The collective failures of the Bernie Madoff ponzi scheme and the collapse of the real estate markets share one common thread: the unwillingness of most commercial investors to perform even basic due diligence on their asset purchases.
I’ll start with Bernie Madoff’s ponzi scheme. Madoff’s scheme continually raised red-flags which were ignored, even by his most sophisticated clients, the feeder-funds which funneled huge sums of money into his ponzi scheme. Even a cursory examination would have revealed that his auditor was a local CPA who was housed in a tiny office. That fact alone should have sent prospective investors running for the exits.
Any individual or organization with millions of dollars to invest is surely sophisticated enough to understand that comprehensive audits of large organizations, such as Mr. Madoff’s, require teams of auditors and large audit firms with the organizational background and experience to complete the audits. A two-person office, even working 60 hours a week for an entire year, likely could not have completed an audit of Madoff’s organization.
Sophisticated feeder funds should have performed extensive due diligence, verifying and independently confirming trade tickets. Their failure to do this is inexcusable, given the purported “monitoring” services being provided to their clients and the fees collected. This, in addition to the most obvious flags of all: that Madoff’s operation would have consumed more options than those publicly traded and purchased on a daily basis. Surely, this calculation could not have been too difficult for these sophisticated organizations. Let’s not even discuss the most obvious flag of all: the near flawless, steady returns that never wavered or spiked. These “smooth” returns should have spurred current and prospective investors to dig deeper and fact-check their portfolios.
Commercial real estate investors, at least those attempting to flip condo’s and other commercial properties, continue to ignore the most obvious red-flag of all: how will they make money from this asset purchase? Assets make money only when they appreciate in value, or, they produce a steady stream of revenue that is non-volatile and which will increase over time. Those investors wading back into the real estate market must ask themselves: if few bulk condo deals have occurred, at least in South Florida, do the largest institutional investors understand basic principles, which other buyers have ignored?
The answer is easily yes, most institutional buyers certainly do understand market fundamentals, which “momentum” investors have ignored or rationalized. This understanding has led institutional investors to conclude that most condo developers are still selling their units at prices which will not ensure positive cash flow and even marginal returns on these bulk purchases. They also understand that rising notices of defaults (at least in South Florida) will eventually lead to increased foreclosure activity, and that the coming Option Arm loan tsunami could swamp the real estate market more painfully than even the subprime debacle. Finally, they understand that in some real estate markets, no asset appreciation will occur for years, perhaps decades.
The common thread between Bernie Madoff and real estate investing is that both investor groups failed (and continue to fail) to perform even minimal due diligence or exercise common sense, choosing instead to rely on the momentum generated by “word-of-mouth” or their “trusted” business advisors. Whether the red-flag is a badge of fraud or merely an indicator of poor business judgment, “market momentum” seems to have replaced judgment. In an increasingly complex world, due diligence and common sense have now been largely abandoned or ignored.
Even sophisticated investor groups oftentimes rely on “check-the-box” due diligence, largely performed by inadequately trained foot soldiers. In isolation, numbers, figures and statistics mean very little, and provide false security when their context is ignored. Counter-intuitively, it seems like the more money requested, the less questions people ask. These failures and frauds will continue to occur as long as investors continue to ignore the red flags that always appear in the face of danger, but which are nearly always rationalized or dismissed.
