This blog post originally appeared on RealMoney Silver on Dec. 12 at 8:59 a.m. EST.

While many are suggesting that the failed auto rescue plan is responsible for the dramatic overnight drop in the futures (down by nearly 5%), I believe that the alleged Madoff fraud might be even more responsible for the dire overnight market decline.

If the Madoff story is correct, it is the single biggest financial story of the year. Indeed, it is bigger than Enron or Tyco, bigger than Boesky and far bigger than Bayou.

It attacks at the core of investor confidence, which has already crumbled and remains very fragile.

About three years ago, an investor of mine, who already was an investor with Madoff, came to me and asked my advice as to whether he should add to that investment. I requested and received his monthly brokerage statements. Now, I am very good with math, but after hours of analysis over a weekend, I could not understand how he generated his returns and suggested that he should withdraw his capital. (The investor discarded my advice and decided to add materially to his investment.)

Piecing together information over the last 12 hours from several Madoff investors and acquaintances suggests that the following events might have transpired.

While the criminal complaints filed against Madoff estimated losses at $50 billion, the fraud likely was closer to the amount that was managed by his company at between $17 billion and $25 billion. My friend, Charlie Gasparino, was on CNBC earlier this morning saying that the company employed leverage, but I doubt it was of the magnitude that would cause a $50 billion fraud. That being said, these days, I guess you never know!

It is clear that Madoff's fraud paralleled Bayou as both firms fabricated investment returns. In the case of Bayou, that firm was apparently aided by an in-house accountant; in the case of Madoff, it was a very small, unknown account based in Monsey, N.Y. This was red flag No 1.

Similar to Bayou, Madoff's returns were not sensational but they were consistent. My sources indicated that he had only a few monthly losses over an extended period of time, never a down quarter or down year, almost a statistical impossibility. The ability to deliver what appeared to be consistent investment performance attracted a large investor base to Madoff and permitted him to provide little in the way of transparency to investors (individuals and institutions) who should have known better. In a May 2001 MAR/Hedge column, "Madoff Tops Charts; Skeptics Ask How," Madoff said that he believes he deserves "some credibility as a trader for 40 years.... The strategy is the strategy, and the returns are the returns." He went on to say that "those who believe there is something more to it and are seeking an answer beyond that are wasting their time." This was red flag No. 2.

Also similar to Bayou, Madoff's firm did not appear to charge investment management fees; his compensation was commission-based. In the same MAR/Hedge interview, Madoff said, "We're perfectly happy making the commissions." This was red flag No. 3.

In all likelihood, while posting consistent returns, Madoff (again, similar to Bayou) churned his accounts and earned high levels of commissions. At the same time the accounts were being churned and consistent returns were reported, both firms likely lost huge amounts of money in an extremely active trading strategy, with commissions inuring to the firm. I suspect that the losses dramatically increased this year, as his split-strike conversion strategy (similar to a classical buy/write strategy) backfired, providing little downside protection in the bear market of 2008. Madoff also said in the MAR/Hedge interview that this strategy works best in bull markets and that "we've really been in a bull market since '82, so this has been a good period to do this kind of stuff." Years of phony investment performance had the effect of compounding the alleged fraud over several decades.

Unlike Bayou, however, Madoff self-cleared -- this was red flag No. 4. -- so the far larger fraud than Bayou was more easily kept secret.

Madoff refused to provide account transparency. This was red flag No. 5. According to several friends of his, if an investor questioned his oblique and undisclosed investment methodology, he threatened to return the funds.

Apparently, Madoff's minimum investment requirement dropped considerably this year coincident with the market decline. This was red flag No. 6.

The disclosures of the alleged fraud at both Bayou and Madoff were accelerated by redemption requests.Madoff's firm received about $7 billion in redemption requests. While he was able in the past to cover withdrawals, $7 billion was too large to cover.

Madoff's investors included captains of industry, corporations (some of which are publicly traded) that used Madoff almost as a high-yielding cash management account, endowments, universities, foundations and, importantly, many high-profile fund of funds.

It appears that at least $15 billion of wealth, much of which was concentrated in Southern Florida and New York City, has gone to money heaven. Real estate has been dealt a fatal blow, both in the luxury residential markets as well as in the office market, where Madoff funds were likely used as debt collateral.

The disclosure of the possible fraud last night suggest to me that anyone on the fence regarding redemptions to the hedge fund industry over the next several months will likely put in their requests for capital withdrawal, as confidence in the system and in investment managers has been irreparably impaired.

Madoff & Co. was also an important presence in market making, raising the specter of counterparty risks. I suspect that the exposure here is minimal as it appears that the market making and investment management businesses operated separately as independent entities. Also, there have been no complaints about settlement problems with Madoff that I am aware of today. I presume that a large brokerage firm will gobble up Madoff's market making business by the end of the weekend.

It's a major blow in a market that is already fragile and in which confidence has been materially shattered.

With so many red flags raised, the Madoff fraud is another example of a derelict SEC. What is even more astonishing is that Madoff runs a broker/dealer through which the accounts are actively managed. Indeed, the MAR/Hedge column from seven and half years ago raised a number of obvious questions regarding the steadiness of Madoff's returns.

And, in the end, it appears that Madoff was made up!

Doug Kass writes daily for RealMoney Silver , a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass' daily trading diary, please click here.



How does an alleged multibillion-dollar 'Ponzi scheme' by market maker and money manager Bernie Madoff affect your confidence in the stock market?

Has no effect.
Makes me more nervous than I already was.
Not as bad as past scandals I've seen.
I've never trusted Wall Street, and I never will.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.

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