The Wizard of Lies: Bernie Madoff and the Death of Trust (10 page)

The line between true and false is very hard to draw so long after the fact, especially given Madoff’s masterful fluency in both truth and lies. There was money to be made in these exotic securities, and Madoff was known later as a big player in at least some corners of this relatively small marketplace. But he is also the man who covered up the losses he inflicted on his clients in the ruinous new-issue market in 1962.

So the possibility that he was deceptively gilding his clients’ arbitrage profits in the 1970s cannot be ruled out.

As the 1970s began, Wall Street was changing as much on the inside as on the outside, and Bernie Madoff would ride those changes to a public leadership position that he would hold for almost forty years—a position that would reinforce his credibility with investors and regulators.

As so often happened, market regulation had grown lax during the intoxicating bull markets of the 1950s and ’60s. The 1970s sobered things up quickly as the Securities and Exchange Commission, the principal regulator of the nation’s financial markets, struggled to catch up with the extraordinary mess that the postwar market party had left behind.

By the end of the go-go years, the manual labor required to keep track of the paperwork generated by trading in those days of paper ledgers and scribbling clerks was beyond the capacity of many Wall Street firms. As the hot mutual funds stepped up their trading pace, the volume of trading grew and the paperwork fell further behind. When the rest of the public started to get excited about stocks, too, the volume picked up even more, and the paperwork lagged disastrously as paper stock certificates had to be physically moved from one brokerage house to another. Keeping track of all this moving paper soon overwhelmed the army of clerks hired to manage it, and the consequent delays and discrepancies made it increasingly difficult for federal regulators to ensure that all this activity was aboveboard and on the level. Old Wall Street hands called it “the paper crunch,” and it bit down fiercely in 1968 and 1969, causing the ruin of a number of Big Board brokerage firms and impressing a young Bernie Madoff with the importance of automating the market’s paperwork procedures.

By then, Ruth Madoff was no longer working at the firm—she had stopped a few months before their first son, Mark, was born in 1964.

Since 1961, Madoff had shared office space at 39 Broadway with a fellow entrepreneur named Martin J. Joel Jr., who was a client of Saul Alpern’s accounting firm. In the same month in 1960 that Madoff launched his firm, Marty Joel and a partner had opened a brokerage firm called Joel, Zuchs & Company. The partnership soon broke up, and Joel invited Madoff to share his office space and split the rent.

Marty Joel would work with and around Madoff for decades. In 1961 he was an aggressive, ambitious young man in his late twenties who was running a small and slightly raucous brokerage business, haggling with regulators, and fielding lawsuits by customers. His repeated run-ins with industry regulators during the late 1960s suggested a certain carelessness about his compliance with the market’s rule book. In 1970, the SEC suspended him from the brokerage business for seventy-five days because of repeated record-keeping and margin violations between 1966 and 1968.

While sharing the rent, Madoff also shared Joel’s office manager, Carole Lipkin, who handled the administrative chores Ruth had once done. In a few years, Madoff hired Carole’s husband, Irwin Lipkin, as his own “back-office” manager—the first outside employee of Bernard L. Madoff Investment Securities—perhaps to draw a sharper line between his firm and Joel’s. There is no sign that Madoff’s firm got tangled up in the regulatory brambles of those years, although he had been cited for minor technical violations in the early 1960s. Whatever their operational differences, Madoff and Joel socialized frequently, and their young families became friends.

Compared with the Big Board firms that served a growing army of retail investors, smaller OTC traders such as Madoff Investment Securities escaped the worst of the strangling paper crunch of the late 1960s, simply because they had fewer clients, traded largely on a wholesale basis with other traders, and were quicker to adopt labor-saving devices such as computers. Indeed, some of these firms not only survived but prospered by providing better service to the mutual funds and other institutional investors who had become frustrated by the logjam at the Big Board and were demanding faster execution of their trades. But this didn’t mean it was easy; Ruth Madoff was briefly recalled from home in 1968 to help the tiny firm deal with the backlog of paperwork.

In response to the paperwork overload and the rising tide of brokerage firm failures in the late 1960s, Congress established the Securities Investor Protection Corporation, known as SIPC (pronounced “Sipik”), in 1970. Although its board was politically appointed, SIPC was not a government agency; it was a nonprofit organization financed through annual assessments levied on Wall Street firms. Its mission was to help ease the bankruptcy process for a failed firm’s retail customers. The same law that created SIPC added elements to the federal bankruptcy code that applied exclusively to brokerage firms. Like the other firms on Wall Street, Bernard L. Madoff Investment Securities became a member and paid its annual assessments.

In the 1970s regulators also began to lean harder on Wall Street to automate and to enable trades to be completed in a reasonable amount of time and tracked for accuracy and legitimacy. Automation would also remove the need to physically transport share certificates; stock ownership would be documented electronically. Technology—in the form of faster, cheaper computers and more sophisticated communications equipment—gradually began to replace the nearly Dickensian record-keeping process built around human clerks and paper ledgers that had failed so spectacularly in the “paper crunch” of the late 1960s.

But the same technology also started changing the very idea of what a stock market was—and this gave Bernie Madoff a legitimate opportunity to reach for greatness.

For traditionalists on the Street, a stock market was a centralized trading floor where men in loud-colored jackets stood face-to-face and shouted bids at one another for a few specified hours each day. That “auction” model—with stock traders bidding against one another like so many art collectors at Sotheby’s or Christie’s—seemed increasingly inadequate as mutual fund managers and other professional investors came to dominate the markets and as over-the-counter stocks became more attractive to them.

As an OTC trading house, Madoff’s firm had never conducted business in the traditional auction-market way. The over-the-counter market, with tens of thousands of unlisted stocks, had no central trading floor where traders could shout out their bids. Instead, it was more like a vast telephonic flea market, whose map was the Pink Sheets. A dealer like Madoff could pick up some shares at one flea market on Monday and try to sell them at a higher price at another flea market being held that day, or at the same flea market on another day.

By the time someone in one flea market noticed a dealer’s price tag on a stock, the stock could be selling for more or less somewhere else. So dealers such as Madoff put a comfortable cushion between the price at which they would buy a stock from another trader and the higher price at which they would sell it. That cushion was called “the spread.” Another term for it would be “profit.”

Spreads on over-the-counter stocks were enormous—sometimes as high as 50 percent—and those fat profits were almost completely hidden from the actual retail investor. Getting a piece of those profits was the hard part.

The market was dominated by a handful of big wholesale dealers with big inventory. Like hundreds of other small dealers, Madoff struggled to get attention. “Often as not, Madoff’s firm did not get called when there was business to do,” a reporter noted in
Traders Magazine
.

Along with a cadre of other farsighted brokers, Madoff quickly saw that if the Pink Sheets were computerized so that their prices could be constantly updated and made available to every dealer—as on the ticker on the Big Board—the dealer offering the best prices for a stock stood a better chance of getting noticed. “We felt, as a small market-making firm, that this would level the playing field for us,” he told one writer. It would also give a much-needed boost to his stock-trading business.

He was not alone in his conviction that the Pink Sheets could be automated; there are at least a half-dozen people with a far better claim than his to having “invented” the automated market that became NASDAQ. But he backed the idea early and emphatically, even as some other market makers resisted it because “you had to show your hand, and they didn’t want to do that,” Madoff recalled. “If somebody just called you up from the Pink Sheets, you could say the price was stale and give different quotes to different people. The system we were proposing would give prices a level of transparency. It was quite controversial.”

The federal regulators, however, were on his side. They quickly saw that computerizing the Pink Sheets would shed more light on price quotes and create more competition in the OTC market. That could narrow spreads and give investors a better deal.

In its push for more automation, the SEC demanded the help of its industry-run partner in the financial regulatory field, the National Association of Securities Dealers, or NASD. For three decades, the policing work of the SEC had theoretically been augmented by the NASD’s own security measures. The organization was empowered to license brokers and to establish and enforce trading rules. Chronic scandals in these years, however, showed that the NASD’s resources often fell short of its responsibilities. Its leadership was divided between small firms fretting about costs and giant firms worrying about investor backlash. And, like any watchdog that is fed and petted by the people it is supposed to be watching, its appetite for fierce enforcement was more of an ambition than a reality.

As divided and occasionally compromised as it was, the NASD’s leadership saw that the status quo was not an option. The group’s automation committee had struggled for years to automate price quotes in the OTC market, and in February 1971, to the muted alarm of the established traditional stock exchanges, an automated system built for the NASD by a computer company called Bunker Ramo made its debut, linking dealers across the country via an electronic network. It was called NASDAQ, an acronym for National Association of Securities Dealers Automated Quotations. Improvements to its primitive archetype—built on a software chassis similar to those already running airline and hotel reservation systems—would follow.

Madoff allied himself firmly with the forces of automation—and somehow his small firm found the money to invest in equipment and software. Did he get some of that money from the investors that Saul Alpern, Frank Avellino, and Michael Bienes were collecting? At least one former employee later thought so, according to allegations in subsequent litigation. But Madoff emphatically denied stealing from customer accounts during the 1970s and ’80s and, nearly two years after his arrest, no evidence had been made public that contradicted him. In any case, the regulatory battles over automation would allow Madoff to add a few brushstrokes each year to his portrait as a committed market innovator, an ally in the crusade to drag the nation’s tradition-bound markets into the modern age.

It is no coincidence that this transformation of the Madoff firm’s reputation—from a struggling over-the-counter trading house to a cutting-edge market innovator—began with the arrival of Bernie’s younger brother, Peter.

Peter Bennett Madoff was in kindergarten when his father’s business failed, and he was a teenager when his brother Bernie married Ruth Alpern. His sister, Sondra, was more than a decade his senior. Like many last-born children, he made his own path—a more seamless transition to adult life than his older brother managed.

Instead of attending Far Rockaway High School, he applied and was admitted to Brooklyn Tech, one of the most prestigious competitive public high schools in the country. He graduated from Queens College in Flushing, New York, where he met his future wife, Marion, and earned his law degree from Fordham University in 1970, just after his daughter, Shana, was born.

By then, Bernie had a growing family. His first son, Mark, whose arrival in March 1964 prompted Ruth to end her brief tenure as Bernie’s office manager, was followed by another son, Andrew, born in April 1966.

Despite the difficulties of breaking into the clubby over-the-counter market, the Madoff firm was apparently doing very well. Bernie moved his young family to Roslyn, on Long Island’s increasingly affluent North Shore, and commuted each day to newer and larger offices at 110 Wall Street, about six blocks from the Fulton Fish Market on the East River. He and Ruth joined a country club; she enjoyed summer days there with the boys, and the family’s golf games improved.

It appears that Peter worked at his brother’s firm while he was still in school—industry records show that he got his broker’s license and joined the firm in June 1969—and he came to stay after getting his law degree. He arrived amid some of the most revolutionary changes since the invention of the ticker tape and telegraph a century before. And he put the Madoff firm on the technological map, spending a lot of its money to do so.

There was little agreement, in hindsight, about whether the Peter Madoff of those days was a warm, engaging man or a sharp-tongued, demanding one. Some former employees, burned by their losses, recalled Peter in less than flattering ways. But even after Bernie Madoff’s fall, the trade journals were full of comments from people who had known Bernie and his brother for years and genuinely liked them. Peter Chapman, of
Traders Magazine
, found that Peter, like Bernie and his sons, “was almost universally liked” on the Street. The Madoff brothers “were just great, great people,” said one of their institutional clients.