Platinum Partners And How To Spot A Fraud

Platinum_partners
Perp Walk, Platinum Partners

Police arrested seven executives connected to the $1+ billion hedge fund Platinum Partners in late December, for fraud.

The charges against them include overvaluing assets and a Ponzi-like practice of paying departing investors with new investors’ money.

Platinum Partners reminds me of lesson number one on spotting financial fraud: If an investment fund never, ever, shows a loss, it’s probably a fraud. I’ll tell a story of how I learned this lesson well, back in 2008.

But first, the rest of the Platinum Partners story. In October 2015, Bloomberg News reported on Platinum Partners’ astonishing investment track-record. One of Platinum’s main funds reported gains in 118 of 119 months – from 2005 to 2015 – a particularly rocky time for investing. Platinum never even lost money in 2008, when every other risky fund lost money.

And Platinum did not invest in safe, low-return strategies either. Rather, they sought out unusual niches in litigation-finance, payday-loan funding, and life-insurance strategies, the kind of investment that pays off when someone dies.

Bloomberg quotes a hedge fund researcher who analyzed Platinum’s business, and came away skeptical:

“When you see nearly flawless returns, it’s intriguing, but also potentially worrying. Even cursory due diligence showed that a number of their dealings ended in death, litigation or handcuffs. Those are the kinds of red flags you can see from outer space.”

In that time Platinum reported an annualized return of 13.5 percent. As it turns out, however, this kind of flawless track record usually only happens when somebody cooks the books.

(Attention fraudsters: You need to be subtler about your fakery. Also: This is not actual financial or legal advice!)

My investor’s experience

The way I learned this number this lesson – that the absence of monthly losses means it’s probably a fraud – involves a story about an investor in my own investment fund, which I began in 2006.

One of my earliest investors was a wealthy man (I’ll call him William) who was introduced to me with the “good” and the “bad” of his investment style explained upfront. The “good” was that he’d allocate a small amount of money early on in the life of a fund with small managers like me, who needed to build up a track record over time. If I produced steady positive returns, William would increase his investment. The “bad” was that if I ever experienced a down month, meaning negative returns, William would probably pull all his money out of my fund very quickly.

flawlessIn the investment management world this is a problem because we all want to attract “sticky” money that won’t leave the fund at the first downturn. And some negative months are inevitable in any risky fund. Nevertheless, I accepted his investment. As a small investment manager, I decided I needed the assets.

I experienced my first significant down month in the Summer of 2008. I made a phone call to William, knowing he’d be more upset than my other investors. Whoo-boy, that call went badly. He insulted not only me, but my wife (who he had never met) in one of the least pleasant conversations of my life. As I had expected, he asked for his money back at the earliest possible moment, which would still be months later.

I next spoke to William on the phone in mid-December 2008. By then, the financial world as we knew it – following the collapse of AIG, Lehman Brothers, Fannie Mae etc – had been completely upturned.

By December, however, William was awfully polite and cheerful with me, and I quickly figured out why. I’d be sending him his money back, with only a minor loss. He had much worse problems than his comparatively small investment with me.

Bernie_madoffThe news of Bernie Madoff’s ponzi scheme had broken a week earlier. Madoff’s claim to fame, prior to exposure, was never suffering a single down month. Of course, William had been an investor with Madoff.

Not only that, however, William had realized by late 2008 that he had invested with at least two other less well-known funds that turned out to be fraudulent Ponzi schemes, one in Florida and the other in Minnesota.

Here’s the thing about William’s strategy: If you invest in lots of funds, and then pull out your money from any funds that have a monthly loss, then you have inadvertently created an algorithm for putting money into the largest number of Ponzi schemes possible.
In the investment world, “you only find out who is swimming naked when the tide goes out,” said a guy. (Ok, that guy was Warren Buffett.)

Well, by December 2008, William was buck-naked at low tide with sharks surrounding him and a steady bleed from his right knee, metaphorically speaking. And it couldn’t have happened to a nicer guy. Yes, I still remember our June 2008 conversation.

But back to the main lesson: If you relentlessly seek out investment funds that never have negative returns – rejecting all those that sometimes lose money – after some period of time you will be left with a very peculiar basket of funds. As I learned from my investor William, that basket will be full of frauds.

fraudI haven’t reached out to William to find out if he’s invested in Platinum Partners, but I wouldn’t be surprised, assuming he hasn’t changed his investment strategy since 2008.

Now, maybe you’ll allow me to extend the metaphor a bit, from investment managers to people.

We naturally seek out flawlessness and celebrate genius. We crave apparent greatness. We want amazing people not just in finance but in many other aspects of our life.

But the frauds tend to be the ones who never admit of doubt. They never accept criticism; they never take responsibility for errors. They never have a down month. As for me, I’m much more impressed by the good ones – in money management and elsewhere – who constantly point out the limit of their own powers. They allow for errors, and they own up to them.

A version of this post ran in the San Antonio Express News and Houston Chronicle.

 

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Book Review: The Intelligent Investor

I never intend Bankers Anonymous as a “How to invest” site,[1] but B$A readers may safely approach The Intelligent Investor as a “How Not to Invest,” a more profitable set of rules in the long run, in my opinion.  I prefer The Intelligent Investor to any modern investment book I’ve ever read, and I recommend it as inoculation against the investment advice crap that fills up bookstores, television, and the interwebs.

Since I started working in finance 15 years ago, acquaintances frequently learn about my background and start in with a “So what do you think of the market here?” or “What do you think of X stock?”  The conversation typically gets awkward from there, as I mumble that fixed income markets are different from ‘the market’ they are asking about and that I typically have no opinion whatsoever about particular stocks.

My professed ignorance is real, but The Intelligent Investor reminds me of why it’s best that I have no opinion.  Benjamin Graham’s quick answer would be that security[2] selection is investing, rather than speculating, only if you have an idea about the value of the company you invest in.  The company’s true value, in turn, would depend on knowing something about the cash flows which may be reasonably expected[3] to accrue to the business you’re buying.  Approximately 0.01% of the people[4] asking my opinion about a particular stock have sought to value a company’s cash flows[5] before making their purchase, or before asking my opinion.  So what my acquaintance really is asking me is whether I prefer red or black at the Roulette wheel, or whether I hit or stay on 16 when the blackjack dealer is showing a 5.  Frankly, I have no opinion, but it’s usually impolite to add that I’m pretty sure the house is going to win against you in the long run.

Please allow me to justify my somewhat extreme response, as it’s contrary to everything most other financial professionals want you to believe, from the Motley Fool to the CNBC fool[6] whose whose primary parlor trick consists of reciting nonsensical facts he memorized about stocks just before the cameras started rolling.  I don’t want to come off like a pretentious finance guy looking down my nose at amateur day traders.  My real target here is not my day trading acquaintances, but rather the entire financial-infotainment-industrial complex, from CNBC to TD Ameritrade, from Goldman Sachs to Charles Schwab, which wants you to believe any or all of the following myths:

1. You can beat the market.

2. Your mutual fund manager can beat the market.

3. Jim Cramer[7] can beat the market.

4. Your investment advisor can beat the market.

5. Your hedge fund guru can beat the market.

Although first published in 1949, very little of The Intelligent Investor feels dated.  I estimate 95% of the opinions and techniques described by Graham still apply.[8]

Here’s a few rules of Graham’s approach that we all mostly honor in the breach, when investing:

  1. Investing in volatile markets requires not a timing approach, but rather a pricing approach.  The entire financial-infotainment-industrial complex will guide you to the former, but investing according to value, when the stock dips into an attractive price range, requires knowing something about how to value a company, and something about the value of your particular target company.  Trust me when I say neither Jim Cramer nor TD Ameritrade will help you in this process.
  2. You should receive investment advice with deep skepticism, whether it comes from your investment advisor, brokerage houses, investment firms, friends, or relatives.  The best investment advisor is one who does two things: She prevents you from imprudent investment behavior, and she claims not brilliance but rather careful and conservative competence.
  3. New issues favor the seller, not the buyer, as the seller has the best access to information and almost by definition picks a favorable time to sell securities.[9]  Individuals should almost never seek to buy new issues.
  4. When deciding to purchase a stock, think like an owner, as that’s what you’ve become.  Expect and hope to be treated by management like an owner.  Realize, however – and this was as true in 1949 as it is today – that shareholder rights barely exist in practice.
  5. Be business-like in your investment practice.  If you would not make professional decisions at work on a whim, based on emotion, or following a rumor you picked up from your gym-buddy, try to resist doing any of those things when making investments.  If you approach investing as an amateur, do not expect profits like a professional, just as you would not in your day job.  Businesslike investing for businesslike profits requires work, an idea which the financial-infotainment-industrial complex would like you to forget.

Benjamin Graham exposes the awful truth that very few of us can competently handle the work required to invest, rather than to speculate.  Even worse, most investment advisors encourage the latter rather than the former.

Once you’ve absorbed this awful truth, what’s an ex-banker to do, you ask?[10]  I’ll paraphrase Graham and add my own editorial suggestions in the light of The Intelligent Investor:

  1. Hire an investment advisor, but pay them to keep you prudent and to deliver market results.  As a logical consequence of this expectation, don’t overpay for investment advice.
  2. Expect market results.  Do not expect to ‘beat the market.’[11]
  3. Markets can be volatile, and that’s not entirely a bad thing.[12]
  4. If you enjoy investing as a hobby, allocate some small part of your investible capital to your hobby, and expect to pay appropriately for that entertainment.  Allocate the greatest portion of your investible capital to a low-cost investment vehicle, not managed by you, that fits your appetite for risk.
  5. Know your appetite for risk.  For example, can you handle losing money?  How much would you be able to lose without losing your head?  Have you considered FDIC-guaranteed bank deposits as a result of thinking about this?
  6. Most people seek to highly diversity their investments, and rightly so.  On the other hand, most people who become very wealthy in their own lifetime typically have extremely concentrated equity exposure.[13] Are you someone who knows enough about owning your business(es) to be extremely concentrated in your equity investments?

Unlike The Motley Fool, I write Bankers Anonymous to “amuse and inform,” but not to give investment advice, or to “enrich.”  Financial advice hasn’t improved much in the last 60 years, which is why The Intelligent Investor is where to begin if you’re looking for investment advice, and it might just be where to end as well.

Please see related post: All Bankers Anonymous Book Reviews in one place.

 


[1] It’s funny how many people, upon hearing my intentions with B$A, have said “So that’s just like The Motley Fool, right?”  I’m not here to “Educate, Amuse & Enrich.”  Just the first two, sorry.

[2] I don’t mean to be jargon-y saying ‘security selection’ instead of ‘stock picking.’ I’m using ‘securities’ to mean stocks or bonds, and Graham refers to them both.

[3] Allowing for Graham’s signature investing rule to always allow for a “margin of safety”

[4] I rounded up that figure, fyi.

[5] I’m saying cash flows here to mean either the income from a bond you own or the expected profits from the company that you own shares in.

[6] Jim Cramer

[7] Yeah, that guy with the clown squeaks, horns and whistles.  Needless to say this brings to mind the great Jon Stewart take-down of Jim Cramer.

[8] Oddly enough, interest rates have done a round trip since 1949, from 2.5% on the 10year to 16% and then back, such that his discussion on expected bond returns feels fresher than it probably would have 30 years ago.  Kinda weird.

 

[10] Last week I came across the best four pages of bullet-pointed investment advice and investment advisory advice I’ve ever seen assembled in one place.  You’ll want to scroll down to Appendix 3, pages 9-12, of this attached PDF.  If any of this blog post/book review speaks to you, you will love printing out those four pages and hanging them on your wall for future reference.  I have zero connection to that author, and I had never heard of him before last week.  You’re welcome.

[11] Now is as good a time as any to acknowledge the weird and ironic truth that Graham’s best-known protégé, Warren Buffett, is the most famous market-beating investment manager of all time.  When I read The Intelligent Investor, I get the strong sense that very few people will ‘beat the market,’ so I should not try it.  But Buffett must have gotten the strong sense of the opposite: that through his efforts he would be one of the rare people who could beat the market.  That’s just one of the small ways in which my life trajectory has differed from Buffett’s.

[12] Graham means it in the sense that stocks sometimes get cheap, so volatility can be your friend.  I mean it in another sense as well.  In the post-Madoff era, we’ve learned that a consistent return with no down months does not mean your investment advisor is a genius, it means he’s a fraud.  Remind me to tell you some time about my client who berated me for 20 minutes over the phone when he experienced the first down month in my fund.  After a period of steady returns investing with me he had come to expect no down months, and suddenly I was “terrible at my job,” and he wanted his money back immediately.  In a related news item, he found out by January  2009 that he had not just Madoff in his portfolio but 3 other Ponzi schemers as well.  He was a lot sweeter to me after that.

[13] The wealthiest man I’ve ever known, someone on the Forbes 400 list, told me when we first met that he’d never invested in the stock market.  Most of his family’s net worth, however, derives from their ownership of a single successful retail business.  That kind of concentrated equity exposure is typically a pre-condition of people who experience massive increases in wealth in their lifetime.  Think Rockefeller, Gates, Jobs, and Zuckerberg.
These folks did not get wealthy through diversification, but rather the opposite.

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Arrest Jon Corzine Right Now

Why is Jon Corzine still a free man?

As the WSJ points out, investigators still have not located $1.6 Billion of supposedly segregated customer money that disappeared three days before the firm declared bankruptcy October 31 2011.

In the history of CEO falls from grace, Corzine’s MF Global debacle ranks far worse than Lehman’s Dick Fuld or Bear Stearns’ Jimmy Cayne.  In the latter case, Fuld and Cayne stand guilty of poor risk management combined with horrific timing.  Their worst crime was failing to reverse course in the face of a financial storm, which frankly, most executives in their position also failed to anticipate properly.  Fittingly, Fuld and Cayne and their cohorts suffered a significant financial setback and some brutal whipping of their reputations in the public square.

To my knowledge, however, Bear Stearns and Lehman never misplaced customer money, the primary and original fiduciary sin.  In the disorderly chaos of March 2008 (Bear’s shotgun purchase by JP Morgan) and September 2008 (Lehman’s Bankruptcy) managers properly segregated customer money, which was later returned to customers in due course.

Not so for MF Global customers, who still await word on the fate of $1.6 Billion of their money, originally held in custody by the now bankrupt firm.

At this point the proper CEO comparison with Corzine’s failure, unfortunately, is not Fuld and Cayne but Stanford and Madoff.

I should back up from my heavy condemnation here and explain what I mean.  Corzine ran Goldman in the early years I worked there.  While many or most fault him for having an outsized appetite for trading risk,[1] nobody has accused him in his career of actively seeking to defraud customers like Stanford and Madoff.

In my wildest paranoid fantasies I do not believe Corzine meant to permanently abscond with $1.6 Billion of customer money.

But – and this is why he should be in jail – I do believe that in a moment of weakness he knew (he knew and authorized!) MF Global’s teensy tiny borrowing of customer money to satisfy (just temporarily, I promise!) margin requirements (just for few hours only!) from creditors demanding margin call money immediately.  In that scenario, Corzine most likely believed, and caused his employee[2] to believe, that a one-day use of customer funds would save a lot of hassle on margin requirements.

The obvious penalty for improperly using customer money is jail.  Which is why I simply do not believe a treasury officer at MF Global would have made an unauthorized transfer without running it by the head of the firm.  Corzine undoubtedly had a plan for a sale or recapitalization that would have made all the MF Global liquidity-squeeze problems go away, if he could just get a brief respite from the margin calls.  In the end, a suitable suitor could not account for all of the firm’s capital and customer money, the rescue failed, and MF Global declared bankruptcy.

I believe it is right and proper that equity investors in Lehman, Bear and MF Global suffer losses, as they took a calculated risk in the hopes of profit.  We forgive the capitalist who invests for a profit but suffers a loss.

But the vanishing of customer money held by a fiduciary is unforgiveable.  It’s the ultimate financial sin, for which heads must roll.  Corzine was the head and I’m afraid should not be a free man.

At least Madoff had the decency to turn himself in.

Please also see: Another Corzine Rant

and Update on Jon Corzine from the MF Global Trustee

 



[1] For which he was pushed aside by his executive team of Hank Paulson, John Thain and John Thornton in the Fall of 1998.  The parallels with Corzine’s 1994 fixed income losses as the head of Goldman’s bond trading department, and his limitless trading appetite during the 1998 Long Term Capital Management episode, are obvious.  With that kind of history, the MF Global trading debacle brought on by Corzine’s European bond trades is not surprising at all.

[2] Whoever actually entered the transfer request

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