Inflation—fed by the government’s pursuit of an expensive foreign war in Vietnam and an ambitious welfare programme at home—was shredding the value of paper money. When Bernie Madoff opened for business in 1960, inflation was less than 2 percent a year. When President Richard Nixon took office in 1969, the annual inflation rate was 5 percent. In the first nine months of 1979, it would hit 10.75 percent. “Inflation this high during peace time was unprecedented in American history,” one Federal Reserve scholar observed.
The dismal decade knocked the US stock market to its knees; the previous decade’s giddy go-go market was utterly gone. There seemed to be no safe place to stand in this storm. Stock prices gyrated wildly—no one could remember mood swings like this, month in and month out. Bonds didn’t hold their value, especially late in the decade, as the US Federal Reserve stepped up its effort to break the inflation fever by sharply increasing interest rates. American retail investors learned new words to worry about: volatility and stagflation.
Putting money in the bank, once the safest option, no longer seemed sensible. For years, US Treasury rules had capped the rates that small savers could get; only the big institutions could earn interest rates high enough to keep ahead of inflation. When rates finally inched up for small savers, the nation’s savings and loans went on a risky lending binge that promised to end badly. Even if you could find a bank or thrift institution that seemed stable, stability alone wasn’t enough. The inflation of the 1970s was eroding the purchasing power of every dollar that careful savers had put into the bank or had used to buy bonds.
The hunger for yield became almost an obsession for an entire generation. You had to find something that would pay you more than the cost of living, or you were forever falling behind. Investors stampeded into the newly created money market mutual funds. Some even turned to complex partnerships investing in oil and gas reserves or silver and other precious metals, whose prices were soaring.
Prudent investors had once accepted the ironclad link between the level of risk and the rate of return: to get higher returns, you had to take greater risks. Corporate bonds paid a higher rate than US Treasury bonds because corporate bonds were riskier; Uncle Sam wouldn’t go out of business. Small OTC stocks climbed many times faster than the blue chips, but were also far more likely to wind up worthless. That was just the way it was. The price the brave paid for high yields included high risk and sleepless nights. Don’t fool yourself, the wise men said: those who want sound sleep and more safety have to settle for lower yields.
Perversely, the greater risk now seemed to be to accept too low a yield on your investments. Apparently, the law that higher-paying investments were riskier than lower-paying ones had somehow been repealed. The 1970s had turned the traditional formula of risk and reward upside down. What you needed was safety and yield—the robust profits of speculation without all that nail-biting volatility, and the security of low-risk investments without the slow erosion of your savings.
That impossible dream was exactly what some lucky people said they got, year in and year out, from Frank Avellino and Michael Bienes: real, steady interest payments, zero volatility. Because Madoff’s returns, like those of a lot of arbitrage traders of that era, were always within a narrow range, the payment of interest to their clients made sense to them. It meant that for some quarterly payments, they’d pay out a little more than they received from Madoff, and for others they’d pay out less than they received, but in the end it would all even out. And if most clients left the interest in their accounts to grow, the rough edges would become all but invisible over time. Avellino & Bienes seemed to have turned the speculative and risky practice of investing in the stock market into a smooth and predictable revenue stream—like interest on a high-grade corporate bond, without the erosion of capital. Bernie Madoff’s steady returns made this possible.
In an inflation-obsessed environment, the change that Avellino and Bienes made in how they handled the investors first recruited by Saul Alpern—“let’s pay them interest”—put Alpern’s little business serving a cluster of “friends and family” into overdrive.
Madoff would later insist that he recovered from his missteps in 1962 and went on to make real money for these early clients—and given the hot market environment in the 1960s and the strategies he claimed to be using, he might have been telling the truth. In his first decade in business, the over-the-counter market was racking up annual gains many times greater than his investors were supposedly getting in those days. Even in the 1970s, Madoff could have been making more money as an institutional investor than Avellino and Bienes were paying out to their retail investors. Indeed, a few faint recollections among investors suggest he may actually have used the money from some early investors as working capital for his young firm, producing enough profits to easily cover the promised returns.
That still would have broken the rules, of course—had they known about it, regulators could have accused Madoff of misappropriating client funds. But it was at least statistically possible that he was successfully investing the limited amount of money that Saul Alpern was bringing in from family and friends.
Word spread, and the word was that the Avellino & Bienes firm was the only way to invest with the remarkable Bernie Madoff, who would not accept individual customer accounts.
That so many of the firm’s accounting clients invested through the firm may simply reflect the role that accountants played in an era before “private bankers” and “investment advisers” were widely available to the moderately affluent people who ran small businesses. For them, their company’s accounting firm was as close to a financial adviser as they could get—and who had time for anything more elaborate, even if you could find someone more qualified? They were running a business, after all.
So the number of Avellino & Bienes investors grew exponentially, and the amount of money involved grew right along with it. By the end of the 1970s the Madoff investment operation made up more than a third of the accounting firm’s business. Four people in the firm’s New York office handled calls and applications and mailed out the cheques and statements: two data entry clerks, a receptionist, and an office manager who dealt with inquiries through the mail and over the phone.
And the firm always paid; no one ever complained or expressed doubts about their operation. No wonder the cheques poured in and the referrals were incessant.
Bienes insisted later that he and Avellino “never advertised, we never promoted, we never sent out a Christmas card—and the money came in.” When they had collected a substantial sum, they would send it to Madoff. At the end of each quarter, they would draw money from the firm’s Madoff account and deposit it to cover the individual interest cheques they mailed out.
Apart from the money, the amount of trust that customers invested in this back-of-the-envelope arrangement was remarkable. No one on Wall Street or in regulatory agencies in Washington had ever heard of Avellino or Bienes. There were no brochures, no fact sheets, no paperwork at all—and the two accountants made it emphatically clear that there never would be, so don’t ask. All you could expect was a simple receipt stating the amount you’d invested and the promised interest rate. “That’s all we’d say. We were very tough,” Bienes recalled later. Those were the rules: put nothing in writing.
Meanwhile, they were also handling their firm’s accounting work. “We had medium-sized, small clients, individual clients,” Bienes later recalled. “A lot of them were oddballs, I gotta tell you. But then again, as Saul Alpern always said, the normal person does not go into business for himself—he goes and gets a job.”
Bienes and Avellino were oddballs themselves, a pair of colourful Damon Runyon characters set in real life. Frank Avellino had the curious habit of referring to himself in conversation in the third person, by his full name. Asked in subsequent testimony about any bank loans the partnership had obtained, Avellino said, “All I could say to you is, at one point in time, Michael Bienes and Frank Avellino borrowed millions
of dollars from Chemical Bank, unsecured, period. . . . We voluntarily turned in our loan to the bank. They hated us for it.”
Avellino did it, he explained, because “I don’t like to give out financial statements, I don’t like them to know—I’m a very private guy, by the way, as is Michael—it’s none of their goddamn business, in plain English, and I think we could afford not to borrow.”
Avellino and Bienes referred to the people who sent them money as “lenders”, not investors. They repeatedly explained that their clients were lending them money to finance the accounting firm’s investment activities. They were promising to pay those individual lenders a stated interest rate, which they paid with the profits they earned by investing with Madoff. Their persistence in this description suggests that they thought they could fit this lucrative business into a legal loophole for “demand notes”, which did not have to be publicly filed with securities regulators.
Later, in response to a question about how the partnership made sure it could pay its promised interest rates to this expanding universe of “lenders”, Avellino answered, “Michael Bienes and Frank Avellino . . . have their own assets, which we always know can be called upon because we are personally liable on those loans.”
Despite these highly unorthodox arrangements, a host of investors came to believe that this, at last, was a legitimate solution to their gnawing investment dilemma. Travelling far beyond regulated Wall Street, they set up camp in a murky land with no written rules and no adult supervision. They nevertheless thought they had found a safe haven: they were getting the security of consistent returns without sacrificing the higher inflation-beating profits of more volatile, riskier investments. Wildly underestimating the risks they were taking, they felt lucky to have been allowed to invest money with—that is, to lend money to—Avellino & Bienes.
For so many clever but credulous investors, the road to Madoff led through a regulatory no-man’s-land. And for many of them, that road was paved, wittingly or not, by their trusted business accountants. Frank Avellino and Michael Bienes were merely the first.
4
THE BIG FOUR
The computer technology that took root on Wall Street in the 1970s allowed the world to take a closer look at the stock-picking, market-timing wizards who seized the public’s attention in the previous decade. Unfortunately for the wizard fraternity, analysts found that a portfolio carefully chosen by some lionized genius typically did no better than a portfolio of stocks chosen utterly at random.
The fatally seductive idea that there was a genius who could be relied upon to pick the right stocks at the right moment and beat the market by double or triple digits, year in and year out, without fail—well, that notion is a phoenix, a feather-headed concept that rises, more or less intact, from the ashes of every market meltdown.
Its indestructible appeal to a wealthy investor named Stanley Chais had enormous consequences for Bernie Madoff, who seemed to be exactly the kind of genius Chais and everyone else were looking for.
Chais was a courtly gentleman who, by the late 1960s, had sold and retired from his family’s East Coast knitwear manufacturing business. Before moving to the Los Angeles area sometime around 1970, he lived in Sands Point, on Long Island, with his attractive wife, Pamela—one New York Times article from the era took note of her “peaches-and-cream complexion” and “tidily coiffed” blond hair—and their three children. Pamela Chais was the daughter of a Broadway playwright and was a promising playwright herself by the time the family moved west.
Before the family relocated, Chais met Bernie Madoff through Marty Joel, the freewheeling broker who had shared office space with Madoff at 39 Broadway and was a client of Saul Alpern’s accounting firm. Chais and Joel had met at Syracuse University and had remained friends. The Madoffs socialized with the Joels, so it was natural they would meet the Chaises. Chais was impressed by the money Madoff was making with arbitrage trading and decided to invest some of his own money in arbitrage. Soon he was making money, too.
Stan Chais and Bernie Madoff would remain connected for nearly forty years. The trust funds for the three Chais children and other family members were invested with Madoff. In time, Chais would have more than four dozen Madoff accounts, including those set up for his charitable foundation. Based on a few documentary traces, it seems possible that Chais also became acquainted with others in Madoff’s immediate circle, including his father-in-law, Saul Alpern.
Chais was not just an individual Madoff investor; nor was he someone who simply set up a Madoff account and put other people’s money into it, as Avellino & Bienes did. Starting in 1970, Chais set up three formal partnerships that raised money from other people and invested it with Madoff. This made Chais the forerunner of the hundreds of entrepreneurs who would create and peddle private funds designed solely to carry other people’s money to Madoff’s door.
Chais set up the first formal “feeder fund”. A feeder fund is simply a fund that raises money from investors and puts it into one or more other funds. Feeder funds raising cash to invest with Madoff would proliferate like oversexed rabbits after 1990. But it all began here, with Chais’s first partnership.
It was called the Lambeth Company, and it opened for business in 1970. The Brighton Company followed in 1973, and the Popham Company in 1975. Chais collected fees from his investors for running these three early funds, which looked very much like informal mutual funds, although he never registered them with the Securities and Exchange Commission. He did not believe he needed to because he had only a few dozen direct investors, according to people who knew him well. For similar reasons, he did not think he needed to be registered with the SEC to act as an informal investment adviser, they said.
Most of his clients found their way to him through word of mouth, either within the creative Hollywood circles frequented by his wife or through an accounting firm he used. And although he and his investment accounts were unregistered and unregulated, Chais and his many clients apparently felt confident that nothing would go wrong.
Each of Chais’s three partnerships took in money from additional “sub-funds”, other formal but unregistered partnerships that collected money and paid fees to their separate general partners. All the money, whether gathered directly through his own companies or indirectly through the sub-funds, was invested with Madoff.
The early paperwork for the three Chais feeder funds indicated that they were being formed to pursue arbitrage strategies—which matches the memories of a few early Madoff investors and other sources familiar with the accounts, and the version of events offered by Madoff himself.
A younger member of one family of very early investors—devastated by their later losses—said that his father was told by Madoff directly, at some point in the late 1970s, that he was using arbitrage as his money-making strategy. “He supposedly had come up with this computerized system for identifying opportunities to purchase preferred stock and short the common stock,” he recalled.
So it seemed possible—perhaps Stanley Chais persuaded himself it was even plausible—that Bernie Madoff could have used legitimate arbitrage strategies to generate steady, reliable profits on the money Chais collected for the Lambeth, Brighton, and Popham accounts at Madoff’s firm in the 1970s.
The strategy would begin to seem a little less plausible as the amount of money entrusted to Madoff grew with each passing year. Most arbitrage opportunities disappeared quickly if too much money was thrown at them too fast. And by the early 1980s, Madoff would be taking in a lot of money. Moreover, big institutional investors started to become more interested in convertible securities—the basic elements of these arbitrage strategies—in the late 1970s, and they would have been competing with Madoff for the best profit opportunities.
As far as Chais knew, however, Madoff had only a few clients and took in new ones only as a favour to a few close friends. Perhaps, in these early days, this was true. Madoff was already cultivating an air of quiet exclusivity. He expected his lucky clients
to keep quiet about being in his elite club—talking about it would cause more people to pester him to get in and he didn’t want that, he said.
This attitude not only lent cachet to his growing business, but it apparently also kept each cash source in the dark about the existence of the others. Over the years, it would be difficult for anyone to mark the point when Madoff’s arbitrage-based investment business grew too large to be plausible.
Memories are fuzzy about exactly what kind of profits the Chais partnerships produced during the 1970s. Could Madoff have been producing steady arbitrage profits of 10 to 14 percent, year in and year out, as some people recall? Maybe. A lot of clever people allowed themselves to believe that’s how he did it. And perhaps, in those early days of the first true feeder funds, they were right.
The accounts Chais set up with Madoff for his own family were not arbitrage accounts; those accounts allegedly bought shares in strong, promising companies and then held on to them for years, or even decades. When Madoff’s account records were examined after his arrest, these Chais family “buy-and-hold” accounts were found to have performed far better than the formal arbitrage partnerships Chais set up for outside investors.
Lawsuits would later assert that by 2008 there were a number of odd errors in many Chais accounts. Stocks had been bought or sold on dates when the markets were closed, or at prices that were outside the stocks’ range on those dates. There would also be accusations, denied by Chais, that he directed Madoff to backdate trades and guarantee there would be no losses in his accounts, or to fabricate trades to produce specific tax gains or losses.
The wealth that accumulated in Chais’s own Madoff accounts, some of it fueled by the fees he collected from his outside investors, allowed Chais to become a devoted and consistent benefactor to economic and charitable institutions in Israel. He was also generous to Jewish charities in the US and was widely respected and admired.
Bernie Madoff, The Wizard of Lies Page 9