The Devil's Excrement

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.

Former Antigua Prime Minister Lester Bird now brings up the US conspiracy theory on the Stanford International Bank story:

“However, the former prime minister contended that the charges against Sir Allen and his Stanford companies were part of a US plot to break Antigua and Barbuda’s offshore financial services sector.

“All these people do not want us to have offshore financial services and Stanford has done such an exponential job in developing money… and these guys decide that he’s giving too much profit,” Bird said.”

The best part is that he even attempts to suggest that supervision may have been lax since he left power in 2004, despite the SEC allegations that Stanford’s investment results were funny since at last 1995-1996. He also says “other banks” are paying even higher interest rates than SIB.

Oh baby!

Monday and Tuesday are holidays in Venezuela, so tomorrow I will be disappearing for a week and blogging will be lighter than usual, but I am sure I will manage to post something given the barrage of news around. I am going to a Caribbean beach (not Antigua) where I will try to relax and forget about the world for a few days, if possible.

But there are some loose ends I wanted to tie before going, none of which make a single post but they are all somewhat related.

First of all, not a week has gone by after Chavez’ referendum win and his tune has already changed from the country being shielded from the world financial crisis, to we are facing a “tough and difficult” situation. That did not take very long, no? By next week I can imagine it will all be the Empire’s fault.

And meanwhile, Chavez’ Government, after intervening the local Stanford Bank today, issued an order prohibiting the Board of Directors of the bank from leaving the country. Of course, this does not include the man responsible for building up the Stanford operation in Venezuela, Gonzalo Tirado, who told the Miami Herald in 2005 that 40% of the deposits at Stanford International Bank were from Venezuela. If this proportion was sustained since 2005, that implies Venezuelans had around US$ 3.4 billion at the Antigua bank. Note in the article Tirado takes credit for building up Stanford in Venezuela and says Allen Stanford, with whom he had a bitter dispute, managed everything directly.

Curiously, in the same Official Gazette in which the Government published the intervention of the local Stanford Bank on Thursday, the Government also published the approval for Tirado to go ahead and buy a local commercial bank by the name of Inverunion.

And while many have tried to portray Stanford International Bank as the bank of the Venezuelan oligarchy, as only the well to do had money there, I hear that the robolutionaries loved the institution, its high rates, as well as other features. You see, Stanford International used Canadian, not US banks, for its wire transfers and did not have the rigorous compliance procedures of US banks after the Patriots Act. Thus robolutionaries apparently were very faithful clients too. Which makes me wonder if this has anything to do with a report by a radio station in Antigua today that a Venezuelan jet carrying some Government officials, arrived in that island for a meeting with the Prime Minister. If they were after the money, they will find very little, if they were after the data, maybe (or hopefully) someone got there before them, after all, the WSJ last wekend already talked about FBI agents being in the small Caribbean island.

Enjoy the long Carnival holiday!

While I have been trying to get away from the Stanford International Bank story, it is not easy. First of all, it was all around me today. From friends to family, I learned today of a few people that I knew who had their money there, who were not able to take it out despite my warnings. I also found out about people I don’t even know who think I am an expert on either how to get SIB to wire their money or estimating how much they will one day recover. The story also provides a break from the sometimes tiring political fights in Venezuela.

I actually know very little about what’s happening, either at SIB or in Antigua, I just tell people not to expect to get their wire out, even if it happened before the SEC stepped into the problem and don’t get your hope up that you will get much back. A pyramid is a pyramid, you pay old investors with new money and keep growing it until it explodes. At most, don’t expect to get back more than 10-20% of what you had, but I am always a optimist, there maybe nothing there in the end for you.

Lot’s of people have asked when I first knew that Stanford was a fraud. The answer is have known for a very long time that something was very fishy. But using Alex Dalmady’s language, I saw the ducky signs one at a time over the years. But let me start at the beginning.

I have known about the existence of SIB for maybe eighteen years, roughly beginning right before the time when the SEC suggests in its injunction, Stanford may have been fudging its investment returns. At the beginning, it was simply hearing about this outrageously high returns on CD’s. When rates for CD’s in the US were 8%, Stanford would pay 12-13%. As rates dropped, they also went down, but always remained 4 or 5 percentage points above market rates in the US.

People always fall for this. In Venezuela, prior to the 1994 banking crisis, you could find banks paying interest rates from 25% to 100% per year, guess which ones failed? But this was in our local currency, the Bolivar, at a time of high inflation.

What I initially thought Stanford was doing, was something we had also seen in Venezuela before, offer high interest rates in US dollars by buying Venezuelan sovereign bonds also  in US$ dollars paying  say, 13% per year, and pay 8% to depositors. This may sound fine at first sight, the problem is bonds change in price. Thus, if they drop in price too much, like they have three times over the last 15 years, the value of your bonds may drop below the value of your deposits. If the depositors start demanding the money you are broke.

In fact, this happened to a local broker when the Mexican crisis struck in 1994. Venezuelan dollar bond prices also plummeted from 60-70% to as low as 38% and when depositors began demanding their money, the broker did not have anyway of paying for them. I thought Stanford was replaying that movie, using a US name and an Antigua bank, which would make a run on them much harder .

At some point, a friend showed me some marketing material which was highly unusual for a bank. An expensive leather bound book explained the history of the group, how conservative and financially savy it was. In a separate sheet, it explained that it was capable of paying such high rates because it did not have to pay for FDIC insurance. And further on, it explained that over half the portfolio was invested in stocks and some of the money in hedge funds. Say what? You gave them your money, got paid a low fixed income return, so they could aim for high returns and make the difference for themselves? What if there is a bad year? Who makes up the difference? The terrible stock market of 2001-2002 came and went, and Stanford survived. Most of its clients were Venezuelans who are somewhat greedy and don’t ask too many questions. Financial culture is very low here. People buy products if you have a fancy office, not if you have a healthy balance sheet.

Then at some point after 2002, I don’t remember when, Stanford started its website (from which everything but contact information was removed today) and publishing its financial statements every year.

The whole thing did not make any sense. Half the portfolio was in stocks, and interest income was a quarter of the interest the bank paid its depositors. Stocks were indeed over fifty percent of the portfolio and there were huge fees paid to financial advisers and parent Stanford Group. It was clear Stanford Group provided SIB with services, but you could not figure out the whole thing. But the scariest thing were the growth rates for deposits in the bank. 20-30% per year, which jived with the aggressive nature of their executives in Caracas. I was told that each executive had to gather a certain amount of deposits each quarter (I was told five million US$) and if he missed the target three quarters in a row, he was out.

At this point, I knew I should warn anyone asking me about it to go somewhere else, earn less interest, but sleep well. Few did, most took “some” money out. The typical excuse: “They have never failed paying me in twenty years”. Sure, until they do.

After the sharp drop in stock markets last year, I discussed with a few friends what Stanford would do in its end of the year financial statement. After all, if equity markets drop 40% on average, hedge funds drop 15% and commodities 70%, only gold and silver could help the Stanford portfolio not lose at least 30-35%. And then in mid-December they come out with a letter calming investors, suggesting they did not even lose money!

As Alex would say, what a Duck!

We were thus eagerly waiting for the Stanford 2008 financials which should show up in the webiste somewhere around April, when two things happened almost at the same time. First, I got an email with the link to a new blog called Venepiramides, which had exactly three posts: the first one on Madoff, the second on La Vuelta, a well known pyramid/fraud that got lots of Venezuelans two years ago and a post on SIB, comparing it to Banco Latino, one of the failed local banks of 1994 (The one that would pay over 100% interest rates). Second, I talked to Toby Bottome from Veneconomy, who I collaborate with regularly, and he asked if I wanted to write an article on  a totally different topic, saying Alex Dalmady had written an article on SIB for his monthly that was really good which suggested in the end SIB was a fraud. My interested was piqued and I sent Alex an email telling him I was looking forward to reading it.

The article had printing problems, but Toby emailed it to me the day it was coming out (I get Veneconomy personally) and I loved the way Alex had written it, avoiding the direct accusation. I also liked his very specific prediction about EMAG expecting to receive funding frm SIB. By then I had added to my Google Alerts the three words “Stanford International Bank” (This is an important trade secret). I began exchanging messages with Alex and then on Friday Feb. 6th. Google let me know about the Elandia funding from SIB, which failed to materialize. We had more evidence.

I was going to write a post for my blog that weekend, but I was really into a post on Central Banks and their balance sheets, showing how the Venezuelan Central Bank kept in its books money that was gone to the tune of US$ 26.3 billion. I wanted to make that post pedagogical and spent most of the weekend on it. I did not get to the SIB post until Monday the 9th. and everything moved very fast after that.

People ask why I did not denounce it earlier. To whom? It is clear that Venezuelan authorities have known about this even before Chavez. Stanford Group bough Banco Galicia in 2004, which I believed was done to give some form of legality to its SIB dollar business. The Government did not object. Military intelligence even raided the SIB “Asesores” office in Caracas in October 2008, so they clearly knew what was being done there. And the person who grew the SIB business in Venezuela bought a commercial bank himself a month ago. Do I have a chance with a Government which condenms an opposition politician for supposedly giving away a car, while multimillion dollar corruption and suitcases full of cash  in the Chavez era is not even news anymore?

In the end, I thought innocently that Duck Tales would blow up locally and not abroad. I even talked to Alex about how surprised I was that his write up had not even made the local news except for Descifrado in its first two weeks. Maybe if I had known how fast the blogs and the mainstream media would catch on to the story I may have posted something. But I didn’t and the credit goes to Alex.

In every post, I think this is the last time I will post on SIB. This time I will not fall  for that. There is now a drug angle to the story, there is the question of how much of the Stanford Group is impaired, where is Allen Stanford, how much money is actualy there, how negligent the Antigua authorities were (As a friend points out,  the Primer Minister said “the fallout threatens to be catastrophic…but there is no need to panic” Huh?) and then there is the local Bolibourgeois angle: will this, like Maletagate, gives us a glimpse into Government corruption?

Stay tuned…