by Guy Lawson
TOILING AWAY in his tiny one-room o!ce across the parking lot, Jimmy Marquez was witness to the great good fortune occurring in the fancy boathouse. Marquez knew about the millions pouring into Bayou’s co$ers. He still owned half of Bayou, and he wanted to be paid for his stake. He sent a proposal to Israel. Marquez didn’t directly threaten Sam with exposure, but it was understood—take care of me, or else.
Carried interest was the industry term for Marquez’s ownership of the fund. Marquez began the negotiation by saying he would take payment for “only” 20 percent of Bayou as a goodwill gesture, e$ectively dropping his equity interest by more than half. It seemed a modest concession, given his role in Bayou’s failure. “But what is the correct methodology for valuing my carried interest in Bayou?” Marquez asked. “Depending on who you are talking to, or what point you’re trying to make, 20 percent of Bayou is worth a whole lot, or nothing. We can both win or both lose depending on how matters are dealt with from this day forward.”
The bottom line: $3.7 million was Marquez’s price. Israel refused—then caved. He had no choice, after all. As part of the settlement Israel also invested $3.6 million of Bayou’s money into a clean coal company Marquez was promoting called KFX. The stock of KFX had long languished as the market doubted its claim to be able to deliver commercially viable clean coal. Marquez was being paid as a consultant to KFX, so he was pro#ting both ways in getting Bayou’s money put into the stock. Israel bought the shares solely to be rid of Marquez.
As the end of the year neared, Bayou was closing in on $80 million under management. The ease with which the fraud was working preyed on Marino’s mind.
What if the fund grew to $500 million? Or a billion? Bayou was more than a fraud, Marino concluded. It was a brilliant business model. By rebating the commissions from the broker-dealer to the hedge fund, Bayou Funds could legitimately claim annual returns of 9 percent after paying salaries and expenses. If Israel was able to make only 1 percent a month as a trader, the fund would report 21 percent annual returns. As long as investors didn’t withdraw their money all at once, Bayou would have the cash "ow to maintain itself inde#nitely. The only thing that could destroy the fund, Marino believed, was the extremely unlikely event that Bayou’s members would suddenly decide to redeem their investments all at once. But why would they do that with such excellent performance numbers?
Such were the calculations of Bayou’s accountant. Paradoxically, the bigger the fraud became, the easier the sale became. All Sam had to push was his story about technical trading. Value investing was a thing of the past, he told prospective members. The future belonged to short-term traders working the tiny in"ections in price. In a bizarre way, Bayou was becoming a miniature Federal Reserve. The accounting trick Marino came up with gave the fund the #at to print money by rebating the commissions and inventing returns. Like the Fed, the system functioned perfectly—provided no one looked behind the curtain.
THE BAYOU BOATHOUSE had become what con artists in the 1930s called the “big store.” Everything looked exactly like a legitimate trading "oor. Bayou’s premises were art-directed with the care and precision of a movie set. Like the betting shop in The Sting, the impression was pluperfect. But in The Sting the people who populated the world were in on the joke, while at Bayou none of the employees knew about the scam.
None knew they were bit players in an elaborate charade. This only made the performances of Bayou’s employees all the more convincing: They weren’t acting.
As the fund grew, Sam’s manner with investors began to change. Instead of being friendly, he became aloof. After brie"y acknowledging the presence of potential investors, Sam often ignored them. It was understood that he was too important and too busy for small talk. Every moment Sam wasn’t trading, he let it be known, was a moment Bayou wasn’t making money. If he wasn’t trading he was hurting the existing investors in Bayou. Then he would suddenly declare in the middle of the morning that he was #nished trading for the day. The reasons were characteristically inscrutable.
Sam would say that his metrics for “normal” market activity had not been met. Or his machine predicted a lull in trading. Or he felt the market was going sideways. It was behavior that bordered on baffling. But that was the point.
“Pay no attention to the man behind the curtain,” Sam would mutter to Dan Marino as Bayou’s investors left the premises.
“We’d laugh,” Sam remembered. “You had to keep your sense of humor about the thing. You had to keep a semblance of your humanity.”
“I laughed when he laughed, and I was sad when he was sad,” Marino countered. “I played politics. But it was all to get him to focus on the business and solve the problem.
I liked Sam, in a limited way. He was smart and he had a lot of potential. I wanted to see Bayou work. It was my ticket to wealth. Sam already had money from his family. I had to keep the relationship working or else I would end up with nothing. I had nowhere else to go.”
At the end of 2001, according to the audit of Richmond-Fair#eld, Bayou had $85,354,183 in net assets. This included $10.7 million in cash on deposit with Bayou’s clearinghouse, as well as $10 million in securities—SPDRs, Texas Instruments, National Semiconductor. The sum “Due from Brokers” was $64,499,627—a measure of the meteoric rise of the fraud.
Almost $7 million of the capital belonged to Sam, a number Marino invented to make it look as if the principal had a lot of his own money at risk. It was understood in the industry that hedge fund managers who put a lot of their own money into their fund provided another level of assurance of #nancial probity. Who would steal from themselves, after all?
If anyone had cared to look, there were signs that Bayou was falsifying its results.
According to the records of Bayou’s clearinghouse, Spear, Leeds & Kellogg (SLK), Bayou had actually lost $17.5 million in 2001. SLK received Bayou’s audited results, so they could have seen the discrepancy between the reality of its losses and the preposterous performance reports—if they had bothered to look at the numbers, as Marino correctly wagered they wouldn’t. What did SLK care? SLK and its parent company Goldman Sachs were making millions clearing Sam’s trades, and that was all that mattered.
The same bewildering lack of oversight was evident in the conduct of regulators. As part of its year-end due diligence, the National Association of Securities Dealers inspected Bayou. A series of violations were discovered, but the infractions were tiny matters like failing to keep up with continuing education requirements and not maintaining proper copies of customer con#rmations for trades. The only #nancial impropriety discovered involved the statement of net capitalization for Bayou Securities. The NASD found that Bayou had understated the capital in the broker-dealer by $4,730. “The difference is not material,” a letter from the NASD said.
Deftly turning the reprimand of the regulator into a marketing advantage, Bayou made the NASD letter part of its sales pitch. The silly little misdeeds the NASD had caught illustrated how closely the business was scrutinized—particularly compared to other hedge funds that had no broker-dealer.
As the months passed, Sam began to believe his own lies, at least in part. He knew Bayou was in a deep hole. But the employees at Bayou believed in him. The investors believed in him. Why shouldn’t he believe in himself? There were many good days. Sam was often an excellent trader capable of getting on a roll. When Bayou was making money, Sam didn’t feel like a pretender. Forward Propagation actually did work, Sam knew, particularly when he was disciplined and followed its dictates. In those times, the hole shrank and a comeback seemed possible. Standing in his trading room at the boathouse, Sam was living out his boyhood dream.
“I was the swami,” Sam recalled. “I made the money. I made something out of nothing. I could turn perception into reality. I did it every day. I was able to create an impression about a stock and leak out that perception and then make that perception a reality. There were lots of ways to do it. Like volume. A lot of the so-called soothsayers on Wa
ll Street build their computer programs around volume. The computers tell them when to buy or sell. So I would buy a particular stock, like Intel or Archer Daniels Midland, to make it look like there was action.
“Once I’d created the impression in the market, I’d call one of my contacts in the media and tell them that it looked like there was a new chip coming out that was going to be great. Or that Archer Daniels Midland had some new pesticide coming out. I’d call Bob Pisani or Dan Dorfman at CNBC. The TV people would go on the air with the tip like it was the word on the street. I never asked the reporters to go on TV and talk about my tip. It was their choice. But it seemed like I was doing them a favor by making them seem smart and in the know.
“I did this thousands of times. I created a good rumor, or a bad rumor. Take your pick. I was always careful to make sure my lies had a modicum of truth to them. They had to be believable.
“Every day I was making history. I would take a company like McDonald’s or Stride Rite shoes and for that day I would control that stock. My actions had far-reaching implications. I a$ected employees, pension funds, stockholders. I could bring down Coke one day, then Bud, then Hershey. I would create the perception that something was wrong with the company. Perception was nine-tenths of reality. And I was one little guy doing that. It felt great. I wasn’t some broker parroting other people. But there was a horrible downside. I created nothing—only money. I couldn’t show my son a building I had created. It was an illusion.”
CHAPTER SEVEN
Scumbaggery
Sam was not a successful hedge fund manager, but he knew how to look like one. It was a role that came to him naturally. In hindsight, by comparison Bernard Mado! was an obvious fraud. Secretive, mysterious, obviously conniving, Mado! behaved like someone with something to hide. Not Sam. Sam didn’t conspire. He didn’t demand secrecy. He didn’t whisper or insinuate. Sam Israel was an open book. He acted like himself—an increasingly exaggerated and unpredictable self. He was eccentric, unpretentious, half crazy. He refused to take himself too seriously, or anyone or anything else for that matter. He dressed casually, often turning up for work in shorts or sweatpants. He arrived late for meetings. He "dgeted with boredom and then bolted from rooms without explanation. Instead of being a poker-faced banker type, Sam would do anything for a laugh, using slapstick humor to break the ice—or distract attention. The most distinctive characteristic Sam possessed was his likability. There was no way to not like Sam—his grin, the glint in his eye, his uncanny ability to make money. He had a term for the lying and conniving he was doing, a term that described the toxic cocktail of self-loathing and arrogance that he personified.
“I called it scumbaggery,” Sam said. “I was the biggest scumbag of them all. From day one on Wall Street I’d learned to cheat. You either played the game or you didn’t play at all. Wall Street was built on cheating. It is nothing but cheating. That is what it was—pure, unadulterated scumbaggery.”
For all his ironic pseudo-self-awareness, there were real consequences to behaving so badly. For years Sam had been tormented by back and neck pain from multiple surgeries, and he’d often disappear for days and be totally unreachable. Holed up at home like a rock star on a bender, he’d vanish into a cocoon. But even that was taken as further evidence of his tormented genius. Keeping up with Sam was exhausting and mystifying, as Marino and the staff at Bayou learned through his daily antics.
In a weird way, Sam’s behavior was not unusual for a hedge fund manager. The business was populated by nutballs and megalomaniacs and idiot savants. His scru!y appearance and goofball attitude were typically atypical. Like the few thousand men—and they were nearly all men—running successful hedge funds, Sam belonged to a tiny and peculiar group who had mastered the mysteries of money. Perversely, the stranger Sam acted the more it enhanced his reputation. Sam used the image of SpongeBob SquarePants on his personal checks. He would suddenly suspend trading to go "shing in Long Island Sound. He was gregarious one moment, hermetic the next, irrepressible then depressive, a maniac then a megalomaniac.
“I didn’t like to socialize,” Israel said. “When I was with a bunch of people I didn’t know I’d disappear. Janice would have people over and I’d literally leave. I’d be polite.
I’d cook dinner. Then I’d go downstairs to make calls. Or take a walk to smoke a joint.
People always wanted to talk to me about money and the market. Like one guy named John who was a friend of Janice’s. At dinner one night, John asked me what he should do with all these tech stocks he’d bought. I said to sell everything. Sell, sell, sell. Then when the Internet bubble burst he complained to me. I told him he should have sold when I told him to. But he didn’t because he got greedy. I said to him, ‘Don’t ask for my fucking advice if you’re not going to follow it.’ I got in a lot of trouble with Janice for that.”
As a young man, Sam had been entranced by Freddy “the King” Graber. In the years since, Graber had fallen on hard times. Divorced, broke, now in his sixties and drinking far too much, Graber had been reduced to calling up old friends to borrow money. Over lunch, Graber would explain that he was about to undergo surgery and that he needed $4,000 to pay for medical tests—a sum calculated to be sizable but not so large as to provoke an answer of no. Graber’s scam was transparent: The money wasn’t for medical care, and it would never be repaid. Dressed in suits too tight by two sizes, the once-great Graber preyed on the mercy of the circle of men from his glory days. The descent was painful for Sam to witness. But the lessons exempli"ed by Graber’s woes—the excess and delusion and ultimate ruination—escaped Sam. Graber had treated the world like a ship of fools. Sam was doing the same thing. But he didn’t see the parallel—or the peril.
NEW INVESTORS ARRIVED regularly at the boathouse to meet Sam. The caliber of people he was encountering was rising with the stakes. Funds with buy and hold strategies were su!ering in a stagnant market. The notion of what being a “trader”
meant had changed. For old-school "gures like Israel’s former boss Leon Cooperman, being a trader meant understanding the fundamental value of a company. For Sam, it didn’t matter what the company did. All that mattered was the next tick up or down.
When the Hennessee Group asked Cooperman for his opinion about Israel, as part of their due diligence in considering investment in Bayou, they were told that he didn’t know how to pick a stock but that he was a good “trader” in the sense of knowing how to buy and sell stock. In the market, there was no higher authority than the superstar Cooperman. Hennessee began to recommend Bayou to its clients—yet another huge coup for Bayou.
To raise even more money, Sam #ew to California. In L.A. he met with Je! Singer, who controlled $300 million for his high–net worth investors. Singer remembered Sam from the eighties, when he’d brie#y apprenticed in Freddy Graber’s o$ce. In those days Israel had been part of a charmed circle, it had seemed to Singer. Now Israel’s hedge fund sounded great. Singer was looking for a strategy with low “beta” (the measure of risk of a portfolio against the market) and high “alpha” (the value added by the manager’s strategy). Sam’s pitch was perfect. So was his analysis of the market. Singer placed $1 million of his client’s money in Bayou.
Sam then returned to L.A. to meet with a group of Singer’s investors—a car dealer, a blue jeans distributor, a dentist, the representative for Matt LeBlanc of Friends. Israel suggested that he and Singer take their wives for a holiday in Cabo San Lucas in Mexico to discuss his joining Bayou full time.
“Sam knew how to keep me laughing,” Singer recalled. “He knew how to keep me intrigued. He also knew a lot about the markets. He’d gone broke when he was younger and he’d learned his lessons. He had these sayings he called ‘Sam-isms.’ Like ‘I don’t tell the market what to do, the market tells me.’ He said his goal was returns of 1 percent a month, maybe 2 percent. That added up to 15 percent annually. The story was great. I ate it up.”
Bayou had never had an e!ective and focused empl
oyee doing nothing but raising money until Singer went to work for the fund. When he joined Bayou, Singer added a new dimension to Sam’s e!orts. Every month for the next three years Singer raised at least $1 million, many months far more—as much as $20 million one month. He was the biggest money raiser Bayou ever had, bringing in more than $200 million. The job was easy for Singer. When he arranged for Sam to meet with investors, the performance was beautiful to behold.
“I pitched myself as someone who was safe,” Israel said. “I explained a short sale to the more naive investors. I told them that most hedge funds weren’t even hedge funds—they didn’t truly hedge like we did. I told them they couldn’t trust their brokers. Wall Street was their enemy. Brokers didn’t provide valuable research. Brokers and investment bankers were our competition. They hoarded stock. Goldman Sachs told their clients to buy stocks they knew were going to tank. They traded ahead of their own customers. That was why we had our own in-house broker-dealer. You couldn’t trust Wall Street. But you could trust Bayou. It was us against the world.”
AS BAYOU THRIVED, Sam didn’t indulge in the typical excesses of Wall Street high#iers—Hamptons beach houses, private jets, art collections. Sam’s luxuries were intangible. Since he was a teenager, Sam had been a fan of southern rock. His favorite bands were Lynyrd Skynyrd, Marshall Tucker, and the Allman Brothers. Sam leapt at the chance to be introduced to Butch Trucks, the drummer for the Allmans.