Monday, March 2, 2009

Not Ponzi Schemes; Just Sketchy CDO Schemes

So where did Bernie Madoff's and "Sir" Robert Stanford's investors' money go? This wasn't intuitively obvious to me until a few days ago. Neither of these guys, particularly Madoff, could have spent that much money on personal lifestyle, nor do I believe that was their primary motive. Rather, it was a cheap source of financing to support their own personal investments in trees that were growing to the sky, a strategy that worked until the markets collapsed. A recent New York Times article might give some clues.

On February 28, the New York Times Business Section ran a story entitled, "Stanford Accused of a Long-Running Scheme", complete with a perp-walk photo of Sanford's Chief Investment Officer, Lisa Pendergest-Holt. The article described the general structure of Stanford's $8 billion portfolio in terms of "tiers". There were three tiers, with each of the first two at ten percent while the third tier comprised the remaining eighty percent of the portfolio. Tier I was cash; Tier II was invested with "more than a dozen managers worldwide", all of whom presumably were legit. Tier III consisted of "more than $3 billion in real estate holdings and $1,6 billion that turned out to be a 'loan to shareholder," be Mr. Stanford'."

Using the Stanford example, it appears that the first tier was maintained to provide immediate liquidity, in other words the triple-A tranche of a collateralized loan vehicle. This probably was the safety net intended to fund current distributions and redemptions as well as unexpected contingencies. The second tier was the triple-B tranche, less liquid and more volatile but still relatively stable; and the third tier was the unrated tranche that bore the brunt of the risk from investments in which Stanford or Madoff probably stood to benefit as the equity owners. Thus, Stanford's and Madoff's investors were merely providing cheap financing for the sponsors' own portfolios, which undoubtedly were further levered.

This or something like it was a great bull market scheme until the shit hit the fan, and the third-party lenders to the third tier assets pulled the plug, leading to near-instantaneous implosion. Sic transit gloria mundi.

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