Of course, this is the story “according to Madoff”, possibly among the least reliable sources in history. So it might be true that, years before the 1987 crash, he was already robbing Peter to pay Paul—robbing the Avellino & Bienes accounts, perhaps, to pay Chais and Picower, Levy and Shapiro. He has consistently denied this, and so far there has been no evidence to the contrary in the public record. But he did not deny that the roots of his Ponzi scheme were planted in the cash demands he faced following the 1987 crash—and, after all, even if his Ponzi scheme was already up and running, those unexpected withdrawals after the crash would have pushed him to the wall.
Bernie Madoff may have been squirming behind closed doors, but to the outside world, he emerged from the crash as a star of the OTC world. He was still a member of the NASD Board of Governors, and he now became an influential voice in putting NASDAQ back together over the next three years.
Apart from the damage from the crash, the NASDAQ market was also struggling with the consequences of the NASD’s flabby discipline—shortcomings that the less adventurous SEC under John Shad repeatedly failed to address. Discipline for infractions was limp and late, to the frustration of regulators and irate customers. For all its technological glitter, the young market was still an adolescent, unruly and resistant to increased supervision. Indeed, one must wonder if Madoff’s firsthand awareness of the NASD’s failings as a regulator encouraged him to think he could get away with his Ponzi scheme long enough to work his way out of the losses he was incurring.
Around this time, Madoff was ploughing capital into his firm’s equipment and software so that it could handle automated orders faster, pressing his competition to keep up. In 1983, Peter had led the firm’s adoption of new customized software to run an in-house automated order system. When it was completed after the 1987 crash, it would set a new standard for speed in handling customer orders.
After the crash, Madoff continued to invest in the Cincinnati Stock Exchange—again, a surprisingly big expense for the firm—which helped that venerable regional exchange conduct all its business electronically.
When the NASD introduced predawn trading at the end of the decade, the Madoff firm and a handful of others were already there—they had invested in the staff necessary to do after-hours trading in the evenings and through the night.
In 1990, further enhancing his growing reputation with the industry and its regulators, Bernie Madoff became the chairman of the NASDAQ market. His back-office work on the trading committees and his own firm’s initiatives on the technology frontier were more significant in shaping NASDAQ than his three one-year terms as its chairman, but the position was a pretty good soapbox. He would need it in the battle that would define Bernie Madoff for many veterans of Wall Street’s trading community—the battle over his practice, introduced in 1988, of paying retail brokerage firms a few pennies per share to steer their customers’ orders to him.
He called those pennies “payments for order flow” and “rebates”. The exchanges that had traditionally gotten those orders, chiefly the New York Stock Exchange, called the payments “bribery, pure and simple” and “kickbacks”. They fought fiercely to have the practice declared illegal, but they ultimately lost the battle with regulators after the firms taking Bernie’s pennies were found to be getting faster and cheaper execution of their orders than on the Big Board. Indeed, by the early 1990s, more than 5 percent of all the trades in stocks listed on the Big Board would actually occur inside Bernie Madoff’s computers, untouched by human hands. One scholarly market study observed that “although the Madoff firm isn’t technically a stock exchange, it functions as a de facto surrogate for the New York Stock Exchange.”
Madoff’s practice of paying for order flow put him on the wrong side of a lot of powerful people on Wall Street, many of whom had access to back-office sources of information about him and his firm. Apparently, none of his hostile and prominent critics found any trace of a hidden Ponzi scheme—if they had, they certainly would have used it to discredit and destroy him in this bitter battle over his rebate practices.
Their failure to find it, however, may not mean that the scheme had not yet begun; it may simply mean that Madoff had planted the first seeds of his Ponzi scheme in one of the least visible and least regulated fields in the financial landscape: offshore hedge funds.
By the late 1980s, Madoff was playing on a much bigger social stage, one that would enhance his reputation among a host of generous donors and charitable institutions—many of which would later become his clients and, ultimately, his victims.
On paper, all of his big clients seemed to be getting rich—only Madoff knew how precarious his finances were. By one popular measure, the stock market had climbed more than 17 percent a year between the birth of the bull market in August 1982 and the end of 1989. And in the circles he now frequented, rich people were supposed to be generous people. So, inevitably, Madoff became an increasingly active donor, giving to the pet charities of favoured or coveted clients, buying tickets to the right benefit dinners, meeting the right people.
In 1980s Manhattan, the “right people” included Howard Squadron, a prominent New York lawyer with a finger in countless political and cultural pies—and a man who would unwittingly be one of the first to steer important Jewish charities into Madoff’s orbit. His relationship with Madoff would become an increasingly familiar pattern within New York legal and accounting circles.
Squadron had once been the boy wonder of the New York legal world. In 1947, barely twenty years old, he collected both a bachelor’s degree in history and a law degree from Columbia University. Besides being a very clever man, he became a very well-connected one. He spent two years as a staff counsel at the American Jewish Congress and would later become the organization’s president. The American Jewish Congress was a melting pot for wealthy donors to Jewish causes and institutions, and it was there that Squadron first met Bernie Madoff.
A tireless recruit on numerous educational and cultural boards, Squadron was instrumental in the rescue of the New York City Center, an important cultural institution. He chaired the City Center board for nearly a quarter century and, along the way, enlisted Madoff’s support. In time, important people at the American Jewish Congress and City Center would become clients of Squadron’s good friend Bernie Madoff, and Madoff himself would join the City Center board—where his fellow board members would include Squadron’s wife and a member of the Wilpon family, which owned the New York Mets baseball team.
When Squadron’s firm landed Rupert Murdoch’s News Corporation as a client, Howard Squadron became very rich. He would invest a good deal of his wealth with Bernie Madoff and would introduce clients and friends to him as well.
Lawyers at several New York City firms set up formal partnerships so their clients could invest with Madoff. The same pattern developed at prominent accounting firms, such as Konigsberg Wolf and Stanley Chais’s accountants, Halpern & Mantovani in Los Angeles, both of which formed conduit accounts through which their clients could invest indirectly with Madoff. Even Friehling & Horowitz, the small accounting firm that handled Madoff’s brokerage firm audits, became a portal for others to invest with him.
It was in these bull market days of the 1980s that a former SEC lawyer named Jeffrey Tucker decided to leave the law firm he’d formed and set up an options trading fund with one of his clients. That client shared Midtown office space with a handsome former banker named Walter Noel Jr, who was trying to build his own money management business by relying on his affluent connections and those of his Brazilian wife. Noel thought Tucker’s new fund might have promise for his foreign investors. “Walter was very impressed with their trading—not just the strategies but the returns,” a contemporary recalled.
Sometime in 1989, Tucker parted company with his former client and began working exclusively with Noel to put the finishing touches on a new fund to be called Fairfield Greenwich. At about this time, Tucker’s father-in-law, a retired knitwear manufacturer
, suggested that Tucker and Noel check out a brilliant money manager he knew: Bernie Madoff.
What was it about Madoff that made all these intelligent, analytical people trust him so much, so easily, for so long? Impressions gathered from personal experience with Madoff and from interviews with dozens of people who knew him provide a few clues. Unlike so many successful con artists, Madoff was never showy or brash, never overtly “charismatic”. Instead, without saying a word, he seemed to create a quiet but intense magnetic field that drew people to him, as if he were true north, or the calm eye of the storm. One associate called it “an aura”. Like a gifted actor, he drew one’s attention simply by stepping onstage, by entering a room.
He wore his expertise casually—“he had the decoder ring,” one former regulator recalled—and he seemed seductively unflappable in times that felt messy, chaotic, and scary to everyone else. He inspired confidence and made people feel safe. Another close associate recalled Madoff’s cool smile during the almost weekly bomb scares at the Lipstick Building that followed the terrorist attacks in 2001; he was always the last one out of the office, ushering his nervous charges down the stairways. Like the calm-voiced pilot in the cockpit or the nightmare-soothing father at the bedside, he simply made it seem as if everything were under control, that everything would be fine. Those close to him knew he could be angry, pushy, controlling, cutting, and rude, but even then he conveyed the reassuring toughness of a no-nonsense drill sergeant who never panicked or lost his grip, who drove his men hard but brought them all back alive.
Whatever the formula for Madoff’s fatal charm, his meeting with Tucker and Noel must have been encouraging. In the middle of the summer of 1989, they invested $1.5 million with him, money they’d raised through a vehicle they later called the Fairfield International fund. Six months later, they put another $1 million into Madoff’s hands. By November 1990, they were ready to market their new $4 million Fairfield Sentry fund and let the world in on their success with Madoff—almost literally “the world”, as it turned out.
This is the period that generates the sharpest questions about the origins of Madoff’s crime. Clearly his financial circumstances underwent a sharp change in the aftermath of the 1987 crash, pressuring him in ways that may have pushed him from the grey areas of tax games and currency flight into a full-scale Ponzi scheme. Absolute certainty is impossible—unless and until he and his accomplices come clean or new documentary evidence can be dug out of the rubble of his business records or those of the people who dealt with him. But reasonable conjecture is possible, and it ultimately focuses on these pivotal years in the last half of the gilded 1980s.
The conditions for a Ponzi scheme were all in place. Besides his new connection with Tucker and Noel, Madoff had caught the attention of a few other young offshore hedge funds. Riding the first wave of widening interest in hedge funds, these funds all started sending him large and increasing amounts of cash. The business taken over by Avellino & Bienes—which probably had only a few dozen customers in the 1960s and which Madoff said was still “not much of a business” by the late 1970s—hit an enormous growth spurt after 1983, driving more cash into his hands. At the same time, the cash demands from some of his biggest clients after the 1987 market crash put a great strain on his liquidity.
Those big clients “were very instrumental in creating my problems” because they “failed to honor their agreements,” he wrote in an e-mail from prison. He continued, “I’m sure you wonder how I could be so gullible. I guess I couldn’t face the fact that as close friends, I couldn’t trust them.”
He obviously saw how ironic it was for him, of all people, to complain about being betrayed by close friends. “I’m sure some of my other friends wonder how I did what I did to them,” he went on. “There was no justification for this. The difference I guess is that I thought I would get out of my problem and I had made so much money for them in the past with legitimate trading.”
He added, “None of this changes the timing I claim the bogus trading started.”
By his own admission, however, Madoff was facing big and unwelcome cash demands at just the moment when the cash spigot was turning on in force. It was a tempting bit of timing, and one that supports the idea that, at the latest, his Ponzi scheme started in the years right after the 1987 crash, using the money from his new investors to finance the withdrawals by his older ones.
He insisted later that this was not true, that these rivers of new cash did not tempt him to cheat—at least, not until a few years later.
6
WHAT THEY WANTED TO BELIEVE
As the 1990s began, Bernie Madoff was running a legitimate and apparently successful brokerage firm, with 120 employees and profits approaching $100 million a year. His firm was responsible for a remarkable 10 percent of the total daily trading volume in Big Board stocks and was handling 385,000 trades a month for larger Wall Street retail brokerage firms and giant mutual funds. As much as his rivals at the stock exchanges hated his practice of paying firms a small rebate for sending him their customer orders, academic studies showed that he still executed those orders at least as fast as anyone, and at prices that were as good as or better than customers could have found elsewhere. His “order execution” prowess impressed regulators and enhanced his firm’s reputation. His sons were developing a small propriety trading operation that made investments for his firm’s own account, and his firm’s software systems were considered among the best on the Street.
Behind closed doors, however, he was also running an immensely larger money management business, one that regulators knew nothing about. This hidden investment advisory operation was supposedly generating commission income for his firm and steady returns for investors whose accounts now totalled at least $8 billion. These included private investors such as Norman Levy, Jeffry Picower, and Carl Shapiro; feeder funds such as those run by Stanley Chais and Walter Noel; “introducers” such as Mike Engler and the brokers at Cohmad; and, of course, the legions of small investors whose money resided in a few large accounts labelled “Avellino & Bienes”.
Madoff grew increasingly careful about concealing how wide and deep the river of cash flowing into his investment advisory business had become. He admonished his feeder fund sponsors to keep quiet about who actually managed their money; he cautioned private clients not to talk about how much business they did with him—or even that they did business with him at all. His caution reflected the fact that his “split-strike conversion” strategy, like the arbitrage strategy it replaced, faced inflexible size constraints. Only so many shares of the blue-chip stocks supposedly in his portfolio were traded at one time, and the number of shares traded was reported every day. Only so many options were traded on the public exchanges in Chicago, and the volume of those trades was reported daily, too.
So a legitimate “split-strike conversion” strategy could not grow endlessly large. The bigger Madoff got, the harder it would be for savvy investors to believe that he was producing an honest profit. At some point, there simply wouldn’t be enough options trading in the public or private markets to hedge the amount of stock he would have been buying, and there would have been little chance he could really buy and sell stocks on the scale required without shoving the markets up and down in very visible ways.
Still, his whole aura of success as an investment manager was that he never failed to deliver the returns his investors expected. He had brought them profitably through all the bad times—the market’s tumble in 1962, the doldrums of the 1970s, even the 1987 crash and its rocky aftermath. No one knew that he had borrowed money from Saul Alpern to replenish his customers’ accounts in his early years, and no one knew that he had been squeezed by a rash of withdrawals in the late 1980s. All his clients knew was that he offered steady returns even in volatile times—and they all wanted to invest more money with him.
It was in this setting, he says, that his Ponzi scheme began. As long as most of his clients left their balances intact, “rolling over
” their reported profits and making few if any withdrawals, he could pay out the occasional disbursement from the flood of new money coming in.
It is the classic genesis of a Ponzi scheme on Wall Street. A money manager falls short of cash to cover some expense or placate some customer or deliver on some promise, and he steals a little money from client accounts. The rationale is always that he will be able to pay off his theft before it is detected. Perhaps this occasionally happens—those are the Ponzi schemes we never learn about. More typically, the sum of stolen money grows much faster than the honest profits do, and the Ponzi scheme rolls on towards certain destruction.
According to Madoff, this is what happened to him, although he disputes the timing. He got into a hole—possibly before 1980, more likely by the mid-1980s, but certainly by 1992—and he just couldn’t get out again. His investment advisory business became a vast game of musical chairs. The only way he could hide the fact that there weren’t enough chairs left for all his clients was to keep the music going for as long as he could.
The music almost stopped in the summer of 1992. In early June, a pair of sceptical investors had sent two documents to the New York City office of the Securities and Exchange Commission describing an attractive investment scheme that made them uneasy. One was a fact sheet about the “King Arthur Account”. The two-page document certainly made the investment sound appealing. “This is a safe fund with no risk of capital paying high income,” it said. The account yielded 13.5 percent a year, paid quarterly—14 percent for investments of $2 million or more.
It’s no wonder the two prospective investors were sceptical: those rates were more than three times the interest rates available in safe “no-risk” certificates of deposit at their banks. And they were notably higher than the gains produced by the much riskier S&P 500 stock index over the previous year—which were about 8 percent without counting reinvested dividends, about 11 percent with dividends included. According to the fact sheet, these remarkable returns were generated through “riskless trading” in arbitrage accounts that the sponsors, Avellino & Bienes, maintained with a “wholesale dealer” in New York who traded in high-volume Big Board stocks. (The reference to arbitrage is curious; Madoff was already telling other investors he was using the “split-strike conversion” strategy—and, indeed, the small Gateway fund had been producing legitimate gains from that strategy in recent years that matched or exceeded the King Arthur fund’s promises. But no one could honestly have called it a “no risk” investment.) The fact sheet was on the letterhead of a financial adviser in San Francisco and was probably written around 1989.
Bernie Madoff, The Wizard of Lies Page 13