Sunday, December 14, 2008

Trust and finance

I've written previously about John Rogers, CEO of the Ariel Funds. Although the funds have performed very poorly in the last couple years, Rogers is recognized as a skilled value investor and has assembled an excellent long-term record. He's also one of the few African-Americans in finance, and he makes it a point to give back to his community. His firm adopted a class in Chicago's South Side and made finance and investing a core part of the curriculum, giving each class $20,000 to invest through their elementary school careers.

Rogers, when asked why African-Americans don't invest more, points to the lack of education about finance in American public schools. He has a very valid point - but I don't think it's the only reason. Social relationships are critical in teaching financial literacy and encouraging investing.

I see the recent case of Bernard Madoff as an example. Madoff was a hedge fund manager who oversaw as much as $17 billion in assets. However, it was all a giant Ponzi scheme, probably the largest ever carried out by one individual(Enron and the subprime fiasco were larger, but Enron was a S&P 500 company and the subprime thing involved most major banks).

Madoff had significant connections among the Jewish community and was a "pillar of finance and charity." He served on the board of Yeshiva University and other institutions.

“He was thought of as a great philanthropist, a pillar of the community, the chairman of Nasdaq — all of that stuff,” said one hedge fund executive who knew him.

“There was a joke around that Bernie was actually the Jewish T-bill,” the executive went on, referring to the ultrasecure investment of treasury bills. “He was that safe.”

Mr. Madoff had traveled far from his roots in eastern Queens, where as a young man he cobbled together a $5,000 grubstake from his earnings as a lifeguard and sprinkler installer to start the famed investment firm that eventually bore his name, Bernard L. Madoff Investment Securities.

He had come to move easily in the clubby Jewish world that iterates between New York City and its suburbs and southern satellites like Palm Beach.

Indeed, in the world of Jewish New York, where Mr. Madoff, 70, was raised and found success, he is largely still considered as a macher: a big-hearted big shot for whom philanthropy and family always intertwined with — and were equally as important as — finance.

In other words, he had many connections and the trust of the Jewish community.

Of course, it was all a fraud. Hedge funds of all stripes have been facing many requests for redemptions. They have to sell securities to meet redemptions. It appears that Madoff's entire operation was a fraud, so he had no securities to sell. Had more people been investing money than redeeming it he might not have been found out, but the opposite was the case.

Madoff gives us a very spectacular lesson about the power of trust within racial/ethnic groups. Of course, readers shouldn't plan on starting Ponzi schemes among their social networks. However, if Madoff managed to cheat a lot of people by leveraging the power of social networks, the converse is true: if properly leveraged, social networks could be a tool for empowerment. John Rogers' actions in Chicago are one example, as are Grameen Bank's actions in Bangladesh and the salon workers affiliated with Cut It Out, an anti-domestic violence initiative. There are a number of for-profit banks on the U.S. West Coast that serve predominantly a Chinese-American clientèle, such as Cathay Bancorp and East-West Bancorp. As the CEO of one small Chinese-American bank put it, Chinese prefer to bank with Chinese."

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