Tag Archives: investing

Madoff’s Programmers

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In my last blog entry, I took exception to Mark Cuban’s use of the term Financial Engineering to imply that the word ‘engineering’ was synonymous with the word ‘fraud’. It has been my experience that engineers hate to be wrong about anything, which is no doubt due to their analytical nature, and so as a rule, they are not very good liars. To every rule, however, there are exceptions.

We see evidence on the Internet every day that technically skilled individuals are applying their skills to cheat people out of money. I like to believe that the perpetrators of these scams are a small minority, and it’s only because of the vast reach of the Internet that they seem so ubiquitous. I suppose there may also be cases where otherwise honest programmers are persuaded to help dishonest people because they are desperate for money or want to keep their jobs.

I recently read the book, Madoff with the Money about Bernie Madoff’s Ponzi scheme that swindled investors out of more than $50 billion. The details of the how the scheme was pulled off are not really covered in the book, but all the while I was reading it, I knew that Madoff must have had technical help. Madoff barely possessed the computer skills to send an email. His computer, which basically was set up to display stock ticker data, confounded him. By all accounts, he was of average intelligence, not the financial genius that many people thought he was.

Madoff’s results at significantly outperforming the market year-over-year for more than a decade were baffling to most Wall Street insiders. There are a lot of really motivated people in the financial arena who have access to the brightest minds and best information available and they couldn’t figure out how he was doing it. For that reason alone, many assumed he was doing something illegal. There was even one whistle blower, Harry Markopolos, who contacted the SEC several times including going so far as sending detailed complaint letter describing in excruciating detail 29 ‘red flags’ that indicated that Madoff was either front running stocks (basically a form of insider trading) or, more likely, operating a Ponzi scheme. Markopolos had first contacted the SEC about Madoff in 1999 and several times after that. They ignored him.

About a month ago, two of Madoff’s programmers, Jerry O’hara and George Perez, were arrested and charged for their role in the fraud. They have been subsequently released on $1M bond. Apparently, they are the ones who wrote the programs and operated an old IBM AS/400 computer known as ‘House 17’ that printed out the fictitious statements and reports that made the investment results look real. Below are a few examples of the statements that Madoff investors received.

madoff-earnings-statement-page2

madoff-earnings-statement-page2

Apparently, using historical market data, they were able to adjust the market entry and exit dates and ratios of stocks to achieve any return rate that they wanted for the month. Prediction is hard, especially about future events, but predicting the past is easy. But there were a lot more nuances to the fraud than just revisionist history of trading events. They had to make sure that the trades wouldn’t look out of scale with daily volumes or any other anomalies that would set of alarm bells with auditors and regulators. When Madoff had only a few large investors, it was possible to generate statements with this method manually, but as the number of investors grew, so did the complexity of generating the fictitious earnings reports and so it was necessary to employ computer programs to help generate the reports. And of course, any Ponzi scheme must get bigger and bigger to stay alive and to be able to be able to make good on early investor redemptions or it would otherwise collapse. Neither Madoff nor his lieutenant, Frank DiPascali, had any computer skills, so they needed some programmers to help them. I wish I could have been a fly on the wall during those discussions.

I have to wonder what excuse their lawyers will come up with to assert their innocence. Were they just carrying out orders from the higher-ups? Some of the world’s greatest crimes have been perpetrated by people who were just following orders and trying to please their bosses. Their claims of innocence will be challenged because at one point, they decided they didn’t want to participate in the scheme any longer and they withdrew their own funds from the phony investment account, reportedly worth several hundred thousand dollars each. But then they made the mistake of taking $60,000 bonuses and 25% raises to reverse their decisions and continue on with the fraud. That makes it look a lot like taking ‘hush money’. It will be extremely damaging to their claims that they were unwilling participants. Another troubling fact is that they participated in the scheme for more than 15 years. They are now facing up to 30 years in jail.

The irony of all of this is that these programmers had the technical skills to make a decent living, and yet for the sake of making some extra money or to keep their bosses happy, they will lose all of that money defending themselves in addition to facing the prospect of jail time.

Engineers are generally pretty good at understanding the nature of cause and effect relationships, and so it’s hard to explain why a programmer would choose to aid and abet in a criminal activity. Perhaps it was the Svengali-like charm of Madoff himself. After all, he successfully tricked a lot of really smart people into handing over their life’s savings. Maybe it was a case of getting in so deep they didn’t know how to get themselves out it. Whatever defense they use, it should make for some interesting legal wrangling in the courtroom.

Engineering is not Fraud

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Mark Cuban, owner of the Dallas Mavericks, recently wrote an article in his blog and used the term Financial Engineering, implying it was responsible for ruining financial markets. I agree with the points he makes, but find his application of the term ‘engineering’ to be a gross misapplication of the word. I suppose it puts engineers in good company, since the term ‘doctoring the results‘ has similar negative connotations, even though doctors are generally thought to be upstanding members of the communities they serve.

I shouldn’t give credit to Cuban for coining the term since there is a short Wikipedia entry for Financial Engineering. It reads:

“Financial engineering is a multidisciplinary field involving financial theory, the methods of financing, using tools of mathematics, computational and the practice of programming to achieve the desired end-results.

The financial engineering methodologies usually apply social theories, engineering methodologies and quantitative methods to finance. It is normally used in the securities, banking, and financial management and consulting industries, or as quantitative analysts in corporate treasury and finance departments of general manufacturing and service firms.”

Not that the Wikipedia is an authority on the topic, but Cuban’s use of the term financial engineering, implying that it involves fraudulently manipulating the market to profit a select group by creating huge losses for true investors, is not consistent with that definition.

Engineers are measured by how well they can discern and explain truths. If you’re an engineer and prone to lying about your calculations, you won’t be an engineer for very long. You could even get someone killed. I’m not saying that it’s impossible for an engineer to lie, it’s just that engineers who do lie usually aren’t very good engineers and generally leave the profession, usually moving on to areas where that skill is better appreciated.

Some professions actually place a high value on stretching the truth and consider it a desirable trait. Marketing comes to mind :-). One of the most prolific writers on the subject of marketing, Seth Godin, actually wrote a book entitled ‘All Marketers are Liars‘, and it became a best seller. I read it and it’s very good, just like his other books. Godin originally wanted to call the book “All Marketers are Storytellers”, but used the word “Liars” to sell more books. That’s an example of lying wrapped in the guise of clever marketing.

Marketing isn’t the only profession where spinning a good yarn can be appreciated. If you’re guilty of some crime, you probably would want a lawyer who could spin the facts to make it look like you’re actually innocent. Used car salesmen are often times thought to be quintessential liars, not all of them, mind you, just the really good ones. If you’re an actor, you have to lie to convince the audience you’re some character that you’re obviously not. So lying may be a necessary skill in some professions, but engineering is not one of them.

That’s why when Cuban uses the term ‘financial engineering’ as the cause the stock market bubbles and current credit crisis, it rings hollow for me. I’m not suggesting he call it ‘financial marketing’, ‘financial lawyering’, or ‘financial acting’, although those terms might more closely align with his implied definition than ‘financial engineering.’

I wish I could help Cuban out by coming up with a new term for the financial fraud that periodically gets perpetrated on Wall Street, but perhaps we should just call it what it really is, that is, fraud, since there’s no reason to tarnish a profession by implying that its name is synonymous with the word ‘fraud’.