Lawrence Jackson/AP
Security Exchange Commission Chairman
Christopher Cox

Madoff Fraud Could Scare Foreign Investors Away From US

December 17, 2008 11:04 AM
by Anne Szustek
One possible reason the U.S. government bailed out AIG was to keep up confidence in American government bonds. But will the Madoff scandal erode that trust?

Madoff Scandal Leads to Trepidation Over U.S. Investment

The alleged Madoff Investment Securities Ponzi scheme walloped several major European banks.

British bank HSBC said that it had some $1 billion that may be “affected,” as the BBC put it, by the Madoff scandal. Royal Bank of Scotland announced that it stands to lose up to $601 million from Madoff, and France’s Natixis may lose as much as $605 million.

Another top European financial player, Santander, a Spanish bank that is the parent company of British banks Alliance & Leicester, Bradford & Bingley and Abbey, potentially lost $23 million in the alleged fraud, while investors in its Optimal fund division had another $3.11 million tied up with Madoff.

Banks in the Santander family have been exposed to other financial ills as of late. The U.K. government announced this past autumn the nationalization of Bradford & Bingley’s £50 billion ($91.8 billion) in mortgages and loans. Abbey bought up B&B’s  £20 billion ($36.72 billion) savings division.

Nicola Horlick, the head of London’s Bramdean Investments, told the BBC, “I think now it is very difficult for people to invest in things that are meant to be regulated in America, because they have fallen down on the job.”

U.S. Securities and Exchange Commission chair Christopher Cox essentially conceded that in a statement issued late Tuesday. “The Commission has learned that credible and specific allegations regarding Mr Madoff's financial wrongdoing, going back to at least 1999, were repeatedly brought to the attention of SEC staff, but were never recommended to the Commission for action,” said Cox, quoted by MarketWatch.

In what is turning out to be possibly the largest-ever fraud on Wall Street, the assets of Madoff Investment Securities were frozen and put into receivership Friday after federal authorities received a tip-off that the $50 billion firm is allegedly a giant Ponzi scheme.

The number of investors hit by the deal continues to balloon. Among the victims are Sterling Equities Inc., the company that owns the New York Mets, as well as the firm’s owner, Fred Wilpon. Wilpon had invested millions of dollars into the investment firm and was a longtime friend of Madoff Securities founder Bernard L. Madoff. Other big-time investors who may have lost millions include former Philadelphia Eagles owner Norman Braman, the charitable foundation of Sen. Frank Lautenberg, D-N.J., and GMAC Financial Services chair J. Ezra Merkin, who was a heavy benefactor of Jewish causes, which as a whole are reeling from the scandal.

AIG, another potential weight on the markets, received Federal Reserve and TARP bailout funding with one potential reason being to retain confidence among foreign investors. The official rationale for injecting AIG with liquidity while letting Lehman fend for itself: Lehman had contingency plans in the works, whereas AIG’s fall took them by surprise.

Background: Madoff scandal, fingerpointing at AIG

As an insurance company, AIG falls under state, rather than federal regulation. And, in a move to keep the company afloat, New York state had pledged $20 billion in cash to AIG earlier this week. But after the Fed announced its $85 billion bailout, “The asset swap will not now take place,” said David Neustadt, director of public information for the New York State Insurance Department.

As of Sept. 22, AIG was no longer included in the Dow Jones Industrials Average, replaced by Northfield, Ill.-based conglomerate Kraft, on the grounds that the Fed’s bailout is tantamount to “effective nationalization.”

Observers at home and abroad have perceived incongruities between the laissez-faire economic ideals championed in the United States and its lifelines to AIG and others. “We have the irony of a free-market administration doing things that the most liberal Democratic administration would never have been doing in its wildest dreams,” American financial historian Ron Chernow told The New York Times.

The March emergency Fed loan to Bear Stearns and the government’s subsuming of Fannie Mae and Freddie Mac are not really parallel situations to AIG’s. Fannie and Freddie were already backed by the government, and Bear Stearns was government-regulated. AIG, in addition to offering insurance policies, was also involved in derivatives trading. Those largely fall out of regulators’ scope and are not backed by the FDIC. But, contrary to the justification given for the Fed’s bailout, AIG’s looming financial abyss was in plain sight.

Opinion & Analysis: Propping up the dominoes at home and abroad

AIG, despite its name, was founded in China—in Shanghai in 1919, to be exact, by Cornelius VanderStarr—from which Greenberg’s C.V. Starr gets its name. AIG has a large employee base there and owns nearly 20 percent of the stock of state-owned People’s Insurance Company of China. Given that Asian financial holdings have been a fundamental source of foreign direct investment (FDI) in the United States, it makes financial and diplomatic sense to shore up a company that plays a key role in Asian confidence in American companies in general.

“When the dust settles, I think Asia will come out ahead of the U.S.,” Henry Lee, the managing director of a Hong Kong investment advisory firm told The New York Times. Financial analysts see Asian markets bouncing back more quickly from the current economic lull than America’s, for one. China’s 2007 economic expansion of 23 percent in dollar terms is testament to this. True, double-digit growth is common among emerging markets.

But tiger economies are not to be overlooked—especially when they start pulling securities out of developed ones, like those of the United States. According to statistics cited by The New York Times, central banks, many of which were Asian, bought up $18.2 billion of U.S. securities in July, compared to a monthly average of $22.3 billion during first-half 2008. China’s central bank controls some $1.8 billion in reserves, “grew $280.6 billion in the first half of this year—a pace of $64 million an hour,” writes the Times.

Market consternation over AIG fallout has played into a weaker U.S. dollar. As of Wednesday, the greenback had fallen back against the euro, the Swiss franc and the British pound. Forex expert Grace Cheng writes, “Apparently, many people, particularly retail investors, are scared that there might be more worms lurking beneath the carpet.”

Conversely, the weak dollar could also entice FDI into the United States. German insurers Allianz and Munich Re are looking to make inroads into American markets, and cheaper acquisitions may just be the ticket.

“I don’t think you can reach satisfactory growth numbers if you are not a substantial player in the US,” Michael Diekmann, Allianz’s Board of Management Chair, was quoted as saying by German newsmagazine Der Spiegel. “From what I see of some of our competitors in the US, this is not a bad time to look at the US market.”

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