Banks lent billions to Madoff ‘feeder funds’

By James Mackintosh in London and Francesco Guerrera and Henny Sender in New York

Leading banks from Britain, France and Japan helped investors treble or quadruple bets on Bernard Madoff by lending billions of dollars to “feeder” funds, which placed their money with the alleged fraudster.

HSBC, Royal Bank of Scotland, Nomura and BNP Paribas lent the money without spotting a fraud, and in at least one case without due diligence teams visiting Mr Madoff’s brokerage, which held the assets.

Banks including Nomura and Spain’s BBVA also helped create special “notes”, structured products that allowed small investors or those barred from investing in offshore vehicles to put as little as $50,000 into Madoff feeder funds. BBVA – which raised €300m ($429m) through these products – offered a guaranteed return of capital, while Nomura provided leverage.

Madoff’s alleged $50bn fraud also hit some fully regulated onshore funds accessible to small investors, with shares in feeder funds listed on Irish and Luxembourg stock exchanges.

Bankers said they had done everything they could, including checking the auditor and regulatory reports, and could not have been expected to spot a fraud.

“The lending bank clearly looks at all the data available, looks at the audited material, what the regulators have said, does a site visit to the fund of funds [feeder fund]: they go through everything,” said one bank facing a big potential loss.

However one banker specialising in fund lending, who was not exposed to Madoff, said: “Every bank has to look at their own procedures and ask the questions – it underscores the importance of a solid due diligence function.”

Lending by all the banks was secured on the assets, making it appear to be a low-risk loan. Even so, RBS and HSBC limited lending to twice the level of assets, while Nomura was willing to go to three times, according to documents and people familiar with their practices.

In the case of RBS, now majority-owned by the British government, bankers lent £400m ($601m) to two feeder funds even though private banking advisers had decided not to put client money with Madoff, according to one person familiar with the bank.

HSBC lent $1bn to a handful of feeder funds, while BNP lent €350m and Nomura Y27.5bn ($307m).

The banks earned hefty fees from their lending, leading to an increase in the size of the teams running fund derivative businesses over the past few years.

John Godden, head of IGS, the consultancy, said: “It became increasingly competitive and, every time a bit of capacity became available in the Madoff feeders, the banks had to lap it up and move quickly. So they didn’t go and do the due diligence.”

The banks declined to comment.

Copyright The Financial Times Limited 2008

Financial crisis: Free money coming your way!

The crisis is so bad that governments are ready to print money to stop the economy seizing up.

By Edmund Conway, Economics Editor
Last Updated: 9:20PM GMT 17 Dec 2008

The fact that the Fed is advocating the sort of helicopter drops of cash Milton Friedman and Ben Bernanke once speculated about is startling Photo: GETTY

New year is a time for new beginnings; for resolutions; for sweeping out the old and making a fresh start. But never before has the turning of the year brought such a transformation for the economic landscape. When the sun rises on January 1, it will do so on a world which has changed beyond recognition, a world in which interest rates are no longer the chief tool for economic policy-making and helicopter drops of money are the modus operandi; in which the banking system – that once-great foundation for the global economy – is on the brink of nationalisation; and in which the big question is not how much wealth the economy is capable of generating in the coming 12 months, but whether it faces a year or a decade of recession.

If anyone harboured doubts as to the scale of the crisis, these would have been dispelled on Tuesday night. Not only did the United States Federal Reserve cut its benchmark rate to zero; it also indicated that it will leave rates there for some considerable time and that it will pull out the big guns – in other words ready the printing presses – to fight the worsening crisis. The following morning we learned that the Bank of England had been considering reducing rates by even more than the percentage point it opted for this month. Zero – or near zero – interest rates are only a few months away on these shores.

These are drastic measures, but understandable when one considers the scale of the economic devastation thrown up by the financial crisis. It is not merely that most of the Western world is now in recession, but that its scale is of a kind few of us have experienced. Only months ago it seemed hyperbolic to compare it with that of the early 1990s – still less the 1970s or, God forbid, the 1930s. But the statistics are bearing out the pessimists' worst fears. Unemployment is rising at the fastest rate since the 1970s in the US, and in Britain faster than at most points during the last recession. Two million people will be jobless by Christmas. Companies of all hues, in all sectors, are laying off workers and slashing investment. Banks are cutting credit lines and leaving many firms facing bankruptcy. House prices are falling at a sharper rate than in modern history.

Even so, the fact that the Fed is advocating the sort of helicopter drops of cash Milton Friedman and Ben Bernanke once speculated about is startling. For as long as we can remember – whether you were trying to manipulate levels of money in the economy, as in the 1970s and early 1980s, or inflation, as in the 1990s and 2000s – interest rates have been the key tool at policy-makers' disposal. Those days are over. Instead, the Fed must control the economy by pumping money in and out directly. It must directly buy up assets until the economy finds its feet again. This has alarming precedents: it was the printing presses that did for Weimar Germany, and sparked Zimbabwean hyperinflation.

Should quantitative easing – as central bankers call these measures – prevent a long, drawn-out period of deflation, it would do so only at the cost of brewing up a tremendous bout of inflation in subsequent years. Whether this results in double-digit inflation is academic: the upshot will be a sharp rise in interest rates for a long period. A year or so ago it was fashionable to paraphrase Robert Frost to warn that we are trapped between the extremes of fire and ice. The contrast today is even more stark: on the one hand lies a long, potentially inescapable stretch of deflation, on the other is high inflation, high interest rates and sluggish growth.

As bad a taste as it may leave in the mouth, I feel the inflation option is the better one. This might seem peculiar given that the Consumer Price Index is still above 4 per cent, but before long the UK will be experiencing widespread falls in prices. Soon, we will be crying out for a little dose of inflation.

So, the chances are that the Bank of England will follow the Fed and drop rates to zero – or thereabouts. And life will start getting rather peculiar. It is not inconceivable that banks could start charging customers to hold their money – after all, their business model is predicated on positive interest rates. Some lucky households – those who took out tracker mortgages a few years ago – may find themselves with a negative interest rate, where their bank should be paying them for the privilege of holding their money. All of these things are possible with zero interest rates, though the Bank will most likely ape the Fed and cut only to a half or quarter percentage point. Mainly, though, just as the millennium bug sparked fears of a computer meltdown, the worry is that zero interest rates would cause an unpredictable chain reaction of destruction in the financial system.

The one thing likely to save us from the big zero is the pound's weakness. We are not in a sterling crisis – not yet at least. When currencies fall they usually do so for one of two reasons: because investors are worried that the economy is heading for a slump, or because they have lost faith in the people running the country. All the indications are that the pound's fall has owed more to the former; indeed, the yield on government debt, a key sign of faith in economic management, has dropped to the lowest levels in more than 20 years.

But while an International Monetary Fund bail-out is only a distant possibility, one cannot rule it out. The problem is that, for all those trillion-dollar figures that float around, we still don't know precisely the scale of the losses facing the banking system. The poisonous potion of mortgage debt which brought down the lenders has not yet been drawn out of the system, and governments have concentrated on life support. So, despite a
£50 billion infusion of public cash, Royal Bank of Scotland, HBOS and Lloyds TSB are still having to cut the amount they are lending, as they scramble to repair balance sheets. While this is to be expected, it has the by-product of worsening the slowdown. In a recession there are always plenty of opportunities to find bargains, but what if no one will lend you the money to buy one?

All of which is why it looks increasingly likely that the Government will have to go one step further towards nationalising the banking system. Just when you thought the financial crisis had died down – to be replaced by the economic slump – it returns. As the Bank Governor, Mervyn King, warned the Chancellor this week, the coming months will see more public money having to be put behind the banks. This is not quite the same as nationalising the "means of production" in an effort to exert government control, it is temporary hospitalisation. This is not Old Labour – it is new nationalisation, or, for those on the other side of the Atlantic, neo-nationalisation.

It is hard to predict what will emerge from this wreckage, but now is not the time to write the obituary of the US or the UK economy. The next few years will be tough, but we are not alone. Nowhere – not China, not the Middle East – will escape this slump. Times are bleak, and will remain so for a while. But the chances are that this time next year we will be talking about the green shoots of recovery, and speculating how long before the strange parallel world of zero interest rates comes to an end.

Bush pledges $13bn to prevent collapse of US car industry

The White House today stepped forward to prop up America's ailing motor industry by providing emergency loans of $13.4bn to stave off a potentially disastrous collapse of Detroit's leading car manufacturers.

A week after political wrangling in Congress scotched a legislative rescue package, President Bush used his executive power to deliver a three-month reprieve for General Motors and Chrysler.

"Allowing the US auto industry to collapse would not be a responsible course of action," said Bush. "It would be an unacceptably painful blow to Americans far beyond the auto industry."

The money will come from the US government's $700bn economic bail-out fund originally intended to support struggling banks. GM will get $9.4bn and privately owned Chrysler will receive $4bn. Ford, which is in better shape, told the White House it did not need an immediate handout.

The money has strings attached. Carmakers must prove by the end of March that they have long-term viability. By the end of next year, they will be obliged to cut workers' pay and benefits to make them "competitive" with their counterparts at Japanese firms such as Toyota and Nissan, a timetable which unions have branded unworkable.

Outside the Oval Office, the president said he faced a tough decision. While he believed the government had a responsibility not to undermine private enterprise, he also believed it had a duty to safeguard the broader health of the economy.

"If we were to allow the market to take its course now, it would almost certainly lead to a disorderly bankruptcy and liquidation for the auto makers," said Bush.

He said such a scenario would push the US economy into a longer and deeper recession. "It would leave the next president to confront the demise of a major industry within his first days of office," he said.

Economists believe the damage caused by the failure of one of Detroit's "big three" manufacturers would be economically spectacular. The Michigan-based Centre For Automotive Research has suggested that more than a million jobs could be lost among suppliers and contractors dependant on the motor industry.

General Motors is in particular difficulty and had indicated it may not have enough cash to see it through the new year. It was quick to welcome the White House's intervention, issuing a statement saying: "This action helps to preserve many jobs, and supports the continued operation of GM and the many suppliers, dealers and small businesses across the country that depend on us."

The case of Chrysler has attracted greater controversy because the company is owned by a wealthy private equity firm, Cerberus, which has refused to commit more of its own money to support the business. In a sign of its financial predicament, Chrysler will today shut its manufacturing operation for an extended Christmas break of a month to save money, temporarily laying off 46,000 staff.