No One Would Listen: A True Financial Thriller (8 page)

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Authors: Harry Markopolos

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Frank Casey and Dave Fraley began pushing me hard to reverse engineer Madoff’s strategy so Rampart could market a product that would deliver similar returns. Frank didn’t believe what Madoff was doing was real; he knew that Madoff was using that split-strike jargon to cover for whatever he actually was doing, but he also didn’t believe that it was a Ponzi scheme. “Ponzi’s a strong word,” he said. “Okay, we know he’s a fraud, but maybe he’s doing something else and just claiming this to keep it simple.” What he did believe was that I could design a financial product that could compete with Madoff. “Just look at the return stream this guy is putting out,” he said. “This is what the market wants to buy. Can’t you develop something that we could run at Rampart that would compete against Madoff? Believe me, Harry, Thierry de la Villehuchet is looking for something that would net ten, twelve percent to the client. If we can offer him anything even close to that . . .” He didn’t need to finish that sentence.
 
Frank really pushed me to work on the new product. At times we both got a little testy. He was pretty blunt about it. His deal with Rampart guaranteed him a percentage of the business he brought in, and he had a client who could raise hundreds of millions of dollars if he provided the right product. “C’mon, Harry, I need a product to sell. Rampart needs the product. Let’s just build the frickin’ thing and get it out the door.”
 
But each time he asked me if I was making progress, I explained to him that it was impossible to compete with a man who simply made up his numbers. I couldn’t do it. Nobody could. And each time I said that, he would urge me to keep trying. He really wanted to believe Madoff was real, even if he wasn’t particularly legal. He suggested a lot of different possibilities, and I’m sure the excuses he offered for Madoff were precisely the same reasons the hedge funds gave for accepting his numbers: He’s one of the largest market makers, he’s got better execution, he’s been doing it for years, these are audited numbers, and, if there was something wrong, didn’t I think the SEC would have closed him down years earlier?
 
I thought this was a complete waste of my time and did my best to avoid working on it. I had a lot of responsibilities at Rampart. But Dave Fraley kept banging on me hard. He saw only the big picture: “Thierry can raise a hell of a lot of money. He’s got $300 million invested with this guy. So whether he’s real or not, if Thierry’s clients want to buy something like this, let’s find something we can deliver to them that’s pretty close. They want to diversify away from Madoff, and if we’re there maybe we can gather in some of these clients.”
 
Finally, one afternoon as he walked past my desk I stopped him. “Hey, Dave, you know what? I think I’ve got it figured out. I know how we can duplicate it.”
 
“Okay,” Fraley said, sitting down at my desk. “How’s it work?”
 
“Well, actually we have a choice. We can either front-run our order flow or just type in our returns every month. It’s probably a Ponzi scheme, and that’s the only way we can compete with him.” Fraley stood up. “What?” I’d done what they had asked. I’d figured out Madoff’s magic formula, but they didn’t believe me. There were people in management who suspected I just wasn’t good enough at the math to figure it out, that Madoff really was superior. They thought I was blowing smoke with my accusations.
 
I know how frustrated Frank Casey was. He once told someone that working with me required pinning my shoulders down with his knees and then prying out my teeth. He kept challenging me, asking in what I hoped was a joking manner, “How come you can’t figure out Madoff?”
 
I thought I’d already done that. I was really starting to get pissed off. Neil and I had no doubt that Madoff was running some kind of scam, but at least two of the three principals in the firm and maybe Frank Casey weren’t so sure. My pride was at stake. I knew my math was better than Bernie’s, but even then, even at the very beginning, people just refused to believe me. This was the legendary Bernie Madoff we were talking about. And I was just the slightly eccentric Harry Markopolos.
 
From the day Frank came back from Access with Bernie’s numbers, Neil and I continued talking about it. We spent every day looking across the width of two desks at each other. We became so close that when one of us breathed out the other one breathed in. So unraveling Madoff became the subject of a lot of conversations. We started throwing numbers into the Bloomberg terminals, which allowed us to download a basket of stocks to create models. It wasn’t really rocket science, but it required some technical ability. From the beginning we created different scenarios: How do we construct this so we succeed regardless of whether the market goes up, goes sideways, or goes down? We reached the inescapable conclusion that the only possible way to do it was to have perfect market timing ability. You had to be able to forecast the direction of the market, and you had to be right about it almost every time.
 
At that point I still had no idea how much money Madoff was handling or for how many clients. Nobody did. As we rapidly discovered, that secrecy was key to his success. Because this operation was so secret, everybody thought they were among a select few whose money he had agreed to handle. Madoff had not registered with the SEC as an investment advisory firm or a hedge fund, so he wasn’t regulated. He was simply a guy you gave your money to, to do whatever he wanted to do with it, and in return he handed you a nice profit. He was the Wizard of Oz, and he made everybody so happy that they didn’t want to look behind the curtain.
 
Madoff practically swore his investors to secrecy. He threatened to give them back their money if they talked about him, claiming his success depended on keeping his proprietary strategy secret. Obviously, though, his goal was to keep flying below the radar. Madoff’s clients believed he was exclusive to only a few investors, and that he carefully picked those few for their discretion. They felt extremely fortunate that he had agreed to accept them as clients. When I started speaking with his investors, I discovered that they felt privileged that he had taken their money.
 
We began to get some concept of how big he was within a few weeks by looking at the open interest on Bloomberg. The open interest, in this case, was the number of Standard & Poor’s 100 index options actually in existence at each moment in time. Like most people in the industry, I had a working knowledge of the hedge fund industry, but I certainly wasn’t an expert. Hedge funds were a relatively new concept. The first fund was founded in 1949 by former
Fortune
magazine writer and editor Alfred Winslow Jones, with the concept that he would protect his long stock positions by selling other stocks short, hedging against a big move in the market that could devastate his investment. In 1966, when
Fortune
reported his ability to consistently outperform mutual funds, the hedge fund world exploded. But a lot of those new companies didn’t bother to hedge against anything; they became highly leveraged investment firms, and a lot of them went belly-up in down markets. By 1984 there were only 88 known hedge funds.
 
That began changing again in the 1990s bull market. The hedge fund world exploded once more; by the turn of the new century there were an estimated 4,000 hedge funds investing about half a trillion dollars. Hedge funds long ago had stopped being conservative money management firms; a hedge fund meant simply an investment fund run as a private partnership and limited to wealthy investors and institutions. They were basically unregulated and invested in all types of financial instruments. While Madoff didn’t acknowledge that his money management operation was a hedge fund, that’s the way he was set up. He accepted money from high-income investors, institutions, and other funds and supposedly invested it. Supposedly.
 
Madoff’s unique structure gave him substantial advantages. As far as we knew at the time, the only entrance to Madoff was through an approved feeder fund. That meant his actual investors couldn’t ask him any questions, and they had to rely completely on their funds—who were being well rewarded—to conduct due diligence. I knew about the world’s biggest hedge funds: George Soros’s Quantum Fund, Julian Robertson’s Tiger Fund, Paul Tudor Jones’s Tudor Fund, Bruce Kovner’s Caxton Associates, and Lewis Bacon’s Moore Capital. Everybody did, and we estimated they each managed about $2 billion. Both Neil and I had read Jack Schwager’s
Market Wizards,
which profiled the most successful investment managers, and Madoff wasn’t even mentioned. So when we started trying to figure out how much money Madoff was running we were stunned. Absolutely stunned. According to what we were able to piece together, Madoff was running at least $6 billion—or three times the size of the largest known hedge funds. He was the largest hedge fund in the world by far—and most market professionals didn’t even know he existed!
 
There was no logical explanation for what we had discovered. It was like going out for a nice stroll and discovering the Grand Canyon. It was just so hard to believe. Neil and I didn’t
have faith
in the numbers, we didn’t
believe
in the numbers, we knew that numbers can’t lie. If our math was correct—the 6 percent correlation to the market, the steady 45-degree return, the number of options Madoff would have to own to carry out his strategy—(and we continually checked our math), the largest hedge fund in history appeared to be a complete fraud.
 
We never actually initiated an investigation. We never discussed it. Suddenly we were in the middle of it. We had no specific objectives; we just wanted to figure out what was going on. We started by gathering as much information as possible about Madoff’s operation. Frank, meanwhile, was continuing to meet with potential clients. Generally in those meetings the portfolio managers would outline their investment strategy and Frank would probe, looking for an opportunity. Among the managers he met with during this period was the Broyhill All-Weather Fund, a hedge fund of funds. In 1980 the Broyhill family had sold its South Carolina furniture manufacturing business and established an investment fund. As the manager of that fund, Paul H. Broyhill, pointed out, “It’s a whole lot easier to make money when you’re not losing it.” Frank met several times with Broyhill representatives in the lobby of a New York hotel. They showed Frank their product, which they explained was steadily producing 1 percent a month, and asked Frank if he could find a bank to guarantee it. As it turned out, the fund depended basically on two managers the Broyhill representatives would identify only as Manager A and Manager B. They handed Frank a promotional pamphlet and a single page showing Manager B’s returns.
 
Frank took one look at it and knew it was Madoff. Either this was an amazing coincidence and Frank had chanced upon two of the few funds investing in Madoff or he was much larger than we had imagined. We began to wonder how far into the industry his tentacles extended.
 
This material was the first solid evidence we had found. As soon as Frank handed it to me, I began breaking it down. “The manager’s investment objective is long term growth on a consistent basis with low volatility,” Broyhill’s fund description began. It explained that the fund utilized “a strategy often referred to as a ‘split-strike conversion,”’ which meant purchasing a basket of stocks with a high degree of correlation to the general market. Madoff’s subtle—but unspoken—message was that he had access to trade flow information because clients were buying and selling through his brokerage, so he knew what stocks were going up. Well, I had already proven that was false. But then it continued, “To provide the desired hedge the manager then sells out of the money OEX index call options and buys out of the money OEX index put options. The amount of calls that are sold and puts that are bought represent a dollar amount equal to the basket of shares purchased.”
 
Well, that was interesting. Like many people, Neil and I had been actively trading OEX options, but we had stopped and substituted S&P 500 options in the mid-1990s when these options, called the SPX, came to dominate the market and the S&P 100 OEX index options fell by the wayside. We were trading large numbers of option contracts, as much as 30,000 options at one pop. When you do trades like that, it shows up in the market. Bloomberg reports how many contracts are traded and at what price, where the market was when the trade hit the floor, and where it was after the fact. All the details are there. And the market responds. You can’t do trades of that size and not be noticed.
 

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