Incentive management and the Madoff affair

We know there was an incentive-management problem: the odor of fish was detectable, and in fact detected, but no one had a strong motive for raising a fuss.
What we don’t know is where the money went. It ought to be HARD to lose $50b.

One thing seems clear about the Madoff affair: it wasn’t impossible to figure out that the deal had a fishy smell, and some people did in fact figure it out. But no one, inside or outside the firm, and either official or unofficial, had a sufficiently strong incentive to blow the whistle.* [See second update.] That offers a hint about the required fix. A little qui tam, anyone?

What isn’t clear (to me) is where the $50B went.** [See third update below.] It must have been some combination of outright theft, trading losses, and expenses (commissions, salaries, etc.). If it was stolen, then it must still be somewhere; Madoff could hardly have spent any noticeable fraction. It’s also hard to see how expenses could have accounted for much of that sum. Did he really manage to lose most of 50 gigabucks? Shouldn’t that be hard to do? Roughly as hard as making that much? After all, every trade has a counter-party, so what Madoff lost someone else gained.

Update Josh Marshall wonders what I wondered: did this start out as a fraud, or did it start out as real investment-management activity that made some bad bets and then engaged in fraud to cover up the results? Answer: It seems to have been a fake at least as far back as 2001 1999. The described investment strategy simply wasn’t capable of yielding the claimed returns.

* Second update Actually, at least one person, Henry Markopolos, had it spotted from 1999, and tried hard to make a fuss about it, but couldn’t get any action out of the SEC. Of course I don’t know what Markopolos’s false-positive rate is, or how many others make claims of fraud with equal surface plausibility in cases where no fraud exists, but this suggests that some sort of “private attorney general” set-up might have saved investors tens of billions of dollars.

** Third update Robert of Robert’s Stochastic Thoughts thinks it must have mostly been paid out to the early investors.

Author: Mark Kleiman

Professor of Public Policy at the NYU Marron Institute for Urban Management and editor of the Journal of Drug Policy Analysis. Teaches about the methods of policy analysis about drug abuse control and crime control policy, working out the implications of two principles: that swift and certain sanctions don't have to be severe to be effective, and that well-designed threats usually don't have to be carried out. Books: Drugs and Drug Policy: What Everyone Needs to Know (with Jonathan Caulkins and Angela Hawken) When Brute Force Fails: How to Have Less Crime and Less Punishment (Princeton, 2009; named one of the "books of the year" by The Economist Against Excess: Drug Policy for Results (Basic, 1993) Marijuana: Costs of Abuse, Costs of Control (Greenwood, 1989) UCLA Homepage Curriculum Vitae Contact: