No One Would Listen: A True Financial Thriller (9 page)

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Authors: Harry Markopolos

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If Madoff actually was purchasing these options, we would have seen the footprints of his trades. At the volume he had to be trading to produce the results he claimed, his trades should have been reflected in the market activity. But there was no sign of his presence in the market. He supposedly got in and got out, bought and sold, without leaving a trace. But then I began doing the math. I knew that there was in existence a total of $9 billion of OEX index put options on the Chicago Board Options Exchange (CBOE). Madoff claimed to be hedging his investment with short-term (meaning 30 days or less) options. You can realistically purchase only $1 billion of these, and at various times Madoff needed $3 billion to $65 billion of these options to protect his investments—far more than existed. This was a breathtaking discovery. There simply were not enough options in the entire universe for him to be doing what he claimed he was doing. If that wasn’t sufficient proof, then assuming that those options actually existed, the cost of purchasing those puts would eat up the profits he was claiming.
 
I also knew that he wasn’t buying them in the over-the-counter (OTC) market. That would have been prohibitively expensive, and if he had bought them there those dealers would have laid off their risk in the listed markets, and that would have shown up. It hadn’t; he wasn’t buying them there.
 
The explanation in Broyhill’s marketing literature failed on so many levels. Broyhill’s Manager B, Bernie, claimed to be selling call options on individual stocks, which capped his potential profit. That meant that the best-performing stocks in his basket of 35 would be called away; he’d lose the stocks that were going up, leaving him with stocks that didn’t rise significantly, stayed at about the same level, or declined. As I pointed out one day to Neil, “You know, this is the only strategy I’ve ever seen that actually penalizes you for picking great stocks.”
 
Rampart had run similar strategies, although we never took the single stock risks that Madoff claimed to take. We would buy the entire index, all the stocks, and what we had discovered over time was that this strategy gave us about two-thirds of the market’s return with one-third the risk. It was a successful strategy—until the market really began rising. If the market went up more than 15 percent, for example, we would miss much or most of all returns above that. In the 1990s, when the market went up as much as 30 percent (or more) in a year, we actually would lose customers, who complained, “The market was up 34 percent this year, and you were up only 22 percent.” They didn’t want to hear about protection; they wanted everything the market provided. I knew that Madoff would have run into a similar problem, especially if his insider knowledge did allow him to buy the best-performing stocks.
 
Until this time, which was about two months after we had encountered Madoff, the only people I had discussed him with outside Rampart were Dan DiBartolomeo, Leon Gross, a few other people whose opinions I valued, and my brother Louie, who was an over-the-counter block trader working for a firm in Miami. He knew the hedge fund world and had access to a lot of promotional material. He had agreed with me from the beginning that something was wrong with Madoff, and immediately began contributing marketing literature to our growing pile.
 
The fortunate thing was that at that point we didn’t know enough to be scared. It never occurred to us that we were going to be stepping on some potentially very dangerous toes. So at the beginning, at least, I didn’t hesitate to ask people I knew throughout the industry about Madoff. After examining the Broyhill materials, for example, I began questioning some of the brokers I worked with on the CBOE. A lot of these guys were longtime phone friends; I did business with them regularly and had gotten to know them on that level. I began bringing up Bernie Madoff in our conversations. It didn’t surprise me that almost all of them knew about Bernie’s brokerage arm, but knew nothing about his secretive asset management firm. I asked numerous traders if they had ever seen his volume, and they all responded negatively. But a few people who were aware he was running a hedge fund asked us if we could give them his contact information. Everyone wanted to do business with him.
 
But nobody admitted they were doing business with him. It was as if he had walked through Times Square naked in the middle of a summer afternoon and no one admitted seeing him. He was the ultimate mystery man.
 
My motive to continue this investigation was basically self-defense. My bosses had continued to pressure me to mirror Madoff so we could pick off some of that business. I knew it was impossible to compete with someone making up his own numbers, and I just wanted to get rid of the pressure. I wanted the intellectual satisfaction of proving to my bosses that they were wrong.
 
I certainly didn’t think of myself as a detective. I didn’t own a trench coat like Lieutenant Columbo, I had no physical handicap to overcome like Ironsides, and instead of a talking car to help me like Michael Knight had in Knight Rider, I had Neil and Frank. The only weapons we had were our knowledge of the numbers and our Rolodexes.
 
What I did have in addition, though, was my experience in the purloined fish case and very good military training. I had served 17 years as a commissioned officer in the army’s reserve components, seven of those years in a special operations unit as a member of a civil affairs team. I had also served for many years under Major General Boyd Cook as he worked his way up the chain of command from the rank of colonel. In civilian life he was a Maryland dairy farmer, and I learned a lot from him. General Cook did not tolerate fools—and he forced his officers to stretch themselves. He would ask his officers to describe their biggest failure. If you didn’t have a big enough failure, he would fire you for not having tried hard enough; his theory was that if you hadn’t failed big, then you couldn’t achieve bigger. As a result of that philosophy we had a high-performing unit because we were continually trying new things. Not all of them worked, but those that did achieved significant objectives. Oddly, I remember pleasing him one year with a failure, although I can’t remember specifically what it was. But he loved the fact that I took a chance, I hadn’t backed down, and at least I tried something new.
 
General Cook had a low tolerance for bullshit. He always wanted to know the bad news, not the good news, and knew that he could determine the quality of his officers not by speaking with them, but rather by questioning the troops they commanded. Among the many things I learned from my military career that would prove invaluable during this investigation were persistence, human-based information-gathering techniques, interviewing skills, and the ability to maintain my composure.
 
We began by snooping. There are basically three ways to collect information in the financial industry. First, you can collect the publicly available information, including promotional literature, the pitch books firms distribute to create business, and everything on their web sites. I took everything off Madoff’s web site, although there wasn’t much of value. Second, you can buy data from numerous sources that will provide you with whatever type of esoteric information you want. Everyone has access to this information. And third, as I’d taught Neil, you can get the truly vital information by talking to people, by listening carefully to the rumors and the gossip, the boasting and the complaining. We took all three routes. Once we started working with Access, which was a large feeder fund to Madoff, we got a complete look at all its data. Frank Casey would collect material from his prospects, telling them, “I’m interested in placing money with Madoff,” and if we wanted something specific from a fund, my brother Louie would call and explain, “I’ve got a client who’s interested in getting into Madoff. Can you help me?”
 
Talking to Wall Street people was extremely informative. Most of these people I was talking with during the normal course of Rampart business, but whenever I had an opportunity I would ask a few questions about Madoff. I spoke with the heads of research, traders on derivatives desks, portfolio managers, and investors. Neil was doing the same thing, and both of us were doing it secretly, because if our bosses found out about it they would have demanded that we stop.
 
Probably what surprised me most was how many people knew Madoff was a fraud. Years later, after his surrender, the question most often asked would be: How could so many smart people not have known? How could he have fooled the brightest people in the business for so long? The answer, as I found out rather quickly, was that he didn’t. The fact that there was something strange going on with Bernie Madoff’s ’s operation was not a secret on Wall Street. As soon as I started asking questions, I discovered that people had been questioning Madoff’s claims for a long time; but even those people who had questioned his strategy had accepted his nonsensical explanations-as long as the returns kept rolling in.
 
The response I heard most often from people at the funds was that his returns were accurate—but he was generating them illegally from front-running. By paying for order flow for his broker-dealer firm, he had unique access to market information. He knew what stocks were going to move up, and that enabled him to fill his basket with them at a low price and then resell them to his brokerage clients at a higher price. Several people confided in me that they didn’t really know what he was doing, then point out that no one else on Wall Street had access to the quality of information he had, and no one generated the consistent returns he did. When those two facts were considered together, it seemed to make a strong argument that he was using his customer order flow to subsidize his hedge fund. Neil, who had done some analysis of payment for order flow when studying for his master’s in finance, believed it could truly provide Madoff an edge—but certainly not enough of an edge to generate the types of returns he was delivering.
 
There were at least some people who told Neil and me, confidentially of course, that Madoff was using the hedge fund as a vehicle for borrowing money from investors. According to these people, Madoff was making substantially more on his trading than the 1 to 2 percent monthly that he was paying in returns, so that payout was simply his cost of obtaining the money. These were sophisticated financial people. When I heard something like this, I just shook my head and wondered if they actually believed what they were saying. There was no reason Madoff would have to pay 12 percent interest—there were many other ways he could have gotten money at a lower cost. The only sensible explanation for this scenario was that he couldn’t risk having one of the rating agencies—Moody’s Investors Service or Standard & Poor’s, for example—come in and look at his operation.
 
Some of the explanations I heard bordered on the incredible. These were sophisticated guys who knew they had a great thing going and wanted it to keep going. They were smart enough to see the potholes, so they had to invent some preposterous explanation to fill them. They knew, for example, that a split-strike strategy can’t produce a profit in all market environments, so they had to explain how Madoff always returned a profit. “Here’s what I think it is, Harry,” a portfolio manager told me. “He’s really smart. It’s really important to him that he show his investors low volatility to keep them happy, so what he does when the market is down is he subsidizes them.” In other words, in those months when Madoff’s fund loses money, he absorbs the loss and continues to return a profit to the investors. “He can afford to eat the losses.” This explanation positioned Madoff as the greatest investment manager in the history of Wall Street. He made it impossible for the investor to lose.
 
Neil admitted to me once that this was not an investment strategy that had ever been discussed at Bentley College. When we heard some of these explanations we would just look at each other and laugh. There was no other sane way of responding. Not only did these people refuse to look behind the curtain, but they granted the wizard even greater powers than he personally claimed.
 
Apparently Madoff also had the ability to time the market perfectly. He said he invested in the market only six to eight times a year, and even then for only brief periods of time ranging from a few days to maybe three weeks, tops. Fortunately, he had the ability to invest only when the market was going up. I had noticed in his return stream that the market had declined rapidly in July and December 1999. When I asked one of his investors to explain to me how he could have avoided a loss those months, I was told, “He wasn’t in the market. He goes one hundred percent cash when he thinks it’s going to fall.” He had proof of that, this man told me. He had copies of Madoff’s trade tickets.

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