No One Would Listen: A True Financial Thriller

by Harry Markopolos

  Thierry began every one of our 20 meetings the same way: “Harry is just like Madoff. It’s an option-based derivative strategy, only he offers a higher risk and a higher return. But it’s different enough from Madoff that you should have him in your portfolio. If you have Madoff and you want some diversification, this will do it.”

  And every time he said it I got furious. What I wanted to shout out loud was that I was offering higher returns than Madoff because my returns were real and his were not. And now that I had corrected my math error, I was a lot lower risk, because at most I was going to lose only 50 percent of their money while with Bernie they were going down a full load.

  But I didn’t. Instead I smiled and explained how this strategy worked. After that we would drill down to the details. I’d go through my pitch book. Then they would ask the usual range of questions: What are your risk controls? What are your trading rules? What is the frequency of the bad events that can hurt you?

  It was the potential risk that scared them. I told them that way less than 1 percent of events could hurt the product, although admittedly should it happen it could be catastrophic. I was honest: “You could lose half your money very quickly.” I didn’t bother to describe the near meltdown Neil and I had survived—and learned from.

  The only fund that asked what I thought were the right questions about my due diligence was Société Générale. The people I met with there knew their derivative math. They told me, “We like your risk controls. You’re the only guy who’s ever come in here and specified what we can lose. But that risk is too high for us.” Ironically, we found out in January 2008 that they actually weren’t such good risk managers, as an employee named Jérôme Kerviel defrauded them of more than $7 billion by executing a series of “elaborate, off-the-books transactions that circumvented the bank’s internal controls.”

  These meetings generally lasted about 90 minutes, and Thierry would end each one the same way: “When can I have your answer? When shall I call you to find out how much you’d like to invest?” It was never “if you want to invest,” always “how much.” He was a master salesman.

  While the objective of this trip was to introduce my product to these fund managers, it also turned out to be an extremely educational trip for me. I came back with a lot more knowledge about Bernie Madoff than I had expected—and what I learned changed my life.

  My team had absolutely no concept of how big Madoff was in Europe. We assumed several European funds and funds of funds had invested with him, but we never appreciated the number of funds or the size of their investments. It became clear to me during this trip for the first time that Madoff presented a clear and present danger to the American capital markets—and to the reputation of the Securities and Exchange Commission (SEC). While obviously I had lost confidence in the SEC, I also knew that investors around the world believed that it offered them a great level of protection and that their money was safe. That was one reason they invested here. When they discovered that wasn’t true, that confidence in the integrity of the American markets that led people to invest in them was going to be badly shaken. When Madoff went down, and that was inevitable, the American financial system was going to take a worldwide beating to its reputation. A primary reason to invest in the United States would have disappeared.

  Of the 20 meetings we had, the managers from 14 of those funds told me they believed in Bernie. Listening to them, I got the feeling it wasn’t so much an investment as it was some sort of financial cult. What was almost frightening was the fact that every one of those 14 funds thought that they had a special relationship with him and theirs was the only fund from which he was continuing to take new money. At first I thought the only reason they would admit to me, someone they didn’t know at all, that Madoff was managing their money was because they trusted Thierry, but then I began to understand that they were telling me this to impress me. The message was practically the same in every one of those 14 meetings: “We have a special relationship with Mr. Madoff. He’s closed to new investors and he takes money only from us.”

  When I heard that said the first time I accepted it. When I heard it the second time I began to get suspicious. And when I heard it 14 times in less than two weeks, I knew it was a Ponzi scheme. I didn’t say anything about the fact that I heard the same claim of exclusivity from several other funds. If I had, or if I had tried to warn anyone, they would have responded by dumping on me. Who was I to attack their god?

  What I did wonder about was what was going on in Thierry’s mind. He heard these 14 fund managers bragging, literally bragging about this special access, just like I did, and he knew it was a lie just like I did. But we never discussed it. Like Frank, I had previously tried to warn him. Before we’d left for Europe I’d told him, in these precise words, “You know Madoff is a fraud, don’t you?”

  And just as he had done when Frank told him, Thierry became extremely defensive. “Oh no, that’s not possible,” he’d replied. “He’s one of the most respected financiers in the world. We check every trade ticket. We have them faxed. We put them in a journal. He’s not a fraud.”

  I had considered asking to see those trade tickets, knowing I could use them to prove to Thierry I was right, but I didn’t. I was afraid that if I asked to see them he would think I was using them to reverse engineer Madoff, and I knew he wouldn’t let me kill his golden goose.

  I cared about Thierry and I wanted to save him. After it had become clear that Thierry wouldn’t listen to me, I called Access’s director of research, who was a bright guy and understood derivative math, and told him that I had compiled a substantial amount of evidence proving Madoff was a fraud. “I get into the office at 6:30 in the morning,” I’d told him. “If you’ll come over half an hour early before tomorrow’s scheduled meeting, I can prove to you mathematically that Madoff is a fraud.”

  He never showed up. And then I got it. He didn’t want to know. Thierry didn’t want to know. They were committed to Madoff; without him they didn’t exist. It was their access to Bernie Madoff that allowed Access International to prosper. So when Thierry heard each of these funds claim an exclusive relationship, there was nothing he could do about it. It changed nothing. I also felt absolutely no obligation to tell any of the 14 asset managers that Madoff was a fraud. I had no personal relationship with any of them, and I certainly didn’t want Bernie Madoff to know we were tracking him. Like Access, these funds needed Bernie to survive; they didn’t need me. Where would their loyalty be? And what would happen to me when Madoff found out I had warned them?

  I did appreciate the fact that they were trapped. They had to have Madoff to compete. No one had a risk-return ratio like Bernie. If you didn’t have him in your portfolio, your returns paled in comparison to those competitors who did. If you were a private banker and a client told you someone he knew had invested with Madoff and was getting 12 percent annually with ultralow volatility, what choice do you have? You’re going to either get Madoff for that client or lose the client to a banker who has him. And Madoff not only made it easy; he made it lucrative. He allowed the feeder funds to earn higher fees than anyone else and always returned a profit.

  That was the reason so many European funds gave their millions to him. It was after these meetings that I strongly suspected Madoff was even bigger in Europe than he was in the United States. I estimated the minimum amount of money Bernie had taken out of Europe was $10 billion and in retrospect even that probably was low.

  Once I realized how much money he had taken out of Europe—and was continuing to take—there was no longer any doubt in my mind that he wasn’t front-running. This was a Ponzi scheme. If he was front-running he wouldn’t want new money, because it would lower his return on invested capital. The money to pay the investors in his hedge fund would have had to come from investors in his broker-dealership. The more money invested in the fund, the more money he would have been forced to drain from the broker-dealership. Eventually it would have been spotted by some of his more
sophisticated customers. And once those investors figured out they were getting bad price fills—which eventually they would have—that business would have declined rapidly, making it impossible for Bernie to continue paying such huge hedge fund fees and returns.

  So he wasn’t front-running. For a Ponzi scheme to continue to survive you have to bring in new money faster than it is flowing out, because you’re robbing Peter to pay Paul. The more Pauls you have to pay, the more Peters you need to find. It’s a ravenous monster that needs to be continuously fed. It never stops devouring cash. To me, the amount of money invested with Bernie, and the secrecy he required, were vital pieces of information.

  But it became clear to me that the Europeans believed he was front-running—and they took great comfort in it. They thought it was phenomenal because it meant the returns were real and high and consistent and that they were the beneficiaries of it. They certainly didn’t object to it; there was a real sense of entitlement on this level. To them, the fact that he had a seemingly successful broker-dealer arm was tremendously reassuring, because it gave him plenty of opportunity to steal from his brokerage clients and pass the returns on to them. They never bothered to look a little deeper to see if he was cheating other clients—like them, for example. What they didn’t understand was that a great crook cheats everybody. They thought they were too respectable, too important to be cheated. Madoff was useful to them, so they used him.

  They were attracted to Bernie like moths to a flame.

  Just like the Americans, they knew. They knew. Several people admitted to me, “Well, of course we don’t believe he is really using split-strike conversions. We think he has access to order flow.” It was said with a proverbial wink and a nod—we know what he’s doing. And if the American Madoff got caught, well, c’est la vie. They believed that the worst that could happen was that he could get caught and go to prison for a long, long time; but they would get to keep their ill-gotten returns and would get their principals back because they were offshore investors and the U.S. courts have no legal hold on them.

  But for me, the most chilling discovery of this trip was the fact that many of these funds were operating offshore. It was not something that was spoken about; it was just something I picked up in conversation. Offshore funds are known as tax havens, places for people to quietly hide money so governments won’t know about it. It’s a means of avoiding law-enforcement and tax authorities. They’re particularly popular in nations with high tax brackets, like France. While offshore funds certainly can be completely legitimate, to me it indicated that at least some of these funds were handling dirty money, untaxed money.

  An offshore fund allows investors from a high-tax jurisdiction to pretend their income is coming from a low- or no-tax jurisdiction. While I have no direct knowledge, I definitely don’t believe that all income from offshore tax havens is eventually declared to the proper government. But what was a lot more frightening to me was the fact that offshore investments are used by some very dangerous people to launder a lot of money. It is common knowledge that offshore funds are used by members of organized crime and the drug cartels that have billions of dollars and no legitimate place to invest them.

  For me, that suddenly added a frightening new perspective. It wasn’t just the people in these luxurious offices who were going to be destroyed when Madoff went down; it also was some of the worst people in the world. I was pretty certain the Russian mafia had to be investing through one of those funds. I didn’t know about the Latin American drug cartels, but I knew they went offshore and were probably into Madoff in a big way. Obviously Bernie had to be worried about a lot more than going to jail. These were men who had their own way of dealing with people who zero out their accounts. Maybe Bernie was close to being a billionaire—we had no idea how much of the money he was keeping for himself—but we knew that even he couldn’t afford that.

  The knowledge that offshore funds were so heavily invested in Madoff staggered me, absolutely staggered me. It wasn’t until this trip that I realized that my life was in danger. People kill to protect their money, and if my team was successful, a lot of people were going to lose a lot of money. And while I didn’t know the names of these investors, I felt quite certain that if these people discovered what I was doing they would have to try to take me out. I was the most active threat to them. Even Bernie Madoff, the respected Mr. Madoff, was potentially a threat to my life. He was playing a dangerous game of unimaginable complexity. How was he going to respond if he found out that I was trying to bring him down? Was it better for Bernie to get rid of me or let these offshore investors get rid of him?

  This wasn’t paranoia. Everybody in the money business has heard stories and rumors about what happened to people who made bad decisions and created problems. Some of them may be apocryphal—but a lot of them aren’t. I remembered the story Frank Casey had told me about a problem he’d had early in his career. In 1980 he had devised a strategy that fell into that gray area of legality. Its legality depended completely on an interpretation of the tax law. It was called a commodities straddle, a very complicated, highly leveraged strategy that allowed him to move money from one tax year to the next for individuals who needed that done, and then convert it to long-term capital gains. Basically it involved buying a commodity in December and taking all the tax benefits, then selling it the following year. These were riskless trades designed solely to create short-term losses for one tax year while providing long-term capital gains for the following year. Wall Street firms were doing it for their wealthy clients with a variety of commodities, ranging from silver to soybeans. And like the product I created, it could go south quickly. If it worked it was beautiful—it would save clients about 30 percent of their taxable dollars. The product Frank designed was slightly different. While his product had the same benefits—it would save clients about 30 percent—it also included some risk, which made it ethical and completely legal. And even if it blew up, the way Frank hedged it the most his clients could lose was 10 percent. So it had a 3:1 reward-to-risk ratio, a very nice ratio.

  In late November 1980 a Merrill Lynch broker who specialized in private wealth management asked Frank to meet several of his clients in Carteret, New Jersey. The clients wanted to do a commodity tax straddle; for tax purposes they wanted to move income into the following year. Because Frank’s strategy depended on some market volatility for success, he normally started by early September, which gave the market plenty of time to move. Beginning too late in the year was risky, because if the market stayed flat the strategy wouldn’t work.

  As Frank described this meeting, “Four guys with no necks were sitting there and one of them is a lawyer. It seemed obvious to me that the other three men were not exactly legitimate businessmen. I didn’t care. This investment was legal and ethical and was going to be reported as required. The lawyer explained that they had flipped some property and ended up with a one-and-a-half-million-dollar short-term capital gains liability that they wanted stretched into the following year. I told them the risks—that if the market flatlined there was nothing I could do about it. They agreed to pay me a fifty-thousand-dollar commission, which I would split with the broker.

  “I set up the strategy and the market went flat. Nothing happened, no movement. The lawyer with no neck began calling me every day. ‘How much did we save today?’ he’d ask. When I’d tell him, ‘Nothing,’ I could hear the silence.

  “Finally, the second week in December he called me and said pretty clearly, ‘Frank, you gotta make something happen. I don’t think you understand the situation. There are extenuating circumstances. We can’t be caught flat-footed like this. This money cannot be on the books. You need to create a million-two in losses.’

  “I reminded him that I’d warned his clients about this possibility. That there was nothing ...

  “ ‘Frank, that is not an answer. And if I don’t get the right answer I’m gonna put a bullet in you.’

  “I didn’t think I heard that correct
ly, or maybe I was just hoping I hadn’t heard it right. ‘Excuse me?’ I said.

  “ ‘I said you either do this thing right or we’re gonna put a bullet in you.’

  “But the market didn’t move and I was trapped. Late one afternoon they showed up at my office. ‘Do something now,’ the lawyer said. The whole scenario was out of a bad movie. These were just dumpy-looking guys, wearing brown suits. They looked like anybody out of the neighborhood, except they seemed serious about shooting me. I went to my boss and I told him I had to lever up my position about five to one over what I had already leveraged, knowing I could get at least some movement out of that. I told the people from Carteret that I needed another twenty-five grand, which they handed over, and I put this monster position on. I warned them that they easily could lose thirty percent of their money on this deal.

  “It did occur to me they had no intention of losing any money.”

  Frank had been through military Ranger training; he was capable and experienced with a weapon. So he began carrying a .357 with hollow-point bullets. This was a pretty tough time in his life. He was going through a difficult divorce, he had started drinking heavily, and four mob guys from New Jersey were threatening his life. It wasn’t precisely what he had envisioned when he decided to work on Wall Street.