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.
But of all the stories I heard those first few weeks, the one that probably shocked Neil and me the most was told to Frank Casey by the representative of a London-based fund of funds. The majority of people we spoke with actually hadn’t invested with Madoff. Those people didn’t want to talk about it; they didn’t have Madoff, that’s all. No explanation. But a trader at one of Wall Street’s largest firms told me that Madoff had been up there trying to interest them in investing, but they’d turned him down when he refused to let them conduct the necessary due diligence. They wanted to conduct a standard financial investigation to make certain he was legitimate and had been turned down. That’s the brightest warning signal of all.
Due diligence can take many different forms. The object is to make sure the numbers are real. It can include everything from a complete audit of records, which involves matching trading tickets to exchange-reported time, price, and quantity for each trade, to extensive background checks on the fund managers. Conducting a thorough due diligence can take several months and cost more than $100,000. But when you’re investing hundreds of millions of dollars, it isn’t the time to try to save a few bucks. A London-based hedge fund of funds told Frank a similar story. It was handling a substantial amount of Arab oil money, and before investing with Madoff it had asked his permission to hire one of the Big Six accounting firms to verify his performance. Madoff refused, saying that the only person allowed to see the secret sauce, to audit his books, was his brother-in-law’s accounting firm. Actually, we heard this from multiple sources. The fact is that Madoff’s accountant for 17 years, beginning in 1992, was David Friehling, who definitely was not his brother-in-law. Friehling operated out of a small storefront office in the upstate New York town of New City. It seems likely that Madoff claimed he was a relative because it was the only plausible reason he could think of to explain why a sophisticated multibillion-dollar hedge fund would use a two-person storefront operation in a small town as its auditor. Brother-in-law or not, this certainly should have been a major stop sign. Even a marginally competent fund manager should have said, “Thank you very much, Mr. Madoff, but no thanks,” and run as fast as possible in the other direction. But this fund of funds didn’t. Instead, this firm, which had been entrusted by investors with hundreds of millions of dollars, handed Bernie Madoff $200 million. The firm knew enough to ask to see how the machine worked, but after it had been turned down flat it still handed over $200 million.
None of us—Frank, Neil, or myself—was naive. We had been in the business long enough to see the corners cut, the dishonesty, and the legal financial scams. But I think even we were surprised at the excuses really smart people made for Bernie. The fact that seemingly sophisticated investors would give Madoff hundreds of millions of dollars after he refused to allow them to conduct ordinary due diligence was a tribute to either greed or stupidity.
The feeder funds—funds that basically raised money for a larger master fund—knew. They knew as much as they wanted to know. They knew they could make money with him; they knew that if they kept their money with him for six years they basically would double their original investment, so they were betting against the clock. And he wasn’t that unusual. It wasn’t like everybody else in the business was complet
ely honest and he was the only one cheating. They all knew how much of Wall Street’s business was done in the shade. This was just another guy cutting some corners. They must have been assuming he was illegally front-running his brokerage arm’s order flows, but they accepted it because Bernie was their crook. And he was a crook they knew they could trust. It was a great deal; they were reaping the benefits of this financial theft without having any of the risk. My guess, and this is just a guess, is they assumed that even if Bernie got caught, their ill-gotten profits would end but their money was safe. How could it not be safe? Bernie Madoff was a respected businessman, a respected philanthropist, a respected political donor, a self-proclaimed cofounder of NASDAQ, and a great man.
We were beginning to see him as he really was: a monster preying on others; a master con artist.
Unfortunately, we were only at the beginning of our investigation. We couldn’t even imagine how much of that we would encounter in the next eight years.
Any lingering doubts any of us had that Bernie Madoff was running a multibillion-dollar scam, maybe even the biggest fraud in history, had long since disappeared, but the question that Neil, Frank, and I continued to debate was: What kind of scheme was it? Was he front-running, was it a Ponzi scheme, or was it maybe even something else? Obviously we weren’t shocked to find gambling in Casablanca, or swindlers on Wall Street. The famous 1950s bank robber Willie Sutton was quoted as explaining that he robbed banks “because that’s where the money is.” It’s probably a good thing Willie Sutton didn’t know about Wall Street.
Throughout history, where there has been money to be made there have been crooks, con artists, and swindlers ready to sell get-rich-quick (or sometimes slowly but consistently) dreams to willing investors. And with the proliferation of new and extremely complicated financial products, there was more money to be made on Wall Street in the past three decades than probably anyplace else at any time in history. Although Bernie Madoff surrounded himself with all the symbols of success and respectability, in fact he was no different than George Parker, who made a career out of selling the Brooklyn Bridge to tourists, the infamous con man Joseph “Yellow Kid” Weil, or even the legendary Charles Ponzi.
The mechanics of a Ponzi scheme are pretty simple. People are offered an opportunity to invest in a business that seems real and even logical—it’s often a business that supposedly exploits some kind of financial loophole—in return for unusually large and rapid profits. These initial investors get every dollar they were promised; they usually earn a profit large enough to make them boast about it to everyone they know. Other people rush to get into this business to receive the same kind of returns, sometimes begging the perpetrators to take their money. In fact, in a true Ponzi scheme there is no underlying business and there are no investments; there is nothing except the cash coming in and the cash going out. The initial investors are paid with seed money used to set up the scam. From that point until the scheme collapses, investors are paid with funds received from later investors. Generally, a substantial number of these investors reinvest their supposed profits in the business. On paper, they can become wealthy, but only on paper. The scheme can last as long as new investors continue to hand over their money so old investors can be paid.
It didn’t originate with Charles Ponzi. A similar scheme is a plot element of Charles Dickens’s 1857 novel, Little Dorrit. In 1899 a man named William “520 Percent” Miller supposedly stole $1 million by offering investors a return of 10 percent weekly on their money. At one time this type of fraud was known as a “rob Peter to pay Paul” scheme. Ponzi just perfected it. Ponzi’s scheme was actually based on a legitimate financial quirk. In 1919 people were able to buy international postal coupons in one country that could be exchanged in another country for stamps that would cover the entire cost of a reply. He realized that if the cost of postage differed in the two countries, it was possible to redeem coupons in one country for a profit. Potential investors who investigated would discover that this actually was true.
Ponzi began promising investors that by investing in postal coupons he could double their investments in three months. And for the initial investors that’s what he did. His company, ironically called the Securities Exchange Company, grew so quickly that he had to hire agents to collect the money for him—and he paid them as much as 10 percent of the money they brought in. The scam grew into a regional frenzy. Thousands of people invested their life savings, and other people borrowed money or mortgaged their homes to get in on this get-rich-quick opportunity. It was estimated that more than half the officers of the Boston Police Department were investors.
Even then there were whistleblowers trying to warn people that this was a con game. Ponzi successfully sued a Boston financial writer for libel—winning a $500,000 judgment. There were obvious red flags that everyone ignored; for example, one of his former publicity men wondered why Ponzi had deposited several million dollars in a Boston bank that paid only 5 percent interest when he could easily have doubled it by investing in his own company. Obviously there was no answer to that. That same publicity man later wrote that Ponzi was not very good at math and could hardly add.
Eventually, Clarence Barron, the publisher of Barron’s financial newsletter, was asked to investigate Ponzi’s business. Barron discovered that to cover Ponzi’s investors there would have had to be about 160 million postal coupons in existence—and according to the U.S. Postal Service there were only 27,000. That was amazingly similar to our discovery about the number of options on the OEX. But even with all the evidence beginning to pile up, people continued to invest with Ponzi. They refused to believe it was a scam. Supposedly, in a last desperate attempt to stay out of prison, Ponzi went to a racetrack and bet $1 million on a long shot. It’s estimated that Ponzi cheated investors out of about $15 million, a fortune at that time, but he served only three and a half years in prison. After being released, he tried several other scams; but none of them were successful, and he died in poverty. His name, though, was attached forever to this get-rich-quick scam.
Rather than investors getting smarter, Ponzi schemes have actually become reasonably common since then. In 1985 it was revealed that a Ponzi scheme run by highly respected San Diego currency trader named David Dominelli had cheated more than a thousand investors out of more than $80 million. Greater Ministries International leader Gerald Payne claimed God was his investment adviser and would double the $500 million that 20,000 people invested in his fake precious metal business. Lou Pearlman, who created the boy bands *N Sync and the Backstreet Boys, swindled investors out of more than $300 million by showing them fake financial statements supposedly produced by nonexistent accounting firms to convince them to invest in the fictitious companies he created. In 2003, Reed Slatkin, cofounder of Internet service provider EarthLink, was sentenced to 14 years in prison for a Ponzi scheme that swindled investors out of approximately $250 million. In 2008, a Minnesota businessman named Tom Petters was accused by the government of swindling investors out of as much as $3.5 billion. Neil and his co-workers at Benchmark Plus had determined earlier that Petters was likely to be a fraud.
There were several reasons I believed almost right from the beginning that Madoff’s operation was a Ponzi scheme rather than front-running or even something more creative. We found out quickly that Madoff was continually on the prowl for new money—although obviously we had no idea of the full extent of that this early in our investigation—and by definition a Ponzi scheme requires a continuous flow of new money to pay old investors. If you’re front-running, you don’t need new money. In fact, raising additional cash cuts down on your own profit. Nor did it seem likely that Madoff was using the hedge fund as a vehicle for borrowing money from investors. Just like Charles Ponzi putting money in the bank at only 5 percent interest, why pay investors 1 to 2 percent a month or more for the use of their money when you can borrow it in the overnight markets much more cheaply? That made no sense to me, so I was pretty certain it was a Ponzi scheme.
Frank Casey disagreed completely with me. He felt just as strongly as I did about it, but he was certain Madoff was front-running. It has been my experience that front-running is common in the broker-dealer industry. It’s a form of insider trading, and the SEC allows it to go on because they know they can’t stop it. They would successfully catch two or three cases a year, and think they actually were accomplishing something. Meanwhile they let thousands of cases continue unmolested.
Front-running is the industry’s dirty open secret. Everybody knows it goes on. “Here’s what I think is really happening,” Frank said to me. “He wants to build the biggest, most powerful independent broker-dealer in the world. He wants to be the biggest market maker, and his biggest problem in doing that is a lack of capital. To take down the block trades, to handle 10 percent of the total volume of the stock market, he needs tremendous amounts of capital. So what he’s doing is putting out some fancy-ass story and he’s giving his investors some wild explanation of how he’s making money for them. What he’s really doing is using them to raise dumb equity.” That was a phrase Frank used to describe using investors’ money as equity on a highly leveraged basis to make a lot of money for himself. “He’s treating the equity as a loan. What does he care if he pays them one to two percent a month if he’s making one hundred percent or one hundred fifty percent annualized profit?”
No One Would Listen: A True Financial Thriller Page 7