The Madoff infinite loop

Apparently, the Madoff fun is just getting started:

A hedge-fund manager friend called last night to talk about Madoff. He wanted to talk about just how ugly the unraveling of the Madoff saga was likely to get. And if the first name on his lips was (obviously) Madoff, the second was Bayou. Bayou was a fund that blew up and was revealed in 2005 to be a fraud with some $450 million in investor losses. Bayou is memorable for two reasons. One is founder Samuel Israel III's staged suicide. (He eventually rose from the dead and turned himself in after prosecutors went after the girlfriend who helped him disappear.) The other is a legal precedent set in the Bayou case that should scare the heck out of anyone who once invested with Madoff but who managed to get out safely in the last few years: Any investors who managed to take out profits from a fund like Bayou before the fraud was revealed had to give the money back.

On the face of it, the Bayou ruling (which stories in the Wall Street Journal and Forbes have, to their credit, noted) seems reasonable: If some early investors made outsized gains, doesn't it make sense for them to pay back the money to those who lost everything? But, as this fund-manager friend pointed out, it has some pretty extreme implications.

The obvious consequence of Bayou is that a country-club friend who'd given his money to Madoff and then gotten suspicious can't just take his money out and then go to the cops. If he reports his suspicions, he's likely to be asked to repay any of those 10-percent-a-year "profits" he'd accumulated for a decade. This is bad enough. But there's more to it here.

Much of the money that Madoff managed came from people who'd written a check not to Madoff directly but to so-called "funds-of-funds": hedge funds that had raised money from investors. A few of these funds-of-funds, such as Fairfield Sentry and Tremont Group's Rye Investment, had billions of dollars invested with Madoff and teams of auditors to track it. These companies should have wised up to what was going on much earlier.

Thanks to the Bayou court decisions, however, the moment Madoff was revealed as a fraud, any money that these funds-of-funds would have managed to take back would become gains that have to be given back to be redistributed among all the losers in the Madoff scheme. Now, this sounds bad enough, but ... again, there's more. There's no time limit on the gains they'd have to give back, so any fund that outed Madoff could be on the hook for any profits it had gained from its Madoff investments for years back. So, as my fund-manager friend puts it, "The question people have to ask is not, 'Do I have money in a fund that has exposure to Madoff now?' but, 'Do I have money in a fund that that has ever invested with Madoff?' "

At this point, the complexity of the situation should be clear. But maybe not the whole potential for absurdity. Imagine that Rich Folks Capital Management--RFCM--placed its money with Madoff 10 years ago and then decided, five years ago, that something didn't feel right and pulled it out. Well, now RFCM is on the hook for any of its gains from the time before the fraud was discovered. But what happens if the people who'd invested with RFCM 10 years ago aren't the same as the people who invest with it now? Tough noogies. RFCM's current investors are probably responsible for paying back gains in the RFCM fund that they never even saw. Or, possibly, RFCM needs to go after its own former investors. No one's really sure.

The technical Wall Street term for this is a nightmare. The Bayou precedent means that the discovery of a huge fraud leads to a whole chain of liabilities that stretches back for years and may hit investors who hadn't dealt with Madoff in a decade. A few folks who think that they've lost everything may, at the end of the process, get back some portion of their money. But many others who thought they'd escaped, or didn't even know they had any link to Madoff, will turn out to have huge losses.