No One Would Listen: A True Financial Thriller

by Harry Markopolos

  These were the tools we depended on throughout our investigation.

  When Neil returned to college in the fall of 1992 to earn credit for his work as an intern, he had to write a paper. This will tell you what you need to know about Neil: The paper he wrote criticized the basic investment strategy we used at Rampart because it violated the efficient markets hypothesis.

  Three years later, after working in various jobs at several different types of investment companies, Neil returned to Rampart. Initially he was hired to upgrade our accounting system, with the unspoken hope that eventually it might become something more. For several months Neil ran two accounting systems—our legacy system and the new system—in parallel, and reconciled everything to the penny. If he couldn’t get that last penny to balance, he’d work at it until it did. But what he really wanted to do was portfolio management. Eventually our desks were back-to-back; so we sat directly across from each other, separated only by a divider about 18 inches high, for nine hours a day, five days a week. Over several years we got to know each other better than we knew our families. Neil and I were both research geeks who loved the hunt, and we spent considerable time searching for ways to optimally create portfolios that had the highest chance of beating the benchmark with the lowest risk. We pushed each other. So when we first encountered Bernie Madoff it was only logical that we would see it as an academic exercise, as another strategy to be taken apart and analyzed to help us develop a strategy that would benefit our clients, and not as the largest fraud in Wall Street history. We weren’t looking for a crime; we simply wanted to see how he made his numbers dance.

  It was Frank Casey who first brought Bernie Madoff to my attention. Frank Casey worked on the other side of the ledger; years ago he would have been known as a customer’s man, but now he was a marketing representative. Frank is a gregarious Irishman, a man who attacks life and has combined his gift of language with his effervescent personality to become a successful salesman. In addition to selling our financial products, he also would find needs in the market that we might fill. On Wall Street a salesman is an interpreter of numbers. While Frank isn’t a quant, being the middleman between the customers and the quants meant that he had to have enough understanding of the market to bring needs and products together.

  Frank had been working in the industry doing a great variety of jobs for more than a quarter century when we met. He grew up with a love for the market, using money he earned running a jackhammer on a summer job while still in high school to buy his first stock, Botany 500, a men’s clothier. At that time he didn’t own a suit, but he had the stock. He doubled his money, and he was hooked. He remembers spending much of his junior and senior years in high school reading the stock market pages and books about investing—and writing poetry. He learned the realities of the market less than a year later; when the 1967 Israeli-Arab War started, he figured American Jews would become patriotic, so he invested in Hebrew National—and watched as the stock sat unmoved. But after that there was no doubt in his mind where he wanted to work. After four years in the military, finishing as an army captain, Airborne Ranger qualified, he started as a trader at Merrill Lynch in 1974 with an interesting strategy: “I figured everybody else who was starting as I was, cold-calling from the Yellow Pages, went from the front to the back. My buddy and I split the book in the middle, he worked middle to the back and I worked middle to the front. We called every business in the Boston Yellow Pages. That was our sophisticated strategy.” By 1987 Frank was hedging more than a billion dollars in mortgages for banks. Because during most of his career he has earned his paycheck from commissions rather than from a fixed salary, mostly by creating and executing sales of his own products, he has developed an intuitive feeling about the people working on Wall Street and the products they market. So while at the very beginning he couldn’t quite figure out what Bernie Madoff was doing, whatever it was, it just didn’t feel right to him.

  Frank Casey and Rampart cofounder Dave Fraley had met while both of them were working at Merrill Lynch in the mid-1970s. Like many relationships on Wall Street, their paths had crossed several times through several companies since then. When Frank found out that Rampart was specializing in options, an area in which he had a lot of experience, he approached Fraley, the managing partner in charge of marketing our products, and began working on commission. He was a Wall Street prospector, finding companies that would benefit from Rampart’s products. In return, Dave Fraley directed me to execute trades through Frank, for which he earned a small commission. That’s how we met. To me, he was an aggressive marketer. As I later found out, to him I was just another geek portfolio manager. It was a typical Wall Street retail versus institutional relationship. We needed each other, so we got along. That began changing in February 1998 when Fraley hired him to market products and develop new business.

  It was impossible not to know Frank was there. His office was right next to the trading room and he was salesman-loud. At first we simply shut his door; but his voice boomed right through that closed door, so eventually management had to erect a glass wall so we could concentrate. I got to know him pretty quickly because he would sit down at my desk and ask me to explain our products to him. He understood the marketing aspect, but he wanted to understand exactly how they worked. Frank wanted to know the nuts and bolts of each product, how it worked under various market conditions, and where it fell short. He asked endless questions. What are the trading rules? What are your stop losses? What triggers a trade? What causes you to sit on a position? He wasn’t a mathematician, but he wanted us to explain the math to him until it made sense. This was his way of getting that edge over the competition.

  There are few things quants like more than explaining their math to an interested listener. And Frank does have that Irishman’s way of making you feel comfortable with him. So it was only a matter of time before we were continuing our discussions after work in the better pubs of Boston. Over time we discovered several things we had in common, including the fact that although I was a reserve army officer while he had been regular army, both of us had been commissioned as second lieutenants in the infantry, which allowed us to tell plenty of funny stories about military life; and neither of us had a lot of respect for the corner-cutting ways business was often done in the financial industry.

  It is surprising that nobody actually knows how many hedge funds or money management firms operating as hedge funds exist in this country. There are no regulations that require funds to register; in fact, there are actually few regulations that they have to follow. But there at least 8,000 hedge funds, and perhaps thousands more. So out of all of those funds, how did I manage to find and identify the single most corrupt operation in the world? (Or at least I certainly hope he was the most corrupt one.) Our investigation of Bernie Madoff started with these conversations between Frank Casey and me.

  A properly managed firm invests its clients’ money in a variety of financial products. The firm’s goal is to create a balanced portfolio that has the potential to earn substantial profits while being protected from any drastic losses. A conservative portfolio, for example, consists of about 60 percent equity—stocks—and 40 percent bonds. Frank would meet regularly with portfolio managers to see what kinds of investments they were looking for and try to fulfill those needs.

  Like Neil and me, Frank was always looking to expand the number and quality of Rampart’s products. He had been hired because our two primary products, the Rampart Options Management System and a covered call writing program, had lost their sizzle and we needed something new to sell. So almost immediately he began trying to develop innovative ways to market our expertise. Among the products he and Neil worked on were principle-protected notes, which provide the chance of making a profit with the guarantee that you can’t lose the principle. Basically they involved using part of the investment to buy zero-coupon Treasury bonds, knowing the return over five or 10 years would equal the entire investment, and using the rest of the money to invest
in hedge funds with leverage. The worst-case scenario was that after five or 10 years you’d get the original investment back but without any earnings. Basically, if the investment went south, the most a client could lose was the interest he or she would have made on the principle over five or 10 years. Frank’s plan was to have certain banks construct a blended pool of fund managers that could use the investment portion to produce something close to a 1 percent monthly return to the client, with the triple-A-rated bank guaranteeing the return of the original investment. Dave Fraley was supportive, telling Frank to try to build that part of the business. So Frank began prospecting institutions throughout New England, all the way into New York City.

  The financial industry is a business of contacts and relationships. No one ever buys a product and says, “That product is the sexiest thing I’ve ever seen. I don’t care who’s selling it.” Generally people do business with people they trust and like, or people who are recommended by someone they trust. So like any good salesman, Frank was always looking for leads. He was constantly asking us who we knew at what firms. Who could we introduce him to? He used to complain that I never introduced him to my friends, and there was some truth to that. Finally, though, I referred Frank to my old friend Tim Ng, who was then a junior partner at a Madison Avenue fund of funds, Access International Advisors. Basically, Access was a hedge fund of funds whose investments were spread among several other hedge funds. It was what I always referred to as fighting size, meaning it managed more than $1 billion. I only found out later that almost all of its clients were European royalty or high-born old money.

  As I told Frank, “I’ve heard from Tim Ng that his boss found a manager who’s putting out one to two percent a month or more net to client. Would that help you in building these principle-protected notes?”

  The fact is that I was curious to see how this manager could consistently generate such a high return. Nobody ever beats the market month after month—nobody. The market can go up, remain neutral, or go down. There is no single strategy that provides a consistent return no matter what the market does. So I told Frank, “Why don’t you go down there and figure out what their game is?”

  Frank wanted to know about this manager, too; if he really was that good, Frank could refer him to the banks that were building portfolios for Rampart. If he actually had discovered the holy grail, we could use him in our products.

  They met in Access’s Madison Avenue office. Unlike so many of the elaborately decorated financial offices, this one was tastefully but simply decorated. It was an open plan, with steel desks side by side: a working office. Tim explained to Frank that he didn’t handle that side of the business and set up an appointment for him with the CEO of Access, a Frenchman named Thierry de la Villehuchet. Like Frank, I would eventually get to know and like Thierry very much. Rene-Thierry Magon de la Villehuchet was a terrific person, a French nobleman who, as it tragically turned out, truly was a noble man, a man of honor. He wasn’t an expert in financial math, but he was a great salesman. He and another Frenchman, Patrick Littaye, had founded Access. Both Thierry and Patrick had lived in the United States long enough to consider themselves Americans. They loved the American entrepreneurial spirit and considered themselves Americans in spirit. Thierry believed completely in American values. He took the Statue of Liberty very seriously. As Thierry once explained to me, in a French accent tempered by the years he’d lived here, “The French are socialists; we’re not socialists. Americans are capitalists; we’re capitalists. We believe in economic freedom; therefore we’re Americans.”

  Thierry had a medium build, and everything about him was impeccable. He was always formal, always dressed in a suit and tie. The product he was marketing was himself, and he sold it well. I never knew precisely how old he was, but I guessed he was in his mid-50s when we met. I never knew how wealthy he was, but clearly he was a quietly rich man. Like Frank, Thierry was passionate about sailing, and one afternoon I took him to a shop that specialized in miniature sailboats and nautical items for home decor. He bought a miniature sailboat for $5,000 for his home in Westchester County, New York. “Maybe I overpaid,” he told me, “but I loved that boat.”

  As it turned out, Thierry had his own motive for meeting Frank Casey. While his firm was called “International,” almost all the investments managed by Access came from Europe, and Thierry was trying to raise Wall Street money. So during this first meeting with Frank, Thierry spent considerable time promoting his company. That’s probably why he was unusually candid about the business. “At first I was the hedge fund unit of a French bank in the United States,” he explained. “I built this business basically to find the best managers early in their careers and lock them up for capacity, so later when people wanted to invest with them I would have access to them. Therefore the name of our firm: Access to the best managers. That’s what we provide for our clients.”

  When Frank asked him specifically about the manager who supposedly was producing a 1 to 2 percent net return each month, Thierry nodded. “It’s true. I do have this manager who’s producing a good steady one to two percent net, and I found him early in the development here. He’s my partner. But I’m sorry—I’m not supposed to tell his name to anyone. If I do he might not give me any capacity.”

  That was curious. Generally, when someone is consistently able to produce such spectacular returns, they would want their name and success widely circulated. What could possibly be better for business? But this manager was threatening to turn away clients who dared mention his name. Frank asked why this manager wanted his identity kept secret.

  “He doesn’t hold himself out to be a hedge fund. He has only a few large clients. Actually he’s a broker-dealer, but he’s using hedge fund strategies in his money management business.”

  At that moment Frank had no reason to question any of this. And if what Thierry was telling him was true, this manager was a major find. He told Thierry, “You know, we might be interested in doing business with Access if you could put together a portfolio. If you included managers like him I probably could get the banks to guarantee the return of principle.”

  Thierry liked that concept. “His name is Bernie Madoff.”

  Anyone who had worked in the stock market even for a short period of time knew that name, if not his background. The company he’d founded, Madoff Investment Securities LLC, was among the most successful broker-dealers on Wall Street, specializing in over-the-counter stocks. Madoff Securities was a well-known market maker, meaning he both bought and sold stocks, making his profit by selling for a few cents more per share than his purchase price. Madoff Securities was a pioneer in electronic trading, enabling the company to rapidly move large blocks of over-the-counter stocks. But what really set Madoff apart was his willingness to pay for order flow. Normally, the difference between what market makers paid for a stock and what they sold it for was about 12.5 cents. That was their profit. But instead of taking a fee for this service, as was normally done, Bernie actually paid firms as much as two cents per share for their business. Even though he was earning a penny or two less per share, he more than compensated for that with greatly increased volume. In the early 1990s Madoff Securities was reputed to be responsible for almost 10 percent of the daily trading of New York Stock Exchange-listed securities. By the end of the decade the company was the sixth largest market maker on Wall Street. That strategy had made Madoff rich, and had enabled him to become one of the most respected men in the financial industry. He marketed himself as a cofounder of NASDAQ and had served as its chairman; he was a prominent New York philanthropist and a member of numerous industry and private boards and committees. Thierry might have been born with royal blood, but Bernie Madoff was a Wall Street king.

  Frank Casey had never heard anything about Bernie Madoff managing money, though. But even more unusual was the arrangement between Access and Madoff. As Thierry explained, “I opened an account with Madoff Securities and he gets to use the money any way he wants. I’ve given
him full discretion to put my client’s money with his personal money when it’s needed.”

  “So basically you’re loaning him the money, right?” Frank asked.

  Thierry agreed, pointing out, “It’s secured by his good name.” In other words, if you couldn’t trust Bernie Madoff with your money, then there was no one who could be trusted. Madoff’s investment strategy was a technique known as split-strike conversion, a strategy that Frank knew a lot about—and knew that by design it would produce only limited profits. There was nothing unique or exotic about the split-strike conversion strategy. Option traders often referred to it as a “collar” or “bull spread.” Basically, it involved buying a basket of stocks, in Madoff’s case 30 to 35 blue-chip stocks that correlated very closely to the Standard & Poor’s (S&P) 100-stock index, and then protecting the stocks with put options. By bracketing an investment with puts and calls, you limit your potential profit if the market rises sharply; but in return you’ve protected yourself against devastating losses should the market drop. The calls created a ceiling on his gains when the market went up; the puts provided a floor to cut his losses when the market went down. As Thierry explained, Madoff had a big advantage: “He determines what stocks to buy or sell based upon his knowledge of the market and his order flow.” In other words, he would use the knowledge gained from his role as the middleman in stock trades, which sounded suspiciously like insider trading. Although this was the first time this possibility was raised, we were to hear variations of that claim numerous times in the following years. It was a convenient way of explaining the inexplicable. But however he was doing it, according to Thierry it worked extremely well: “This guy produces about one percent or more every month with almost no downside.”