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Madoff Lawsuit's Perverse Incentives & Implications

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A suit filed against Citigroup by the trustee representing Bernie Madoff's victims would seem to put banks in an impossible position.

According to a report in the Wall Street Journal, here are the generally agreed upon facts.

Sometime prior to November 2006, Citigroup lent $300 million to a Madoff feeder fund called Tremont Partners.

Then, in November of 2006, Madoff sought to renew the $300 million loan—and increase the loan amount to $400 million.

On November 27, 2006, Citi held a meeting with Madoff to discuss the loan.

After that meeting, Citi not only decided not to increase Madoff credit—it decided to terminate the loan entirely.

In March of 2008, Citi was repaid the $300 million they lent to Madoff's fund.

Now, Irving Picard, who is the attorney representing Madoff victims in his role as their trustee, has filed suit against Citi.

Picard is seeking $430 million in his law suit. That figure comes from adding the $300 million that Citi lent Madoff—and was later repaid—plus an additional $130 million "from other transactions."

Now, think about this:

What were Citi's options when they began their due diligence research for renewing, and possibly increasing, the loan to Madoff?

For the sake of argument, let's assume that Citi properly performed its due diligence at the time it initially made the loan.

(This isn't a totally unreasonable assumption—since prior to 2006 few people suspected anything was amiss with Madoff's finances. It's entirely possible, even likely, that the elaborate fraud Madoff perpetrated on so many could survive a due diligence check from Citigroup. )

Madoff then later requests that Citi up his credit line from $300 million to $400 million. Citi performs their due diligence—and discovers everything is not quite as it should be.

Based on what they discover about Madoff's business practices, Citi decides to pull the credit line entirely.

Now, Picard argues that Citi should have to disgorge the $300 million in loan repayment that they received from Madoff.

This was Citi's money in the first place—he just paid it back to them.

(In other words, Picard is going after the loan's principal—not just interest and fees, which would represent Citi's profit on the loan.)

One might quite reasonably argue that Citi was only doing precisely what it should be doing to protect its interest when Madoff requested more credit.

What perverse set of incentives does this set up for banks?

Well, first it would seem to encourage banks not to do additional underwriting on existing loans.

If you own an outstanding loan, and the borrower wants to increase its size, you don't want to do any additional underwriting—because if you find a 'red flag' you might have to forfeit the principal of the loan—or later get sued for it.

So if you’re the bank, that means you have two options: 1) Deny more credit to your customers; or 2) provide them with additional credit without properly assessing their credit worthiness.

Neither seems like a particularly appealing option.

Worse, if you do engage in proper due diligence, and you find something suspicious, what are your options then?

If you thought you would need to ultimately disgorge all of the money you'd already sunk into the loan, it might encourage you to recklessly lend more money to your client.

Because: Why not? You're going to get fired either way.

In fact, it might actually encourage bankers to become part of ongoing criminal conspiracies.

If investigating the future creditworthiness of an existing lending client caused the bank to forfeit the full value of the loan anyway, there is no telling what perverse incentives might arise for people who were desperate not to lose their job or to suffer public ignominy. Especially if they were blameless in the first place—and made good faith efforts to do proper due diligence at the inception of the loan—and were being penalized anyway. It is a very odd set of incentives indeed.

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