Madoff Mess is a real Black Eye for Banks

Chismillionaire says: "At least this collapse didn't steal from the average non sophisticated investor, rather the Palm Beach set and bankers who should have known better but who were too inept or careless to look after their own money.
People had been complaining to the SEC for almost a decade that the returns generated by Madoff were not possible with his holdings without front running or outright fraud. This was not a shock to some.

Charity begins at home. If it seems to good to be true, it probably is."

NEW YORK (Fortune) -- The losses in the Madoff mess are still being tallied. But even if U.S. financial firms avoid a big hit, this episode won't exactly bolster their tattered reputation.

Bernard L. Madoff Investment Securities collapsed Thursday, when Madoff, the founder of the big broker-dealer, was arrested on a charge that he ripped investors off to the tune of $50 billion in a long-running pyramid scheme. The failure of Madoff's firm may have cost thousands of investors their life savings.

So far, none of the big losers have come from the ranks of major U.S. commercial and investment banks. Bank of America (BAC, Fortune 500) and Citigroup (C, Fortune 500) declined to comment on their possible exposure to Madoff, and JPMorgan Chase (JPM, Fortune 500) didn't immediately respond to calls seeking comment.

Investors may soon find out if Goldman Sachs (GS, Fortune 500) and Morgan Stanley (MS, Fortune 500) are on the hook for any potential Madoff-related losses when the New York-based investment firms report their fourth-quarter numbers. Goldman's results are due out this morning and Morgan reports its results on Wednesday.

Shares of these and many other banks tumbled again Monday, with JPMorgan falling nearly 8% following a downgrade from Merrill Lynch. Analyst Guy Moszkowski cited depressed capital markets in cutting JPMorgan to "underperform," essentially a sell.

It's clear that uncovering a massive fraud in the middle of the worst year for investors in decades hasn't helped sentiment. Merrill Lynch economist David Rosenberg noted "the hit to investor confidence from the Madoff affair" in his morning memo Monday.

The biggest losses to this point have been borne by the fund-of-hedge-fund firms that steered wealthy investors' dollars to Madoff's firm, and some big overseas banks.

HSBC (HBC), the big London-based bank, said Sunday it could lose "in the region of US$1 billion" from its financing of institutional clients who invested their funds with Madoff. Other foreign banks that face possible Madoff-related losses include BNP Paribas of France and the Royal Bank of Scotland.

Those aren't the only institutions that will get a black eye in the collapse of the Madoff empire. Banco Santander, the Spanish bank that's the biggest financial institution in the euro zone, said it had invested $3 billion of client funds with Madoff through its Optimal Investment Services unit.

But if these sums aren't enough to threaten institutions with balance sheets running into the trillions of dollars, they certainly do nothing to shake the growing suspicion that the finance industry has failed spectacularly in its duty to guide its customers away from problematic investments.

"There has just been a lack of common sense," says Mark Sunshine, the president of middle-market lender First Capital in West Palm Beach, Fla. "No one has bothered to do the math."

The 'smart' money burned more than once

As audacious as the alleged Madoff scam was, Sunshine says it was no less breathtaking than another financial fleecing that was uncovered earlier this fall: the federal fraud case against Tom Petters, the Minneapolis entrepreneur who was arrested this month on charges he defrauded investors of as much as $3 billion over a more than decade-long span.

While Madoff's secretiveness and his years of unusually steady gains now appear to have been surefire marks of investment returns that were too good to be true, Sunshine says the claim behind the alleged Petters scam was even harder to believe.

An informant told federal authorities that Petters had, in one case, lured investors by promising outsize returns on name-brand electronics gear that the Petters group was buying for the purpose of selling to big-box retailers.

This, Sunshine says, should have raised red flags among investors because carrying out such a plan "would have required a warehouse the size of New Jersey."

"The whole thing was just beyond ludicrous," he says.

Yet according to an indictment filed Dec. 1 in Minnesota federal district court, Petters managed to keep his scheme going for 13 years. Along the way, he picked up stakes in well-known companies such as Polaroid and direct marketer Fingerhut.

Petters' companies filed for Chapter 11 bankruptcy protection in October. They have been sued by several investors including Ritchie Capital Management, which claims to have lost $220 million in the Petters case.

The losses in the Madoff and Petters cases show that when the market tides roll out -- stock indexes worldwide have lost between 40% and 50% of their value this year -- even supposedly astute investors are suddenly exposed.

And regulators' failure to probe the Madoff investment business, despite warnings filed with the Securities and Exchange Commission as much as a decade ago, will do nothing to increase investors' confidence in the fairness of markets.

That's not likely to change until it's clear that Washington is ready to exert itself by vigorously enforcing current laws, let alone adopt new ones.

"The SEC looks out to lunch on this one," Sunshine says. "Investors can make their own stupid mistakes -- they don't need help from regulators not doing their jobs.