Part of the story about the Madoff Ponzi scheme was that Madoff created this elusive, difficult-to-become-a-member club. The exclusivity and rejections made membership all the more desirable to greedy investors.

That actually is turning out to be somewhat of a myth.

There is much more to his canny trick of rejecting investors than initially meets the eye. In reality, he did not really turn away money from investors. What actually occurred was that he refused to take cash from people whose participation would have easily revealed the fraud.

Allow me to explain:

As we noted earlier this week (Why Might a Madoff Plea Deal Take Place?) there are lots of other parties who might get pulled into this story. But the one that intrigued me most came from Credit Suisse, when that firm and its analysts looked into Madoff’s investments, and came away skeptical or convinced there was a fraud occurring.

In particular, there was something the execs who had met with Madoff said to Bloomberg that got me thinking: They noted his little- known auditor who had just one client, his refusal to reveal AUM, his refusal to charge asset management fees. But what was especially noteworthy was the issue of why Madoff served as the custodian of his clients’ assets.

That turned out to be, IMO, the key to his “turning away investors.” This was the scam within the overall fraud, one that made his Ponzi scheme irresistible to gullible investors.

Why? Consider how Custodial accounts work: Your institutional firm, endowment or trust fund is held at a major bank (as the Prudent Man rule requires). That means outside managers use DVP trades (delivery versus payment), with the clients’ monies staying in their custodial account, and the outside firm trading it.

Here’s how that looks int he real world. Let’s say the XYZ Foundation –10 billion in assets, held (custodial agent) at Goldman Sachs. XYZ wants to give the Ima Scammer Fund 10 million in assets to trade. Ima Scammer trades the $10 million of the account, but the cash and shares all stay at GS on behalf of XYZ.

That’s how a custodial account works. The outside fund manager has control over the money only so far as handling that portion of it. But the assets stay with the custodian.

And all of those clients turned away by Madoff? How much do you want to bet me that the vast majority were custodial accounts? Given the alleged scam, Madoff couldn’t do that, because the ruse would have been revealed almost immediately. The custodial accounts could not have generated his alleged returns.

These monies weren’t turned away by Madoff; they were run away from — by him.

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UPDATE: January 15, 2009, 11:47 am

Even more amazing, the Boston Globe is reporting Madoff might not have made any trades

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Previously:

Why Might a Madoff Plea Deal Take Place? (January 2009)

http://www.ritholtz.com/blog/2009/01/why-might-a-madoff-plea-deal-take-place/

Sources:

Credit Suisse Urged Clients to Dump Madoff Funds

Cynthia Cotts, Katherine Burton and Elena Logutenkova

Bloomberg, Jan. 7 2009

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a7Ei7.DM8DHc