The sceptics regarding Bernie Madoff's 'profits' have been proven right

WE'VE BECOME used to stories of regulatory cock-ups and shoddy investor oversight over the last 18 months, but Bernie Madoff's $50 billion fraud is particularly remarkable.

At best, it's a story of official ineptitude; at worst, some of those who entrusted their money to Madoff were themselves far from starry-eyed innocents.

The already battered reputation of the US Securities and Exchange Commission (SEC) has been dealt another blow by the latest revelations.

Harry Markopolos, a money manager and investment investigator, was asked by his bosses why he couldn't produce the kind of strong, smooth returns Madoff was constantly delivering (Madoff was supposedly producing 1-2 per cent every month, no matter the market environment he was operating in). Markopolos tried to reconstruct Madoff's options strategy, only to be greeted with markedly poorer results. He enlisted the help of a top mathematician, who confirmed that Madoff's strategy could not deliver such results. "Madoff Securities is the world's largest Ponzi Scheme," he wrote in a letter to the SEC in 1999.

Markopolos continued to complain as the years passed but SEC investigations, somehow, came to nothing. There were other red flags. Madoff's empire was audited by a three-person team working out of a tiny office. One employee was 78 and spent most of his time in Florida, while another was the secretary.

It's been estimated that his strategy would have required at least 10 times the contracts that trade on US exchanges, with one trader telling Bloomberg that "every index across the board would have felt tremors" if he was really trading such size. Nor did Madoff charge hefty hedge fund fees to investors and distributors who channelled money into his fund. A hedge fund professional warned a colleague off Madoff in 2003, asking: "Why would a good businessman work his magic for pennies on the dollar?"

Furthermore, Madoff threatened to return funds if an investor questioned his mysterious methodology. Suspicions were publicly aired in one hedge fund magazine back in 2001, which noted that sceptics expressed "amazement, fascination and curiosity" about the "complete lack of volatility" in reported returns as well as the "seemingly astonishing ability to time the market".

Somehow, all this escaped not just the SEC but the various "fund of funds" that channelled investor money into Madoff's operation. Fairfield Greenwich Group (FGG), which had half of its $7.5 billion of investors' money invested with Madoff, boasted that they employed "a significantly higher level of due diligence work than that typically performed by most fund of funds and consulting firms", their model requiring a "thorough understanding of a manager's business, staff, operational practices, and infrastructure".

Henry Blodget, a one-time dotcom analyst, was forced to leave the securities industry after he was found to be publicly recommending stocks that he privately rubbished. Blodget has since reinvented himself as a journalist and blogger and he notes that it will be "interesting to see how FGG explains why Madoff's strip-mall based accountant and tiny operating infrastructure satisfied its requirements".

Blodget also offers an intriguing theory as to why so many savvy investment professionals invested their money with Madoff (he counted banks like BNP Paribas, HSBC, RBS and Santander among his clients). Blodget says that, far from being lazy or gullible, a number of sophisticated Madoff investors told him that they didn't believe the numbers for a second. Nevertheless, they continued to invest with Madoff. Why?

They told Blodget they assumed that Madoff, a former Nasdaq chairman and one of Wall Street's biggest market makers, was illegally profiting on insider information.

Robert Chew, another Madoff investor whose wife's family ended up losing $30 million, wrote that he knew that "deep down, it was too good to be true". Nevertheless, "the way it was described to us was that the 'New York people' had a system".

The irony is that the smart guys, the sceptics, were right. Madoff was running a giant fraud, just not the type they had guessed. Far from profiting from Madoff's dodgy dealings, they ended up with nothing because of them.