Bernard L. Madoff ran until last week one of the largest hedge funds in the world, with a reported invested principal of over $50 billion serving investors across the world. Spanish bank Santander, commanded by Emilio Botin, has acknowledged that it had invested over EUR 2 billion in Madoff’s fund through its hedge fund manager Optimal. This is the largest loss of any commercial bank in the world, and undermines, once again, the speculative nature of these unregulated investment vehicles, adding to the controversy and debate about how far deregulation in the financial markets has gone. In March of 2007 the CNMV (Comision Nacional del Mercado de Valores), the Spanish financial regulator, approved the commercialisation of hedge funds, allowing sophisticated investors to invest a minimum of EUR 50,000 in these speculative instruments. Leverage was capped in the Spanish regulation to five times the underlying value of the investment. Funds of hedge funds also operate in Spain. They are allowed to invest at least 60% in hedge funds, with a maximum amount of 10% in each one. The Economist Intelligence Unit reports that as of year-end 2007, funds of hedge funds were managing EUR 999 million, and hedge funds were managing EUR 445 million.
Optimal Investment Services is Santander’s investment boutique that operates in the alternative investments space. According to Optimal’s website, the team “began investing into hedge funds in the late 1980s on behalf of private clients”. According to an article published on Hedgeweek on 15-Nov-2006, Optimal Investment Services “is the independent fund of hedge funds arm wholly owned by Santander, having been investing with hedge funds since 1989 and having 11 products, including two relative value funds, four long’short thematic funds, one global trading (including CTA) fund, a multistrategy fund and, finally, two equity non-hedge funds in North America and Europe”. Banif is Santander’s private bank. According to Spanish News Agency EFE, Bani would have incurred in a maximum lost of EUR 19,5 million.
The IBEX35, Madrid’s stock index, went up by 0.54% on Monday, undermining the importance of the fraud on Santander’s income statement. Santander has acknowledged that EUR 2,01 billion of the EUR 2,34 initially lost would correspond to institutional investors. The remaining EUR 320 million would belong to their clients of private banking.
Financial economics studies the optimum allocation of an individual’s wealth across a variety of asset classes that are characterized by different pairs risk/return. The return distribution on many of these assets is considered to be normal, particularly for stocks. Hedge fund returns do not necessarily follow a normal distribution and have thicker negative return tails that make the likelihood of deep losses more unlikely but larger when they occur. Many investment managers would recommend, based on financial theory that started with Harry Markowitz and William Sharpe, both Nobel Prize winners in Economics, to diversify a person’s or an institution’s wealth across fixed income, equities and in the last 15 years, hedge funds. An institutional investor would typically allocate at most a 5% of the investing portfolio to hedge funds.
Santander’s losses are driven by a faulty due diligence process that should have raised flags. A fund’s chief risk officer is typically in charge of determining the risk profile of a particular investment, and is in charge of making sure that in the due diligence, all relevant questions regarding the hedge fund’s strategy are made. The investment manager’s, in this case Madoff’s team, is then scrutizined. In order to invest a chief risk officer should feel absolutely comfortable with the manager, in this case Madoff. Madoff must have been that great pretender that was able to conquer Optimal’s team.
Bank of Spain’s governor Fernandez Ordonez pointed out that Madoff’s fraud was insignificant vis a vis the current financial crisis. We have unfortunately reached a point in which the importance of any fraud can be underestimated if compared with the subprime fiasco that started in the United States. Madoff’s fraud is per se a serious undertaking that ought to be incorporated to the already numerous cases of hedge funds that have gone busted for various reasons. Regulation is the key answer to protect even the most sophisticated investor. Hedge funds can no longer continue to be black boxes with investment strategies that are not somehow supervised to a certain extent. Their leveraged has to be capped. In the meantime Caja Madrid, La Caixa, Popular, Bankinter and Sabadell have declared they have not been impacted by Madoff’s fraud.