The following week, a similarly sceptical view about Bernie Madoff’s money management operation was expressed by another writer, Erin Arvedlund, in Barron’s magazine, a mainstream financial publication likely to reach far more investors than Ocrant’s story.
After the two articles appeared, Madoff put aside his usual “take it or leave it” attitude towards his big investors and reached out immediately to reassure his largest feeder funds.
Jeffrey Tucker of Fairfield Greenwich had paid little attention to the Ocrant article and wasn’t rattled at all by the “somewhat critical” article in Barron’s. “Much of it I thought was, frankly, just irresponsible journalism,” he said later. But then he got a call from Madoff.
“Are you getting feedback from your clients?” he asked.
“We have some who are concerned,” Tucker answered, adding, “the principal concern I have is that the assets are there.”
“Come up this afternoon,” Madoff said.
When Tucker arrived for this impromptu due-diligence visit, Madoff was ready, thanks to Frank DiPascali’s creative efforts. Besides the phoney trade confirmations and account statements that had been generated for more than a decade, he had set up the bogus “trading platform” that made it appear as if actual trades were being conducted with European counterparties, although the reciprocal trader was actually an employee on another computer terminal hidden in a different room. And he had the clincher: apparent proof that all the stocks he claimed to have purchased were safely held in Madoff’s account at Wall Street’s central clear-inghouse, the Depository Trust & Clearing Corporation, officially called the DTCC but known informally among veteran traders as “the DTC”.
This was the acid test for DiPascali’s masterpiece, a computer simulation of a live feed from the DTCC. He had taken care to duplicate exactly the clearinghouse’s logo, the page format, the printer font and type sizes, and the paper quality of actual DTCC reports. Of course, these counterfeit DTCC records would always verify that the required number of shares were there in Madoff’s account, safe and sound. Only an authorized call to the DTCC itself would have proven otherwise, and the clearinghouse was careful to keep customer information confidential.
Tucker later told regulators about this pivotal visit with Madoff at the Lipstick Building. The executive office suite, now established on the nineteenth floor, was familiar to him. The computer screen behind Bernie’s sleek desk was accessible, and DiPascali was there with stacks of ledgers and journals.
Far from resenting any implied suspicions, Madoff encouraged Tucker on this occasion to be sceptical, to verify the trading being conducted for the Fairfield Sentry fund. Tucker was shown an official-looking “purchase and sale blotter” showing a record of each trade for his funds. Then he was shown a journal that supposedly contained stock records for the Madoff firm.
“Pick any two stocks,” Madoff said.
Any two? Tucker first picked AOL Time Warner, which he knew was among the Sentry fund’s holdings. Meanwhile, either Frank or Bernie had activated the computer screen, explaining that it would provide a live feed to Madoff’s account at the DTCC.
“They continued to move pages of the screen until they got to the AOL page,” Tucker recalled. In the stock journal, he could see the number of AOL shares that Madoff should have owned for his hedge fund clients; on the screen, he could see the number of shares credited to Madoff by the clearinghouse. The two numbers tallied.
Tucker had never actually seen a live feed from a broker’s DTCC account, as subsequent lawsuits would point out. Even if he had, it is unlikely he could have detected that this one was fake. After all, DiPascali had access to a real DTCC account screen every day—there was one available to the legitimate brokerage firm—and he had taken great pains to ensure that his imitation exactly matched the original.
Madoff encouraged Tucker to pick another stock, but Tucker was satisfied. The shares were there; there was no possibility of fraud. He left reassured that there was nothing to the Barron’s article, no reason at all to be concerned.
Even without the tour-de-force demonstration provided to Tucker, most of Madoff’s burgeoning collection of hedge fund clients apparently shrugged off the sceptical articles in May 2001, certain that their trust was justified by Madoff’s character and reputation. One of them, Ezra Merkin, kept a copy of the Barron’s article in his files for years but continued to invest hundreds of millions of dollars with Madoff.
Another copy of the Barron’s article would also rest for years in the files of the SEC’s Office of Compliance Inspections and Examinations in Washington, DC. This was the branch of the federal agency responsible for inspecting brokerage firms like Bernie Madoff’s.
The office’s director had sent the clipping to her associate director, with a note on the top saying that Arvedlund was “very good” and that “This is a great exam for us!” But no examination of Madoff’s firm was ordered; apparently, the only action the associate took in response to the article was to file it.
Lack of action had become almost reflexive at the understaffed agency, uncertain of its mandate and unsure of itself. The 1990s had seen morale plummet at the SEC, as the US Congress passed laws that weakened the regulatory environment for financial firms. One disheartening piece of legislation was the Private Securities Litigation Reform Act of 1995, which made it more difficult for private lawyers to take companies to court over their accounting or management practices. Another came a year later, when Congress broadened the loophole that allowed hedge funds to avoid registration with the SEC. This naturally made it easier and more lucrative to launch a new hedge fund without much regulatory oversight. Thousands of money managers took advantage of this increased leeway.
For years, the quality of the SEC staff had been under relentless pressure, primarily because of tightfisted budgets. The staff turnover rate had climbed so high that it attracted the concerned attention of the US General Accounting Office. The turnover rates for SEC lawyers, accountants, and investigators, which averaged 15 percent in 2000, were twice the average rate for comparable government positions. In a 2001 report, the GAO found that a third of the agency’s staff—more than a thousand employees, at least half of them attorneys—left the agency between 1998 and 2000. At the salaries available, it seemed unlikely that those spots would be claimed by anyone but raw recruits. In the years ahead, increasingly creative Wall Street criminals like Bernie Madoff would be policed by increasingly inexperienced and ill-trained SEC investigators. The dishonestly bullish reports that Wall Street analysts had turned out on flimsy technology stocks and the fraudulent accounting used by technology giants such as Enron and WorldCom in the 1990s would ultimately be exposed—but not through the SEC’s efforts or initiatives, and not in time to avoid massive damage to employees and investors. At a congressional hearing in the wake of those scandals, Senator Paul Sarbanes of Maryland would quote an unidentified observer’s assessment of the SEC: “Morale is at its lowest point. This place is a shambles of what it was 10 or 12 years ago.”
Just a month before the Barron’s article was published, an assistant enforcement director in the SEC’s New York City office had received a referral about Madoff that had come from the agency’s Boston office. It was a complex, somewhat arcane complaint from a quantitative analyst who said he had analysed Madoff’s returns mathematically and was convinced that Madoff was a fraud.
The accusation came from Harry Markopolos, a portfolio manager at Rampart Investment Management in Boston. Markopolos had become interested in Madoff’s returns a few years earlier, when a Rampart executive asked him to investigate why Rampart’s options hedging strategies could not achieve the kind of returns routinely posted by Bernie Madoff. The son of immigrant Greek restaurant owners in Erie, Pennsylvania, Markopolos had earned a bachelor’s degree in business administration from Loyola University of Maryland and a master’s degree in finance from Boston College. Along the way, he worked for his family’s restaurant chain, served in the U
S Army Reserve, joined a family-affiliated brokerage firm, and worked at a small investment partnership before arriving at Rampart in 1991. By 1996 he had met the rigorous requirements for the chartered financial analyst credential and was active in the Boston Security Analysts Society.
Markopolos was an intelligent, slightly naïve man with a pronounced weakness for hyperbole and crude sexist humour. In his memoir, he reported teasing his future wife by offering to pay for her to get breast implants instead of the two-carat diamond engagement ring she wanted. “That way it’s something we both can enjoy,” he supposedly told her. In the memoir, he wrote, “We settled for a carat and a half.”
Even his friends agreed that he was a little odd. The man who would become his firmest ally in the SEC’s Boston office, the veteran investigator Ed Manion, observed that few people who met Markopolos were indifferent to him. “Either you like him or you don’t like him,” Manion said, adding that he thought Markopolos’s personality “fostered” that reaction. “Sometimes Harry is not too smooth” at handling the “people-to-people stuff,” he observed. Indeed, Markopolos would unashamedly joke that the difference between a male and female SEC staffer was that the female could count to 20 and the male “could count to 21—but only if he takes off his pants.” He added, “That usually irritates the women, until I add, ‘But that assumes that he can find it, and unfortunately at the SEC none of them can actually find it. That’s how clueless they are.’ ” As this anecdote suggests, he made no secret of his contempt for the market’s senior regulators.
When Markopolos analysed Madoff’s returns, he found that they did not remotely track the performance of the blue-chip securities Madoff was supposedly buying. He saw no honest reason why Madoff would let his feeder funds reap the huge management fees while he got only the trading commissions. He doubted there were enough index options in the world to hedge a portfolio as big as Madoff’s. And he noticed that Madoff had lost money in only three of the eighty-seven months between January 1993 and March 2000, while the S&P 500 had been down in twenty-eight of those months. “That would be equivalent to a major league baseball player batting .966”—96.6 percent hits—Markopolos noted later. (This analogy would have been less convincing to professional investors than it sounded to laymen. For one thing, the Gateway mutual fund, which pursued a similar strategy, had only fourteen losing months in the same period, so it had a batting average of .839—and even with twenty-eight losing months, the S&P 500 had been batting .678 during those years. These, too, would be implausible-sounding achievements for a baseball player, but both were indisputably the result of legitimate market activity, not fraud.)
Still, Markopolos immediately and accurately concluded that Madoff was cheating somehow—either running a Ponzi scheme or using his knowledge of incoming orders to trade ahead of his customers and thereby benefit from the price changes caused by their transactions, an illegal practice known as front-running. Excited by these findings, he brought them to Manion’s attention. In May 2000, Manion arranged for Markopolos to sit down with Grant Ward, the senior enforcement lawyer in the Boston office.
The meeting did not go well. “Harry tends to lose people,” Manion acknowledged later. Markopolos was a proud quantitative analyst—a “quant” in Wall Street lingo—who unfortunately overestimated his ability to explain things clearly to non-quants. Explaining a complex idea at a whiteboard, Markopolos would draw a circle here, then an arrow pointing to another circle there, then a third arrow pointing to yet another circle somewhere else. Manion described the experience as one of expanding mystification, adding: “And Harry would say: See, there it is, you know. And you look at the stuff and say, well, I don’t see it.”
At the meeting with Ward, Markopolos and Manion could tell that Ward’s eyes had glazed over before Markopolos had gotten past the first “exhibit” point in his analysis of Madoff’s returns. It probably did not help that Ward was just months away from leaving the agency for a job in private practice, but, to be fair, the opening point was an eye-crossing tangle of market jargon and mathematical terms that began like this:
Returns can’t be coming from net long exposure to the market: Part A, a split-strike conversion is long 30–35 stocks that track the 100 stock OEX index, short out-of-the-money (Delta < .5) OEX index call options, and long out-of-the-money (delta, -.5) OEX index put options. . . .
For a non-quant like Grant Ward—indeed, for most regulatory attorneys—this might as well have been ancient Sanskrit.
Ward later assured a frustrated Ed Manion that he had sent the Madoff tip to the SEC’s office in New York for follow-up. But there is no public evidence that he ever did—and an official investigation would later conclude that he had not. When asked about it, Ward said he had no recollection of the meeting with Markopolos at all, although the official report concluded that this, too, was untrue.
For the next year, Markopolos continued to track Madoff’s statistically impossible success. In a note to Manion, he said, “These numbers really are too good to be true. And every time I’ve thought a company’s or a manager’s numbers were ‘too good to be true,’ there has been fraud involved.”
With Manion’s encouragement, Markopolos prepared an updated report on Madoff for a new Boston enforcement chief. This time, on April 3, 2001, Markopolos’s analysis was actually sent to the New York office, where it was referred to an assistant regional enforcement director, who was a competent and well-respected lawyer. A day later, she sent her supervisor an e-mail saying that she had reviewed the Madoff complaint but didn’t think it warranted further investigation. “I don’t think we should pursue this matter further,” she wrote dismissively.
Reading the Markopolos document years later, she was mystified by her decision, which she said she did not even remember making. “My impressions are that this is a document that I probably would have needed to consult somebody about,” she said. “I hope I consulted somebody. I honestly don’t remember.” She added, “I also would have thought that the author of this document was odd, to say the least. But I hope that would not have led me to dismiss this—but I just don’t recall.”
The terrorist attacks of September 11, 2001, shoved the nation’s attention away from the stock market and any possible SEC investigations and diverted the media’s attention away from the obvious follow-up stories suggested by the Ocrant and Barron’s articles and the persistent Wall Street whispers about Bernie Madoff. In fact, the New York staff of FINRA, the Financial Industry Regulatory Authority, was forced to evacuate its Wall Street offices after the attacks on the World Trade Center, and its legal staff took refuge in Madoff’s Midtown offices. When the stock market reopened on September 17, Bernard L. Madoff Investment Securities was standing ready with the rest of Wall Street, posting bids, taking orders, fighting back.
As the stock market gradually recovered and Americans tried to adjust to a new perception of world affairs, the hedge fund party that was helping to fuel Madoff’s fraud resumed in full force. The dollars entrusted to largely unregulated hedge fund managers increased by more than a third between 2001 and 2003. Institutional investors were adding hedge funds to their portfolios, drawn by profits that far outstripped those available in the public mutual fund world and sustained by the faith that they could accurately assess the increased risks that invariably accompanied these higher returns.
While hedge funds ostensibly remained off-limits to all but the rich and sophisticated, the perception that middle-income Americans “deserved” the right to share in their high returns, already given credence in some corners of academia, was gaining traction among policymakers and regulators. Little was said about whether middle-income investors had the same risk-assessment skills as their institutional counterparts—or, indeed, if the institutional investors were as good at weighing risks as they thought they were. It would not be long before ordinary working Americans would catch the hedge fund bug and seize the opportunity to send their money, directly or indirectly, to a hedge fund do
ing business with Bernie Madoff.
One way for middle-class investors to get into the hedge fund world was through something called a “fund of hedge funds”, a financial instrument that made its debut in the US market in the summer of 2002. It was a concept borrowed from the mutual fund industry of the 1960s. Back then, investors could buy shares in a “fund of mutual funds”, paying a double dose of fees for the privilege of having someone else assemble a portfolio of top-performing funds. A fund of hedge funds was the same idea, dressed in Armani. Smaller investors could put as little as $25,000 into the publicly offered fund, whose managers would pass it along to a stable of promising private hedge funds. (Even that modest minimum was self-imposed; legally, these were mutual funds, which were not required by law to set a minimum investment.)
“Funds of hedge funds raise special concerns because they permit investors to invest indirectly in the very hedge funds in which they likely may not invest directly due to the legal restrictions,” SEC chairman William H. Donaldson said in congressional testimony in April 2003. They may not have been able to invest directly because the law allowed hedge funds to accept only “accredited investors”, those who had at least $1 million in net worth. By 2003, however, an increasing number of middle-income American families were meeting that requirement. Housing values were high and still climbing, giving many families substantial amounts of equity in their homes, and their private retirement plans had been around long enough to have accumulated substantial assets. As a result, millions of Americans became potential hedge fund customers.
Indeed, a growing number of them had already moved their “self-directed” individual retirement accounts (IRAs) into the hands of Bernie Madoff. A self-directed IRA was typically one that contained investments other than the traditional (and traditionally regulated) stocks, bonds, and mutual funds. These alternatives ranged from commodities to real property but prominently included hedge funds. Once the savers made their own investment choices, the US tax code required them to use a support firm, called an IRA custodian, to follow the account holders’ directions, make the investment purchases, and do the administrative work. An early Madoff investor in Florida found a small firm called Retirement Accounts Inc that would administer the IRA he had invested with Avellino & Bienes, despite the fact that the accountants’ loose operation was not registered, provided no prospectus, and maintained minimal records.
Bernie Madoff, The Wizard of Lies Page 17