Friday, January 2, 2009

From the Jerusalem Post: Ethics@Work: Too good to be good

Jan. 1, 2009

A number of charities are reeling or even closing as a result of learning that Bernard Madoff's "investments" were just a Ponzi scheme. In a previous column, I discussed principles of prudence that helped keep many organizations from falling prey to fraud - principles which preclude risking any amount of money through any vehicle with the many question marks plaguing Madoff's operation.

This week I will discuss two additional problems with some of the Madoff investments: one related to prudence but not to fraud, and the other to fraud but not to prudence.

Some organizations invested a large fraction of their assets through Madoff. This is a grave mistake even assuming the guy was honest. A lot of totally above-board funds also blew up recently. Consider Bill Miller, until recently the world's leading stock picker who legitimately outperformed the market every year from 1991 to 2005. Miller made a lot of bad bets since and has seen most of his investors' assets wiped out in the recent crash. While many doubted that Madoff could have been a crook, given his high community standing, no one could doubt that his strategy was risky. Since there is an unavoidable trade-off between risk and return, it is possible to obtain such high returns (if at all) only by assuming significant risk.

For example, Hadassah thought it had almost 20% of its endowment invested through Madoff. (Their account with Madoff stated 90 million dollars, but in fact they only put in 33 million. The rest was imaginary paper profits which they never had in the first place.) Some foundations had substantially all their assets invested in Madoff, a glaring lack of prudence.

Prudent investment implies diversification in order to be able to maintain the organization's activity in any economic environment; this certainly precludes investing tens of percent of an endowment in a vehicle which is obviously extremely risky.

A distinct problem with putting money in a suspect investment is that it can make the investor a partner in crime. Any person, but especially a charity organization, should steer clear of any investment which smacks of fraud even if they can be certain that they will not be victimized. A charity exists to make the world a better place; it shouldn't obtain funding from activities that make the world a worse place. A number of observers (most of them hostile to Jews) have pointed out that charities were not only among the victims of Madoff's Ponzi scheme; they were also among the beneficiaries. Some of the organizations now closing their doors were funding their activities for years from the fake "returns" distributed by Madoff - returns that are now known to be stolen.

This angle was eloquently described this week by Rabbi Joshua Hammerman of Stamford, Connecticut. Hammerman explained in an interview: "My synagogue's teens received free Israel trips three years ago because of the generosity of the Lappin Foundation in Boston, but because that money had all been 'invested' in Madoff's fund, that gift that we received was in essence stolen money. . . Even those organizations not directly impacted may have profited in some manner from this money that was stolen from innocent people. Every penny that Madoff ever donated is dirty money."

I don't fault the charities that accepted money from Madoff. Until the recent scandal broke he was considered a reliable and ethical person, and while investors should have paid more attention to oversight at his firm, that is not the job of recipients. But the entire story does highlight the need for charities to carefully vet not only where their money goes, but also where it comes from. Many have pointed out that suspiciously high returns may be too good to be true; Hammerman's comments suggest that they may also be too good to be good.

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