular options trades, losing about $14,000 on the "call" but making about $21,000 on the "put" for a net $7,000 profit. On the surface, this was a straightforward example of the strategy. However, the problem is that if Mr. Madoff replicated the trade firmwide, as he was thought to be doing, the trading wasn't showing up in the options market. On Nov. 11, if it took 11 contracts to hedge a half-million dollars, it would have taken 22,000 contracts to protect $1 billion. Mr. Madoff claimed to be managing $17 billion. But on Nov. 11, only 393 of the "call" contracts the firm sold actually changed hands, according to the Chicago Board Options Exchange. And trading totaled 183 in the "put" options he bought. The so-called open interest in both those contracts -- the measure of contracts outstanding -- was just 4,639. Madoff records from another client show a similar discrepancy in 2007. According to a copy of the client's statement reviewed by the Journal, Madoff bought 114 options contracts based on the S&P 100, while selling 114 others at a different price. The 114 "call" contracts Madoff entered into represented about 10% of the trading volume recorded that day for that contact at the Chicago Board Options Exchange. The 114 "put" contracts represented about 20% of the volume, meaning that if Madoff would have executed similar trades for five other clients, the firm would have made up the entire trading in the options contract that day. Meanwhile, between the Nov. 11 and Nov. 19, the S&P 100 lost nearly 10%. The statement reviewed by the Journal didn't provide a line updating the value of the stocks in the account, but if the stock portfolio behaved as designed and mirrored the move in the index, it would have been down roughly $50,000, far overwhelming the $7,000 gain in the options position. http://online.wsj.com/article/SB122938212422208613.html?mod=testMod

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