To catch new Ponzi schemes like Stanford and Madoff, the SEC needs a geek squad

February 25, 2009

The recent frauds by Bernie Madoff and Alan Stanford were not caught by the SEC in time to save people’s money. In Madoff’s case, he gave up, as his pyramid was collapsing and confessed (I still wonder why he didn’t fudge the collapse). In the case of Stanford International Bank (SIB), the SEC was investigating the illegal sale of CD’s suspecting that the returns were too juicy.

If Stanford had not tried to sell his CD’s in the US, he would have not been caught, except for the keen eye of Alex Dalmady, who not only saw that there was something funny about the whole set up at SIB (Many of us did), but actually sat down and wrote about it (Which we didn’t).

The question is what can be done about it going forward? How can the SEC monitor for frauds better?

Well, off hand (and on vacation) it occurs to me that given the mathematical tools available these days, something as simple as setting up a geek squad, a bunch of mathematically-oriented whiz kids who would go and devise a bunch of tests to dig out possible Ponzi schemes that the SEC could then investigate further.

I can think of three very simple tests off hand:

1) Benford’s law

I have talked about this in connection to Venezuela’s election, which have been shown to follow the law except for the 2004 recall referendum. Very simply, when you fudge data, you ignore the fact that natural data has certain characteristics. In particular, Benford’s law says that in any list of numbers generated for example, by accountants, the distribution of the first (or second) number (from left to right) follow a distribution which is not uniform. In particular, the distribution for the first number is:


That is, the number “1” has a 30.1% probability of occurring, number “2”, 17.6% and the rest of the numbers declining from there.

Why is that?

Because real world numbers tend to be distributed logarithmically and not uniformly. Consider the following: If a company issues checks between 0 and $100,000 and you look at the first number of the amount for each check, it is likely that the number of checks near $100,000 is low and starts going up as the amount gets lower. Well, if the company prints lots of checks, then you could detect fraud if more than expected show up near $100,000 or if a particular number shows up a lot (a common occurrence). This is actually used in accounting to detect fraud. This also applies to investment returns.

Thus, the geek squad at the SEC could simply look at the daily, weekly or monthly performance data supplied by all regulated mutual and hedge funds and compare it to what Benford predicts. Of course, these tests can be done using more sophisticated algorithms, using statistical measures on the first and second digit to detect discrepancies.

Paul Kredosky has actually looked at Madoff’s data and suggested that Madoff’s data did follow Benford, but his conclusion was only visual. Falkenblog actually concluded that the data did not fit Benford’s law. I would suggest the SEC geek squad could carry out a first and second digit test and calculate statistical measures like chi^2 on the differences between the data and what is expected to see how likely the returns are. (Anyone willing to do it? The data is in Markopolos 2005 document to the SEC denouncing Madoff)

Of course, if the returns of a fund did not follow Benford, there may be an explanation, but detecting it this way would allow for a more detailed study of the funds returns by the SEC.

2) Correlations between returns and markets

One of the red flags raised by Markopolos on Madoff was the fact that Madoff’s strategy was based on the stock market, but there seemed to be little correlation between Madoff’s results and the stock market. Indeed, Madoff showed positive returns on 95.5% of the months, which was not happening in the stock market.

This could all be automated.Each fund would simply define its strategy and set a benchmark for its investments and you could calculate the Correlation Coefficient between the returns of the fund and that of the underlying markets in which it participates. This can be done in an Excel spreadsheet. Basically, it would be very difficult to obtain returns which are uncorrelated to the underlying markets. As an example, last year, it would be suspicious if a fund investing in stocks had a negative correlation with the market unless it invested in gold stocks or a sub-sector of the market that did well last year, but there were very few of those.

Finding anomalies in the correlations does not constitute proof that someone is reporting fraudulent results, but one could automate the process and much as in the case of Benford’s law, it would raise a red flag and the SEC could study it further.

3) A stress test for accountants of funds

One could build two databases, In the first one, one would include the accountants who are active part of the American Association of Certified Public Accountants. A second one would include the top tier auditing firms. Then, for each fund you would ask:

a) How much did you charge to audit the fund?

b) Did you confirm who had custody of securities?

c) Ask who managed and who had custody of securities. Is there any relation between the two?

You could then compile statistics of how much do auditors charge for each size funds. And if b) was No, you would have a big red flag, as well as if in c) the answer was yes. Similarly, if there were anomalies in Benford or the correlations and you used a less known auditor, you could research it further.

That’s it. With these three points, you would go a long way at uncovering the fraudulent funds.

Using these three questions you would have caught Madoff with a), b) and c). However, only c) would have raised flags on Stanford, because there is not month to month data on Stanford’s returns, only yearly data.

But I am sure others can add some additional forensic tools to the detection of fraud in money management. I do hope the SEC may read this and start a geek squad. It would cost very little and go a long way.

And indeed, funds could learn to fudge the data going forward to fit the criteria, but their previous record is there for the geek squad to find.


12 Responses to “To catch new Ponzi schemes like Stanford and Madoff, the SEC needs a geek squad”

  1. Bradley Max Says:

    January 22, 2014

    Re: STANFORD INTERNATIONAL BANK LTD Allowed Claim Pricing: 13.00%

    Dear Sir or Madam:

    The Bowery Funds are direct purchasers of claims and among the most experienced purchasers of claims in the industry.

    We are interested in purchasing claims against Stanford International Bank, Ltd and related entities. Bowery believes that it may be able to offer you, your company or client an immediate cash payment for such claims that are allowed in the US and Antiguan proceedings. The potential transaction would be structured as a simple assignment of your claims to Bowery. Bowery would assume all risk with regard to the value of distributions as well as, if and when a distribution on these claims may occur.

    This letter is only an indication of Bowery’s interest in potentially purchasing your claims. Our pricing is subject to market conditions and may change, up or down, without prior notice. However, the pricing may be fixed pursuant to the execution of a Claim Sale Agreement prepared by Bowery. We would be happy to consider reasonable counter proposals.

    Please note that Bowery is also interested in purchasing bankruptcy claims in most of the larger bankruptcy, administration and liquidation cases. Please call for current pricing.

    If you have any interest, questions or comments, please contact me at 212-259-4318 or .

    Very truly yours,
    Bowery Investment Management, LLC

    Bradley Max, Esq.

  2. moctavio Says:

    I think people who had the CD’s will lose 90%-plus of their money. The receiver in Antigua found some US$ 250 million, there is the bank of Antigua, which by now is not worth much and then there are Stanford properties which are unlikely to give much more than a couple of hundred million, incluidng the sale of the network of brokers from Stanford Group. Arresting Stanford is tougher. There are jurisdictional problems, where did he commit the crime? Are CD’s securities and all that? Note that Laura Holt was charged with obstruction of justice…

  3. feathers Says:

    Very interesting all these Stanford history and its possible connections with the Chavez’s boliburguesia.

    Saludos, Miguel 🙂

  4. anna Says:

    Still loving your blogging m!!! You pretty much have encapsulated how I figured out that the stanford cds couldn’t be making that type of returns back in 2007.. Though I’m not the math geek and one of my buddies is, he basically did the same math you showed us.. I really do think sec needs to set up some sort of geek ponzi busting mod squad of sorts??

    How much do you think people who bought their CDs have lost?? I’m told that everyone’s assets are still frozen, that laura holt got booked, Davis is pleeding the 5th and Allen stanford is still denying any wrong doing.. When do you think they’ll arrest stanford and how much do you think they’ll be able to recover???

  5. Mike Says:

    Just passing by.Btw, you website have great content!

    Making Money $150 An Hour

  6. GWEH Says:

    Miguel, I agree but keep in mind that it was those mathematical whiz kids with their MIT degrees that created stuff too difficult for the government to track in the first place … Bear Stearns for example.

  7. GWEH Says:

    OT: Chavez: “Váyase a lavar ese paltó, señor Obama”

    Translation: “”Go fuck yourself, Mr. Obama”

  8. m_aster Says:

    The link works for me, right on this page. It’s just some comments about inquiries into scams being stopped at the top. Here’s an example:

    Remember former SEC attorney Gary Aguirre’s testimony that an insider trading investigation was squelched? (from 2007)

    “In a December (2006) hearing of the Judiciary Committee, just before Congress changed hands, Grassley and the panel’s then-chairman, Specter, uncovered further evidence of Justice Department collusion in efforts to thwart congressional inquiry and intimidate whistleblowers. This involved the unheard-of step of subpoenaing confidential discussions between a whistleblower and congressional staff.
    That hearing focused on charges, by former Securities and Exchange Commission attorney Gary Aguirre, that an investigation into insider trading by one of the largest hedge funds was squelched by SEC officials. Aguirre had wanted to take testimony from a prominent Wall Street figure, who was also a major fundraiser for President Bush. When he pressed the point, he was not only prevented from doing so — he was fired.”

    Also note that neither Madoff nor Stanford are in custody nor does it appear they are likely to go to prison. There is very much a separate “justice” system for the rich and the poor, in the US as well as Venezuela (and everywhere else in the world).

  9. HalfEmpty Says:

    It’s DU, consider it a blessing.

  10. moctavio Says:

    Can’t read the link BTW

  11. moctavio Says:

    I have no idea why the SEC is so slow on its feet. I do believe they were looking into Stanford more seriously only because of the Madoff scandal. What is amazing is that Stanford operated in over 100 countries and none had done much. In Venezuela, Stanford’s products were illegal and sold openly and aggressively and our regulators, past and present, never did anything. In fact, a reporter of one of the major newspapers regularly denounced it and nobody paid attention.

  12. m_aster Says:


    If you are smart enough to figure this out, why do you suppose the SEC is not? They had Markopolous’ info long ago but chose to protect one of their own. Take a look at the phony paper trading in the gold and silver market for another very long running example, and perhaps you might be interested in this:×5119012

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