Bernie Madoff's Legacy: Fraud Insurance?

Bernie Madoff is scheduled to be sentenced tomorrow, Monday, June 29, 2009, in the federal district court in Manhattan. Given the enormity of his frauds, he is more likely to get justice than mercy--and deservedly so. Shakespeare notwithstanding, there are times when the quality of mercy would be strained.

Madoff's legacy includes devastated victims, penniless retirees, ruined charities, embarrassed regulators and a lengthy process of recovering assets that will probably yield his victims only pennies on their invested dollars. Few will benefit from Madoff's scam--he had a good time while it lasted, and the authors and publishers of the 14 definitive accounts of the Madoff story to be released in the next 2 weeks may also benefit. Hollywood script writers surely are busy, even though 9 out of 10 of their products won't actually be made into films.

Madoff is making a contribution to popular culture, although not in a way he would have intended. Perhaps part of his legacy could be a contribution to the investment markets, although not in a way he would have intended.

The Madoff mess raises the question whether there should be fraud insurance; that is, insurance that would protect investors from losses caused by fraud. If, at first glance, this seems like a strange idea, consider the fact that it already exists in other settings.

Fraud is simply a form of theft. Standard property insurance policies like auto and homeowners coverage contain provisions covering losses from theft. Businesses can buy fidelity bonds, which protect them against loss resulting from employee theft and fraud. In a limited sense, FDIC and SIPC insurance protect against some fraud. If a bank or brokerage firm collapse because of fraudulent activities of the persons controlling the bank or firm, the FDIC and SIPC protect customers to the same extent that they would if the bank or firm collapsed because of poor economic conditions. If a brokerage firm takes a customer's money and sends the customer account statements showing stock, bond and other securities holdings, but the firm in fact does not buy anything for the customer and simply pockets his or her money, SIPC would protect that customer to the extent of its $500,000 limit (with a $100,000 limit for cash shown on the account statements).

Credit card companies generally absorb all unauthorized charges when a cardholder's card or account number is stolen. The cost of doing this is built into the fees and interest charges imposed on customers by the credit card companies. That is akin to an insurance policy for credit card theft and fraud where the premiums are included in the overall costs of credit card usage.

Thus, the cost of fraud is regularly quantified and insured in some settings. Greater coverage for investors is likely to be feasible. The FDIC was founded in 1933 and SIPC in 1970. Statistical resources in those days (including databases and computing power) were much less than what is available today. With today's much greater analytical ability, quantifying the potential for fraud should be easier than 40 or 75 years ago.

Fraud insurance could go farther than SIPC insurance, in that it could cover brokerage accounts above SIPC's $500,000 limit. It could also insure against fraud in particular investments. Recall Enron and WorldCom. These are companies whose stock values were largely blown up by management fraud. Of course, fraud insurance wouldn't cover market risk. If a company is honest, but poorly managed, investors will have to take their lumps. But if management loots the company, the insurer would pay. Although the amounts would be larger, this isn't terribly different from the insurer paying when a lower level finance department employee loots a company's checking account.

Of course, some of the details could be devilish. Stockholders lose market value when management engages in fraud, and they're primarily interested in having that market value protected. Insurance policies with carefully crafted and well-disclosed parameters to the scope of market losses covered may be the answer. Insurers could cover specified dollar amounts per share of market loss, or larger specified amounts if investors are willing to pay higher premiums. The reason why quantified exposures could work is that insurers would probably be able to turn around and hedge them with offsetting contracts, or find reinsurers to take some of the risk. Open-ended exposures would be much hotter tamales.

Fraud insurance should be a private sector product. While the private sector doesn't always get it right (look at the mess with credit default swaps creating systemic risk to the financial system), fraud insurance offered under government auspices would entail too much potential for politically driven, morally hazardous bailouts.

Of course, not all investments would be eligible for coverage. Take a congenial, Stetson-wearing fellow driving a nice new three-quarter ton pickup truck with a crew cab who offers sure-to-win shares in an ostrich farm. It's doubtful any fraud insurer would cover his glowing investment opportunities. And an insurer asked to put its butt on the line for a Madoff investment might find Bernie's eerily steady returns a bit too unnerving. However, the unavailability of coverage for some investments isn't necessarily bad: it would provide valuable information to investors. If an investment can't be insured, maybe it's not such a good idea.

Fraud coverage might be expensive, depending on the investment. But giving investors a choice to buy coverage could improve the investing climate, just as the availability of sometimes expensive flood and hurricane insurance in some areas has facilitated development. Today's securities markets are bigger and more complex than ever. Even extremely wealthy, well-educated and sophisticated people didn't figure out that Bernie Madoff was a fraud. Without greater availability of insurance, investors cowed by the bear market and the Madoff and other frauds may find it easier to rationalize stuffing a mattress full of cash. (Note that federal deposit insurance is perhaps the most important reason why customers have faith in the banking system, even though many of today's senior banking executives have provided a plethora of reasons for depositors to hit the mattresses.)

There's a lot of talk in Washington and New York about restoring faith in the financial system. But that talk isn't winning investors over. As they say on the Street, money talks and bullswaggle walks. Fraud insurance means money to an investor who's been ripped off. Its time may have come.