No One Would Listen: A True Financial Thriller

by Harry Markopolos

  The objective should be to combine regulatory functions into as few agencies as possible to prevent regulatory arbitrage, centralize command and control, ensure unity of effort, eliminate expensive duplication of effort, and minimize the number of regulators to whom American corporations must respond.

  It seems logical to me that one super-regulatory agency be formed, perhaps called the Financial Supervisory Authority (FSA). It should have all of the security and capital markets and financial regulators underneath it. To simply command and control, to ensure unity of effort and eliminate expensive duplication, I would place under its command the Fed, the SEC, a national insurance industry regulator, and some form of Treasury or Department of Justice law enforcement entity with a staff of dedicated litigators responsible for carrying out both civil and criminal enforcement for those three combined agencies. All banking regulators should be merged into the Fed, so that only a single national banking regulator exists. Pension fund regulation should be moved from the Department of Labor to the SEC. The Commodity Futures Trading Commission should be brought into the SEC, which would then become the sole capital markets regulator.

  To ensure the highest degree of coordination, this super-agency would maintain a centralized database, a super-duper CALL center so that the details of any enforcement action by one agency would be online for all the other agencies to see and utilize. Spread the knowledge, share the experience, be bigger than the biggest bad guys. Bernie Madoff got caught for the first time in 1992, but apparently none of the investigators after the turn of the century knew about it. Cross-functional teams of regulators from the SEC, the Fed, a national insurance regulator, and the Treasury or Department of Justice should be sent together on audits whenever possible to prevent regulatory arbitrage. The SEC, the Fed, and the national insurance regulator would be responsible for the inspections, while the Treasury or Department of Justice would be responsible for taking legal action against offenders. American businesses need and deserve a simple, easy-to-follow set of rules and regulations, and they deserve to have competent regulation. Financial institutions currently pay high fees to support regulation, but neither they nor the public are getting their money’s worth.

  Thirteenth (lucky thirteen), take away the “Get out of jail free” cards. Right now there is no accountability in government. None. Following the accounting scandals that led to the demises of Enron, Global Crossing, WorldCom, Adelphia, and the others, Congress passed very strict laws that held corporate CEOs and CFOs accountable for their companies’ financial reporting. Under the Sarbanes-Oxley Act (SOX), these leaders can no longer claim that they don’t know what is happening in their companies. If a CEO and CFO has signed off on a company’s books, he or she has assumed responsibility for the numbers; if those books are materially inaccurate, this officer faces a 10-year prison sentence. (That has gotten their attention.) And if they have been willfully cooking their books, they face a 20-year sentence.

  I propose that Congress pass legislation that holds agency heads responsible for the successes or failures of their agency under their watch. If an agency falls to enforce laws passed by Congress, then the head should be referred to the Justice Department for criminal prosecution. It is a disgrace that the regulators charged with overseeing the financial industry have gotten away scot-free. At the SEC a few of the department heads were allowed to resign “to pursue other growth opportunities,” called “pogo-ing out,” often to well-paying positions in private industry. It would be satisfying to see a few of these people sent to prison for their willful blindness in allowing our nation’s financial system to collapse; unfortunately, there are no laws on the books that make that possible. Entire government agencies can remain comatose, letting the industries they are charged with regulating commit crimes without any fear of being penalized for it.

  A similar SOX making agency heads responsible for the failures of their staff would also go a long way toward eliminating so-called regulatory capture, a situation in which the regulators become beholden to the industries they supposedly are regulating. The mission of the SEC is to protect investors, but in reality it ended up serving the needs of deep-pocketed and influential industry firms.

  Fourteenth, publicly censure the SEC. Clearly the SEC has been unofficially censured. Its reputation is in tatters, its employees have been shamed. Obviously no one can take pride in being an employee of the SEC. But maybe we should make that embarrassment official. One way to light a bonfire under agencies that are under-performing or non-responsive to Congressional oversight is to publicly censure them. Call them out. Identify them for what is, a national disgrace. Then force that agency to include that censure in every communication sent out by employees—for a predetermined amount of time or until the agency proves it has rectified its problems. This is a low-cost but effective means for Congress to publicly express its displeasure over the lack of regulatory action. No one, absolutely no one, enjoys playing on a losing team.

  Fifteenth, regulate and give investors some guidelines. Bernie Madoff didn’t just steal billions of dollars; he exposed the lack of government supervision of the financial industry to a public that had already been badly burned. Madoff is already a tragedy. It would be an even larger disaster if we didn’t take the steps necessary to create fair and transparent markets.

  For example, the over-the-counter (OTC) market is unregulated space. It’s where the financial industry’s cockroaches congregate, because it is a place where there is no light, only darkness. And perhaps not coincidentally, this is also where the industry’s highest margins exist, so people will fight like Mike Tyson to protect their profit margins.

  That needs to change. Laws should be passed to prevent American investors from trading OTC products offshore and still receive government protection in the form of bailouts. In other words, there should be no more trading through unregulated entities like AIG’s London-based Financial Products unit, where the risk ends up getting transferred back onshore and U.S. taxpayers end up footing the bill. It seems only fair and logical that if American regulators don’t have visibility into an OTC product traded offshore, then strict risk and capital limits should be placed on U.S.-based counterparties in order to avoid systemic risk.

  You can’t regulate common sense, but some sort of guidelines should be available to investors on the SEC’s web site, pointing out that if you don’t know how to model an OTC derivative yourself, then you, your company, or your municipality shouldn’t be trading them. The SEC should closely investigate all disclosures in the OTC municipal derivatives market, because this sector of the marketplace is just rife with fraud. In many instances it is still a pay-to-play market with opaque disclosure documents and even more opaque pricing mechanisms, which only serve to defraud government entities.

  I have seen the state of Massachusetts lose $450 million because no one in state government knew how to price interest rate swaptions. The Massachusetts Turnpike Authority was picked off by several Wall Street firms because they were lured into OTC transactions in which they didn’t understand the pricing or the risks.

  Once again, you can’t regulate common sense, but we can regulate the OTC markets so they no longer remain outposts of lawlessness. More regulation can only come from the federal government. History has now taught us that we need to shed light on those dark places in our capital markets. Everybody deserves full transparency when they are dealing with investments, and it’s up to the government to provide it.

  Appendix A

  Madoff Tops Charts; Skeptics Ask How

  Michael Ocrant

  Mention Bernard L. Madoff Investment Securities to anyone working on Wall Street at any time over the last 40 years and you’re likely to get a look of immediate recognition.

  After all, Madoff Securities, with its 600 major brokerage clients, is ranked as one of the top three market makers in NASDAQ stocks, cites itself as probably the largest source of order flow for New York Stock Exchange—listed securities, and remains a huge pl
ayer in the trading of preferred, convertible and other specialized securities instruments.

  Beyond that, Madoff operates one of the most successful “third markets” for trading equities after regular exchange hours, and is an active market maker in the European and Asian equity markets. And with a group of partners, it is leading an effort and developing the technology for a new electronic auction market trading system called Primex.

  But it’s a safe bet that relatively few Wall Street professionals are aware that Madoff Securities could be categorized as perhaps the best risk-adjusted hedge fund portfolio manager for the last dozen years. Its $6-7 billion in assets under management, provided primarily by three feeder funds, currently would put it in the number one or two spot in the Zurich (formerly MAR) database of more than 1,100 hedge funds, and would place it at or near the top of any well-known database in existence defined by assets.

  This article was originally published in MARHedge magazine (No. 89) in May 2001. Reprinted with permission of Institutional Investor.

  More important, perhaps, most of those who are aware of Madoff’s status in the hedge fund world are baffled by the way the firm has obtained such consistent, nonvolatile returns month after month and year after year.

  Madoff has reported positive returns for the last 11-plus years in assets managed on behalf of the feeder fund known as Fairfield Sentry, which in providing capital for the program since 1989 has been doing it longer than any of the other feeder funds. Those other funds have demonstrated equally positive track records using the same strategy for much of that period.

  Lack of Volatility

  Those who question the consistency of the returns, though not necessarily the ability to generate the gross and net returns reported, include current and former traders, other money managers, consultants, quantitative analysts and fund-of-funds executives, many of whom are familiar with the so-called split-strike conversion strategy used to manage the assets.

  These individuals, more than a dozen in all, offered their views, speculation and opinions on the condition that they wouldn’t be identified. They noted that others who use or have used the strategy—described as buying a basket of stocks closely correlated to an index, while concurrently selling out-of-the-money call options on the index and buying out-of-the-money put options on the index—are known to have had nowhere near the same degree of success.

  The strategy is generally described as putting on a “collar” in an attempt to limit gains compared to the benchmark index in an up market and, likewise, limit losses to something less than the benchmark in a down market, essentially creating a floor and a ceiling.

  Madoff’s strategy is designed around multiple stock baskets made up of 30—35 stocks, most correlated to the S&P 100 index. In marketing material issued by Fairfield Sentry, the sale of the calls is described as increasing “the standstill rate of return, while allowing upward movement of the stock portfolio to the strike price of the calls.” The puts, according to the same material, are “funded in large part by the sale of the calls, [and] limit the portfolio’s downside.

  “A bullish or bearish bias can be achieved by adjusting the strike prices of the options, overweighting the puts, or underweighting the calls. However, the underlying value of the S&P 100 puts is always approximately equal to that of the portfolio of stocks,” the marketing document concludes.

  Throughout the entire period Madoff has managed the assets, the strategy, which claims to use OTC options almost entirely, has appeared to work with remarkable results.

  Again, take the Fairfield Sentry fund as the example. It has reported losses of no more than 55 basis points in just four of the past 139 consecutive months, while generating highly consistent gross returns of slightly more than 1.5 percent a month and net annual returns roughly in the range of 15.0 percent.

  Among all the funds on the database in that same period, the Madoff/ Fairfield Sentry fund would place at number 16 if ranked by its absolute cumulative returns.

  Among 423 funds reporting returns over the last five years, most with less money and shorter track records, Fairfield Sentry would be ranked at 240 on an absolute return basis and come in number 10 if measured by risk-adjusted return as defined by its Sharpe ratio.

  What is striking to most observers is not so much the annual returns—which, though considered somewhat high for the strategy, could be attributed to the firm’s market making and trade execution capabilities—but the ability to provide such smooth returns with so little volatility.

  The best known entity using a similar strategy, a publicly traded mutual fund dating from 1978 called Gateway, has experienced far greater volatility and lower returns during the same period.

  The capital overseen by Madoff through Fairfield Sentry has a cumulative compound net return of 397.5 percent. Compared with the 41 funds in the Zurich database that reported for the same historical period, from July 1989 to February 2001, it would rank as the best performing fund for the period on a risk-adjusted basis, with a Sharpe ratio of 3.4 and a standard deviation of 3.0 percent. (Ranked strictly by standard deviation, the Fairfield Sentry funds would come in at number three, behind two other market neutral funds.)

  Questions Abound

  Bernard Madoff, the principal and founder of the firm, who is widely known as Bernie, is quick to note that one reason so few might recognize Madoff Securities as a hedge fund manager is because the firm makes no claim to being one.

  The acknowledged Madoff feeder funds—New York-based Fairfield Sentry and Tremont Advisors’ Broad Market; Kingate, operated by FIM of London; and Swiss-based Thema—derive all the incentive fees generated by the program’s returns (there are no management fees), provide all the administration and marketing for them, raise the capital and deal with investors, says Madoff.

  Madoff Securities’ role, he says, is to provide the investment strategy and execute the trades, for which it generates commission revenue.

  [Madoff Securities also manages money in the program allocated by an unknown number of endowments, wealthy individuals and family offices. While Bernie Madoff refuses to reveal total assets under management, he does not dispute that the figure is in the range of $6 billion to $7 billion.]

  Madoff compares the firm’s role to a private managed account at a broker-dealer, with the broker-dealer providing investment ideas or strategies and executing the trades and making money off the account by charging commission on each trade.

  Skeptics who express a mixture of amazement, fascination and curiosity about the program wonder, first, about the relatively complete lack of volatility in the reported monthly returns.

  But among other things, they also marvel at the seemingly astonishing ability to time the market and move to cash in the underlying securities before market conditions turn negative; and the related ability to buy and sell the underlying stocks without noticeably affecting the market.

  In addition, experts ask why no one has been able to duplicate similar returns using the strategy and why other firms on Wall Street haven’t become aware of the fund and its strategy and traded against it, as has happened so often in other cases; why Madoff Securities is willing to earn commissions off the trades but not set up a separate asset management division to offer hedge funds directly to investors and keep all the incentive fees for itself; or conversely, why it doesn’t borrow the money from creditors, who are generally willing to provide leverage to a fully hedged portfolio of up to seven to one against capital at an interest rate of Libor-plus, and manage the funds on a proprietary basis.

  These same skeptics speculate that at least part of the returns must come from other activities related to Madoff’s market making. They suggest, for example, that the bid-ask spreads earned through those activities may at times be used to “subsidize” the funds.

  According to this view, the benefit to Madoff Securities is that the capital provided by the funds could be used by the firm as “pseudo equity,” allowing it either to use a great deal of leverage
without taking on debt, or simply to conduct far more market making by purchasing additional order flow than it would otherwise be able to do.

  And even among the four or five professionals who both express an understanding of the strategy and have little trouble accepting the reported returns it has generated, a majority still expresses the belief that, if nothing else, Madoff must be using other stocks and options rather than only those in the S&P 100.

  Bernie Madoff is willing to answer each of those inquiries, even if he refuses to provide details about the trading strategy he considers proprietary information.

  And in a face-to-face interview and several telephone interviews, Madoff sounds and appears genuinely amused by the interest and attention aimed at an asset management strategy designed to generate conservative, low risk returns that he notes are nowhere near the top results of well-known fund managers on an absolute return basis.

  Lack of Volatility Illusory

  The apparent lack of volatility in the performance of the fund, Madoff says, is an illusion based on a review of the monthly and annual returns. On an intraday, intraweek and intramonth basis, he says, “the volatility is all over the place,” with the fund down by as much as 1 percent.

  But as a whole, the split-strike conversion strategy is designed to work best in bull markets and, Madoff points out, until recently “we’ve really been in a bull market since ’82, so this has been a good period to do this kind of stuff.”

  Market volatility, moreover, is the strategy’s friend, says Madoff, as one of the fundamental ideas is to exercise the calls when the market spikes, which with the right stock picks would add to the performance.