Madoff meets Lehman

It’s not a lot of money compared to the estimated $3 billion that a fund managed by The Tremont Group has lost in the Bernard Madoff scandal. But the same Tremont fund also claims it lost $25 million when Lehman Brothers went bust in September.

In October, Tremont’s Rye Select Broad Market fund filed a lawsuit alleging that it was owed some $25 million on a derivatives contract that permitted it to borrow money from a Lehman subsidiary. The derivative contract enabled the Rye fund to leverage its investment in Madoff’s firm by a factor of 3 to 1—a move that enabled Tremont to generate higher returns and justify the fees it was charging investors.

Tremont’s Rye fund was one of a handful of “feeder’’ funds that marketed Madoff’s fund under its own independent brand name. The Rye fund’s marketing literature said it allocated “substantially all of its assets to one manager.’’ That manager, of course, was Madoff, who federal prosecutors allege may have engineered one of the biggest Wall Street scams ever.

Madoff, the former Nasdaq stock market chairman with more than four decades of trading experience, relied on funds like Rye to attract new money to his enterprise. If Madoff was indeed running a Ponzi scheme, as he himself admits, bringing in new money was essential to its success. The key to a Ponzi scheme is attracting new investors to pay-off older investors who seek to redeem either all, or a portion of their money.

Tremont also operates a separate so-called hedge fund of funds that made a much smaller investment with Madoff. Tremont says it always marketed the Rye fund as a “single-manager’’ investment, even though it had the option to invest with other hedge funds. In the wake of the Madoff scandal, investors in funds like Rye and other funds of funds have alleged that the managers should have done a better job of due diligence. The funds of funds operators dispute that notion, alleging they were deceived like everyone else.

Tremont has sent a letter to investors saying as much: “We believe Tremont exercised appropriate due diligence in connection with the Madoff investments.”

But the deal between Lehman and the Rye fund offers a glimpse into the way many funds of funds had come to operate in recent years. In order to justify an extra layer of fees, on top of the ones charged by the underlying hedge fund managers, funds of funds managers had to amp-up returns. And the only way to do that was by getting leverage from a bank.

In fact, much of BNP Paribas’ more than $400 million exposure to Madoff stems from loans it made to funds of funds that invested with Madoff. The same is true with many of the other European banks that claim to have lost billions in the Madoff scandal. That’s why the estimated losses have already surpassed the $17 billion in assets Madoff claimed to manage at the beginning of the year. In many ways, much of the money that Madoff managed was levered 3 to 1.

In short, the Madoff mess is once again showing the dark side of all the leverage that worked into the financial system during the past two decades.

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