No One Would Listen: A True Financial Thriller

by Harry Markopolos

  Red Flag # 15: Why would a fund of funds investor believe any broker-dealer that commits fraud in a few important areas—such as misstating returns and misstating volatility of returns - yet believe him in other areas? I’d really like to believe in the tooth fairy, but I don’t after catching my mother putting a quarter underneath my pillow one night.

  12. Red Flag # 16: Madoff has perfect market-timing ability. One investor told me, with a straight face, that Madoff went to 100% cash in July 1998 and December 1999, ahead of market declines. He said he knows this because Madofffaxes his trade tickets to his firm and the custodial bank. However, since Madoff owns a broker-dealer, he can generate whatever trade tickets he wants. And, I’ll bet very few FOF’s ask BM to fax them trade tickets. And if these trade tickets are faxed, have the FOF’s then matched them to the time and sales of the exchanges? For example, if BM says he bought 1 million shares of GM, sold $1 million worth of OTC OEX calls and bought $1 million worth of OTC OEX puts, we should see prints somewhere. The GM share prints would show on either the NYSE or some other exchange while the broker-dealers he traded OTC options thru would show prints of the hedges they traded to be able to provide BM with the OTC options at the prices listed on BM’s trade tickets.

  13. Red Flag # 17: Madoff does not allow outside performance audits. One London based hedge fund, fund of funds, representing Arab money, asked to send in a team of Big 4 accountants to conduct a performance audit during their planned due diligence. They were told “No, only Madoff’s brother-in-law who owns his own accounting firm is allowed to audit performance for reasons of secrecy in order to keep Madoff’s proprietary trading strategy secret so that nobody can copy it. ” Amazingly, this fund of funds then agreed to invest $200 million of their client’s money anyway, because the low volatility of returns was so attractive!! Let’s see, how many hedge funds have faked an audited performance history?? Wood River is the latest that comes to mind as does the Manhattan Fund but the number of bogus hedge funds that have relied upon fake audits has got to number in the dozens.

  14. Red Flag # 18: Madoff’s returns are not consistent with the one publicly traded option income fund with a history as long as Madoff’s. In 2000, I analyzed the returns of Madoff and measured them against the returns of the Gateway Option Income Fund (Ticker GATEX). During the 87 month span analyzed, Madoff was down only 3 months versus GATEX being down 26 months. GATEX earned an annualized return of 10.27% during the period studied vs. 15.62% for Bernie Madoff and 19.58% for the S&P 500. GATEX has a more flexible investment strategy than BM, so GATEX’s returns should be superior to BM’s but instead they are inferior. This makes no sense. How could BM be better using an inferior strategy?

  15. Red Flag # 19: There have been several option income funds that went IPO since August 2004. None of them have the high returns that Bernie Madoff has. How can this be? They use similar strategies only they should be making more than BM in up months because most of these option income funds don’t buy expensive index put options to protect their portfolios. Thus the publicly traded option income funds should make more money in up markets and lose more than Madoff in down markets. Hmm . . . that Madoff’s returns are so high yet he buys expensive put options is just another reason to believe he is running the world’s largest Ponzi Scheme. A good study for the SEC would be to compare 2005 performance of the new option income funds to Bernie Madoff while accounting for the cost of Bernie’s index put option protection. There’s no way Bernie can have positive returns in 2005 given what the market’s done and where volatility is.

  16. Red Flag # 20: Madoff is suspected of being a fraud by some of the world’s largest and most sophisticated financial services firms. Without naming names, here’s an abbreviated tally: a. A managing director at Goldman, Sachs prime brokerage operation told me that his firm doubts Bernie Madoff is legitimate so they don’t deal with him.

  b. From an Email I received this past June 2005 I now suspect that the end is near for BM. All Ponzi Schemes eventually topple of their own weight once they become too large and it now appears that BM is having trouble meeting redemptions and is attempting to borrow sizeable funds in Europe.

  ABCDEFGH and I had dinner with a savvy European investor that studies the HFOF market. He stated that both RBC and Socgen have removed Madoff some time ago from approved lists of individual managers used by investors to build their own tailored HFOFs.

  More importantly, Madoff was turned down, according to this source, for a borrowing line from a Euro bank, I believe he said Paribas. Now why would Madoff need to borrow more funds? This Euro Investor said that Madoff was in fact running “way over” our suggested $12-14 billion [Fairfield Sentry is running $5.3 BB by themselves!). Madoff’s 12 month returns is about 7% net of the feeder fund’s fees. Looks like he is stepping down the pay out.

  C. An official from a Top 5 money center bank’s FOF told me that his firm wouldn’t touch Bernie Madoff with a ten foot pole and that there’s no way he’s for real.

  17. Red Flag # 21: ECN’s didn’t exist prior to 1998. Madoff makes verbal claims to his third party hedge FOF’s that he has private access to ECN’s internal order flow, which Madoff pays for, and that this is a substantial part of the return generating process. If this is true, then where did the returns come from in the years 1991-1997, prior to the ascendance of the ECN’s? Presumably, prior to 1998, Madoff only had access to order flow on the NASDAQ for which he paid 1 cent per share for. He would have no such advantage pre-1998 on the large-cap, NYSE listed stocks the marketing literature says he buys (Exxon, McDonalds, American Express, IBM, Merck, etc...).

  18. Red Flag # 22: The Fairfield Sentry Limited Performance Chart (Attachment 1) depicted for Bernie Madoff’s investment strategy is misleading. The S&P 500 return line is accurate because it is moving up and down, reflecting positive and negative returns. Fairfield Sentry’s performance chart is misleading, it is almost a straight line rising at a 45 degree angle. This chart cannot be cumulative in the common usage of the term for reporting purposes, which means “geometric returns. ” The chart must be some sort of arithmetic average sum, since a true cumulative return line, given the listed monthly returns would be exponentially rising (i.e. curving upward at an increasing rate). My rule of thumb is that if the manager misstates his performance, you can’t trust him. Yet somehow Madoff is now running the world’s largest, most clandestine hedge fund so clearly investors aren’t doing their due diligence. And why does he provide the S&P 500 as his benchmark when he is actually managing using a S&P 100 strategy? Shouldn’t the performance line presented be the S&P 100’s (OEX) performance?

  19. Red Flag # 23: Why is Bernie Madoff borrowing money at an average rate of 16.00% per annum and allowing these third party hedge fund, fund of funds to pocket their 1% and 20% fees based upon Bernie Madoff’s hard work and brains? Does this make any sense at all? Typically FOF’s charge only 1% and 10%, yet BM allows them the extra 10%. Why? And why do these third parties fail to mention Bernie Madoff in their marketing literature? After all he’s the manager, don’t investors have a right to know who’s managing their money?

  20. Red Flag # 24: Only Madoff family members are privy to the investment strategy. Name one other prominent multibillion dollar hedge fund that doesn’t have outside, non-family professionals involved in the investment process. You can’t because there aren’t any. Michael Ocrant, the former MARHedge Reporter listed above saw some highly suspicious red flags during his visit to Madoff’s offices and should be interviewed by the SEC as soon as possible.

  21. Red Flag # 25: The Madoff family as held important leadership positions with the NASD, NASDAQ, SIA, DTC, and other prominent industry bodies therefore these organizations would not be inclined to doubt or investigate Madoff Investment Securities, LLC. The NASD and NASDAQ do not exactly have a glorious reputation as vigorous regulators untainted by politics or money.

  22. Red Flag # 26: BM goes to 100% cash for every December 31styear-end according to one FOF invest
ed with BM. This allows for “cleaner financial statements” according to this source. Any unusual transfers or activity near a quarter-end or year-end is a red flag for fraud. Recently, the BD REFCO Securities engaged in “fake borrowing” with Liberty, a hedge fund, that made it appear that Liberty owed REFCO over $400 million in receivables. This allowed REFCO to mask its true debt position and made all of their equity ratios look better than they actually were. And of course, Grant Thorton, REFCO’s external auditor missed this $400 million entry. As did the two lead underwriters who were also tasked with due-diligence on the IPO - CSFB and Goldman Sachs. BM uses his brother-in-law as his external auditor, so in this case there isn’t even the façade of having an independent and vigilant auditor verifying the accounting entries.

  23. Red Flag # 27: Several equity derivatives professionals will all tell you that the split-strike conversion strategy that BM runs is an outright fraud and cannot possibly achieve 12% average annual returns with only 7 down months during a 14½ year time period. Some derivatives experts that the SEC should call to hear their opinions of how and why BM is a fraud and for some insights into the mathematical reasons behind their belief, the SEC should call:Leon Gross, Managing Director of Citigroup’s worldwide equity derivatives research unit; 3rd Floor, 390 Greenwich Street; New York, NY 10013: Tel#or[Leon can’t believe that the SEC hasn’t shut down Bernie Madoff yet. He’s also amazed that FOF’s actually believe this stupid options strategy is capable of earning a positive return much less a 12% net average annual return. He thinks the strategy would have trouble earning 1% net much less 12% net.

  b. Walter “Bud”Haslett, CFA;LLC; Suite 455;NJ 08065; Tel#:or[Bud’s firm runs $ hundreds of millions in options related strategies and he knows all of the math.]

  c. Joanne Hill, Ph.D.; Vice-President and global head of equity derivatives research, Goldman Sachs (NY),; One New York Plaza, New York, NY 10004;

  24. Red Flag # 28: BM’s Sharpe Ratio of 2.55 (Attachment 1: Fairfield Sentry Ltd. Performance Data) is UNBELIEVABLY HIGH compared to the Sharpe Ratios experienced by the rest of the hedge fund industry. The SEC should obtain industry hedge fund rankings and see exactly how outstanding Fairfield Sentry Ltd.’s Sharpe Ratio is. Look at the hedge fund rankings for Fairfield Sentry Ltd. and see how their performance numbers compare to the rest of the industry. Then ask yourself how this is possible and why hasn’t the world come to acknowledge BM as the world’s best hedge fund manager?

  25. Red Flag # 29: BM tells the third party FOF’s that he has so much money under management that he’s going to close his strategy to new investments. However, I have met several FOF’s who brag about their “special access” to BM’s capacity. This would be humorous except that too many European FOF’s have told me this same seductive story about their being so close to BM that he’ll waive the fact that he’s closed his funds to other investors but let them in because they’re special. It seems like every single one of these third party FOF’s has a “special relationship” with BM.

  26. Red Flag # 30: BM’s largest one month loss of -0.55% using index puts does not fit in with the prohibitively high cost of the extremely short-dated OTC OEX put options he would have to be buying to protect his portfolio from losses such that those monthly losses never exceeded -0.55% in any one month.a. Previously with Red Flag # 4, I mentioned that the cheapest possible put cost for BM would be 8%. That very conservative assumption assumes that he could get away with buying one OTC, at-the-money put per year. However, mathematically that one year at-the-money put would have a delta of .50, meaning that for each 1 point drop in the OEX index, the put’s price would only increase .5 of half that amount or 50 cents. Therefore if the market dropped 1.1%, a .50 delta put would increase in price by 0.55%, resulting in a -0.55% loss for the fund.

  b. However, for all market drops greater than 1.1%, BM would experience a larger than -0.55% monthly loss and there were numerous instances of monthly market losses greater than -1.1 % during the time period.

  c. Therefore, BM, in order to limit his losses would be forced to buy a series of shorter dated, higher delta put options with high gamma (a 2nd derivative term denoting that for each $1 change in index price, how much the 1st derivative term delta would change. Gamma is the change in price of Delta and Delta is the change in price of the Option with respect to the Index’s Price). If you aren’t intimately familiar with calculus, the English translation is that BM would need to be buying a continuing series of 1 day put options because these options and only these options would have the high gamma he would need to ensure that his delta changed rapidly enough to protect his portfolio enough so that he could never experience a greater than 0-0.55% monthly loss. If you’ve gotten this far, then if a one-year at-the-money OTC OEX index put option cost 8%, a continuing series of 253 (because that’s how many trading days are in a year) one-day, at-the-money puts, would cost the square root of 253 or 15.9 times the cost of the one-year put. 15.9 times 8% the one year put’s cost = 127.2% is the cost of a continuing series of one-day, at-the-money index put options if a one-year, at-the-money index put’s cost is 8%. And this is a very conservative set of calculations! Consider that one would be carrying over stock positions in this strategy over weekends, so therefore you’d want 365 one-day, at-the-money put options and the square root of 365 is 19.1, so a truer cost of put protection would be 19.1 x 8% = 152.8%. That would mean BM’s stock picking ability is not only the world’s best but that he’d likely have to be an alien from outer-space to be able to pick stocks that went up over 152.8% per year + the 16% gross returns to the HFOF investors + an assumed 4% he’s making in commissions. Therefore his stock picking ability would need to return 170% or so per year in order for him to be carrying out his strategy as he says he is in the HFOF third party marketing materials.

  d. 170% per year from stock-picking is not likely for any human born on the planet earth so if BM’s achieving these types of returns then he may be an alien species from another planet. A DNA test would be sufficient to determine whether this might be the case. However, if BM is an alien being possessing superior stock-picking skills of this magnitude, this would be seen as an unfair advantage in the marketplace and likely would panic the financial markets. Or maybe he’s human and just a fraudster - take your pick.

  e. Anyone capable of earning 170% per year from stock-picking would not need nor want any investors.

  Conclusions: 1. I have presented 174 months (14½ years) of Fairfield Sentry’s return numbers dating back to December 1990. Only 7 months or 4% of the months saw negative returns. Classify this as “definitely too good to be true!” No major league baseball hitter bats .960, no NFL team has ever gone 96 wins and only 4 losses over a 100 game span, and you can bet everything you own that no money manager is up 96% of the months either. It is inconceivable that BM’s largest monthly loss could only be -0.55% and that his longest losing streaks could consist of 1 slightly down month every couple of years. Nobody on earth is that good of a money manager unless they’re front-running.

  2. There are too many red flags to ignore. REFCO, Wood River, the Manhattan Fund, Princeton Economics, and other hedge fund blow ups all had a lot fewer red flags than Madoff and look what happened at those places.

  3. Bernie Madoff is running the world’s largest unregistered hedge fund. He’s organized this business as “hedge fund of funds private labeling their own hedge funds which Bernie Madoff secretly runs for them using a split-strike conversion strategy getting paid only trading commissions which are not disclosed.” If this isn’t a regulatory dodge, I don’t know what is. This is a back-door marketing and financing scheme that is opaque and rife with hidden fees (he charges only commissions on the trades). If this product isn’t marketed correctly, what is the chance that it is managed correctly? In my financial industry experience, I’ve found that wherever there’s one cockroach in plain sight, many more are lurking behind the corner out of plain view.

  4. Mathematically this type of split-strike conve
rsion fund should never be able to beat US Treasury Bills much less provide 12.00% average annual returns to investors net of fees. I and other derivatives professionals on Wall Street will swear up and down that a split-strike conversion strategy cannot earn an average annual return anywhere near the 16% gross returns necessary to be able to deliver 12% net returns to investors.

  5. BM would have to be trading more than 100% of the open interest of OEX index put options every month. And if BM is using only OTC OEX index options, it is guaranteed that the Wall Street firms on the other side of those trades would have to be laying off a significant portion of that risk in the exchange listed index options markets. Every large derivatives dealer on Wall Street will tell you that Bernie Madoff is a fraud. Go ask the heads of equity derivatives trading at Morgan Stanley, Goldman Sachs, JP Morgan and Citigroup their opinions about Bernie Madoff. They’ll all tell the SEC that they can’t believe that BM hasn’t been caught yet.