No One Would Listen: A True Financial Thriller

by Harry Markopolos

  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.

  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 ci
vilian 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?”