After meeting Bernie Madoff in the mid-1980s, Kohn made no secret of her admiration for him—although she abided by his wishes and obscured his role in the sales literature for her funds. According to his employees, she visited his offices frequently and was always greeted by Madoff with great warmth.
Like Ezra Merkin in Jewish charity circles and Walter Noel in the hedge fund world, Sonja Kohn was a linchpin for Madoff since the early 1990s, linking him to new sources of cash in Europe and beyond. She introduced him to Mario Benbassat, the founder of a Swiss firm called Genevalor, Benbassat & Cie, and his two sons. Their firm would set up five early feeder funds in Europe, including the hefty Thema funds, and ultimately would put almost $2 billion into Madoff’s hands. Benbassat was a director of another prominent Swiss investment firm called Union Bancaire Privée, and in 2003 UBP set up its own collection of Madoff feeder funds, one that would ultimately gather $1 billion in fresh cash for him. Subsequent litigation also identified Sonja Kohn as the person who introduced Madoff to Carlo Grosso and Federico Ceretti, the two Italian money managers based in London who set up the Kingate funds to invest with Madoff in the early 1990s and ultimately steered $1.7 billion his way. She also reportedly introduced Madoff to Charles Fix, a scion of a Greek brewing empire who had established himself as a money manager in London—and who, ultimately, invested hundreds of millions with Madoff through the Harley and Santa Clara hedge funds.
To these investors, Kohn’s credentials were impeccable. In her distinctive bouffant auburn-red wig and expensive but slightly frumpy outfits, she became known as “Austria’s woman on Wall Street”, dividing her time between Europe and New York. When Bank Medici was granted a full-service banking licence from the Austrian government in 2003, she and her husband established themselves again in Vienna, where she already had been honoured for her contributions to the Austrian economy.
Then the established bank that had been her minority partner when she formed Bank Medici was acquired by Creditanstalt, one of Austria’s largest financial institutions, and she was catapulted into the aristocracy of European banking. After more mergers, her minority partner, now called Bank Austria, was acquired by the giant Unicredit bank holding company of Italy. It wasn’t long before Unicredit had its own family of Madoff feeder funds called the Primeo funds.
From her gilded and baroquely furnished offices overlooking the Vienna opera house, Sonja Kohn would help steer nearly $9 billion into Madoff’s hands in the decades after their initial meeting in 1985, according to the trustee’s litigation against her. Her hedge fund empire would expand across Europe and beyond, into the former Soviet Union and the offshore fund world of the Caribbean.
From Madoff’s standpoint, one of the most significant things Sonja Kohn did was to help create the Herald fund, which opened for business in April 2004. Of the half-dozen giant feeder funds serving Madoff in those years, none sent more fresh money to him during his 2005 cash crisis than the Herald fund, according to a subsequent academic study. From its inception, the Herald fund would pump more than $1.5 billion into Madoff’s hands, but much of that flowed in during its early years of operation, when he needed the cash so desperately.
Still, the Herald fund was only the pace car for other newborn European feeder funds that helped rescue Madoff. Another promising source of cash in 2005 was Access International, a private money management firm run by two elegant Frenchmen. Access was the sponsor of the Lux-Alpha funds, formed in 2004, which brought in a steady stream of fresh cash in Madoff’s hour of need. The chief executive of Access was the warm but aristocratic René-Thierry Magon de la Villehuchet, but his longtime friend and banking partner, the more prosaically named Patrick Littaye, was the one who provided the link to Bernie Madoff.
Subsequent lawsuits against Access would assert that Littaye insisted that no one at Access deal with Madoff except through him. It isn’t quite clear how the two men met. Madoff recalled that the connection was through a French bank executive whom he knew through his old friend Albert Igoin in Paris, whose ties to Madoff dated to the 1970s. Littaye later recalled that he first met Madoff in 1985, when he phoned Madoff’s office to confirm a transaction for one of his private banking clients. In any case, the two men seemed to enjoy each other’s company, and Madoff was impressed by Littaye’s European connections.
In 1995, Littaye and de la Villehuchet, a gifted salesman, formed Access International, quietly investing its private clients’ money with Madoff. With the formation of the new LuxAlpha funds in February 2004, Access became an even more formidable source of money for Madoff. With the imprimatur of UBS, a prestigious international bank based in Switzerland, the fund attracted investments from such historic names as Rothschild et Cie and brought in a number of aristocratic family fortunes—including de la Villehuchet’s own money, the wealth that enabled him to preserve the beautiful provincial estate near St Malo, on the north coast of France, that had been in his family since 1685.
It seemed that nothing could shake the trust that Littaye and de la Villehuchet placed in Madoff. In early 2006 an Access executive confirmed an odd fact noticed by people on his staff: the options supposedly traded by Madoff were not reflected in the records of Wall Street’s central options clearinghouse. When this executive raised the issue with the Access founders, they insisted on hiring an experienced independent hedge fund analyst to provide a second opinion about Madoff—and this analyst’s opinion was also firmly negative. In early May the analyst joined Littaye and de la Villehuchet for lunch in the soaring wood-panelled dining room of the University Club in Midtown Manhattan. “I did my best to inject doubt in a courteous yet effective manner,” the analyst recalled later. But Littaye, appearing “highly sensitive and defensive,” allegedly stood up for Madoff, questioned the analyst’s “business judgement”, and dismissed his concerns.
By 2006, Madoff had planted his flag on virtually every continent. His presence in Europe had expanded dramatically, with Bank Medici in Vienna and Union Bancaire Privée in Geneva not only running feeder funds directly but also providing advisory services to some of Madoff’s other feeder funds—including Fairfield Greenwich Group, based in New York and Bermuda. The Italian-based Unicredit’s Primeo funds attracted a small investment from a multinational development bank in Central Africa and, in turn, added the money to the $1.5 billion that flowed into the Herald fund. An offshore company called Euro-Dutch Management, run by Dutch bankers, raised more than $2.3 billion for its Madoff feeder funds based in the Cayman Islands. In the course of raising a total of $4.5 billion in fresh cash for Madoff, Fairfield Greenwich would draw money from Singapore, Qatar, Abu Dhabi, Dubai, Korea, and Tokyo. The Optimal funds sponsored by the prestigious Banco Santander in Spain would ultimately raise at least $1.5 billion from investors in the wealthy enclaves of Central and South America.
Even these big feeder funds had feeder funds of their own, which in turn had feeder funds, creating a vast worldwide irrigation system that sustained Madoff’s fraud with steady high-pressure streams of cash. Many of the feeder funds paid “retrocession fees”—the trustee would later call them “kickbacks”, but they also could be called sales commissions—that provided a tangible reward and a powerful incentive for those who brought in new investors.
As hedge funds were gaining strength in Europe, Asia, and the Middle East, they were also multiplying in America. One illuminating example of the proliferation of hedge funds after 2006—a trend Madoff milked to the maximum—was a one-man hedge fund in Florida called Anchor Holdings LLC.
Many of Anchor’s clients were small family or individual “hedge funds”, with names such as the “John Doe Hedge Fund” and the “Jane Doe IRA Hedge Fund”. A few were union or professional pension plans. At its peak, when Anchor Holdings supposedly had more than $12 million in assets, its largest individual account was under $750,000, and its smallest was a Roth individual retirement account worth just $3,224.43. Anchor Holdings invested these modest nest eggs in another hedge fund, which inv
ested all its assets in an apparently diversified portfolio of international hedge funds. That portfolio consisted of the Primeo fund, the Santa Clara fund, and four other hedge funds—every single one of which was invested exclusively with Madoff. Believing they had avoided the risk of putting all their eggs in one basket, these small investors had actually handed their savings over to one man: Bernie Madoff.
It is no wonder that some members of the US Congress were demanding that the SEC increase its attention to the hedge fund industry’s incursions into the middle class. Anchor Holdings could have been Exhibit A in the argument that hedge funds had “gone retail”. But since hedge funds were not required to register with the SEC—a badly drafted rule requiring registration was struck down by an appeals court in 2006 and never redrafted—the SEC had no way of knowing about Anchor Holdings or the countless other funds just like it.
In December 2006 the SEC tried to stem the stampede of middle-class savers into barely regulated hedge funds by raising the net worth requirements for “accredited investors”—those who were wealthy enough to buy hedge funds legally—to $2.5 million, from $1 million. By doing so, however, it walked into a buzz saw of opposition from people who were already invested in hedge funds but would not qualify under the new standard. As one Congressional Research Service report observed, “These investors did not wish to be protected from risks that the SEC might view as excessive.” The effort was shelved.
Some critics of hedge fund registration noted that when Europe introduced a registration regime, it simply made hedge funds seem safer and therefore more attractive to middle-income investors. And some high-profile academics on both sides of the Atlantic were producing learned and widely touted papers supporting the concept of “hedge funds for everyone”. Why, they asked, should the profits of hedge fund investing be limited only to the wealthy and sophisticated?
More than social cachet was involved, although one wry observer noted that mutual funds had become “so yesterday” on the summer patio circuit. The low interest rates established by the US Federal Reserve to sustain the economy in the aftermath of the technology stock collapse in 2000 had sharply reduced the amount of money a generation of ageing Baby Boomers could safely earn on their retirement savings. At the same time, the growing housing bubble was increasing the value of their primary asset, their homes. With mortgage rates so low and home values so high, many people could, and did, borrow against their home equity, invest with Madoff, and earn far more income for retirement than they could have earned with a bank certificate of deposit or low-risk mutual fund.
So, both at home and abroad, directly and through their pension funds, more investors were putting their retirement nest eggs into hedge funds—and enough of that money wound up in Madoff’s basket to more than cure the cash crisis that had looked so deadly for him in November 2005.
Another important factor in Madoff’s remarkable rebound was the boom in derivatives tied to hedge fund performance, a subset of the derivatives mania that was intensifying on Wall Street and in other financial centres around the world.
At this point in the Madoff tale, Harry Markopolos would be drawing circles and arrows on his whiteboard. But it’s helpful to think of derivatives simply as private contracts between a seller and a buyer; each contract is designed to achieve a particular purpose. The purpose of these particular contracts was to allow the buyer, for a fee, to share in the future gains of a specific hedge fund without having to invest in the hedge fund directly.
Why would anyone have wanted to do that? Well, there were a number of reasons. Perhaps an attractive hedge fund was not accepting new investors; a derivative contract designed to track that closed fund would give investors the benefit of being in it even though the door was shut.
More significantly for Madoff, some of these derivative contracts allowed the buyer to invest with borrowed money, which meant that the investor could earn two, three, or even four times the gains produced by a particular hedge fund—leveraged profits that the hedge fund itself could not have provided. Eventually, derivative contracts would be designed to track a number of Madoff feeder funds, but initially the primary “tracking fund” was the giant Fairfield Sentry fund, whose assets totalled nearly $5 billion at the end of 2005.
In August 2006, as the global appetite for all kinds of exotic derivatives grew, a prominent Spanish banking group called Banco Bilbao Vizcaya Argentaria (BBVA) sold $20 million worth of these derivative contracts designed to pay investors five times the future profits of the Fairfield Sentry fund. A month later, it sold another $5 million of the notes. The bank had a substantial presence in Latin America, in addition to its Spanish business, and its gleaming reputation stood behind the unfamiliar new product.
Soon, Nomura Bank International, a worldwide institution with special strength in the Asian markets, would issue $50 million in derivative contracts offering to pay three times the future gains in the Sentry fund. Compared with some of the derivatives being sold on Wall Street at the time, the deal looked conservative.
In December 2006, another $25 million in Sentry-tracking contracts, derivative notes offering five times the fund’s profits, was issued by Madoff’s own bank, JPMorgan Chase, an institution born in 2000 from the merger of two of the most fabled names in American banking history. J.P. Morgan & Co had been founded by the legendary financier who almost single-handedly reversed the financial panic of 1907. The Chase Manhattan Bank, which traced its ancestry to 1799, had been led for more than two decades by David Rockefeller, a grandson of America’s first oil baron, John D. Rockefeller. The JPMorgan Chase notes attracted the attention of an Italian money manager who had been searching for a way to invest in Madoff. The notes produced better returns but were still tied to the conservatively managed Fairfield Sigma funds, the Sentry fund’s euro-based affiliate. “It’s like they were giving you a parachute with a more exciting trip,” he said. “And it was J.P. Morgan!”
Fairfield Greenwich founders Walter Noel and Jeffrey Tucker had come a long, long way from sharing office space with an options trader back in 1989. Now they were sharing their life-size gamble on Bernie Madoff with one of the most historically successful banks in the world.
The development of these derivatives was important for Madoff because the banks selling them had to hedge the risks they were taking on—and they did this by investing directly in the hedge funds whose performance the derivatives were supposed to track. The funds, in turn, invested that money with Madoff. He let it be known that he disapproved of these leveraged derivatives, but they were a new source of cash for him in the summer of 2006, when he needed it desperately.
But these and other Madoff-linked derivatives—which would soon be offered by HSBC, Citibank, Fortis, Merrill Lynch, and several other global institutions—were also a significant milepost in the evolution of Madoff’s Ponzi scheme. Initially, people had invested with Madoff because they trusted him. In time, they invested because they trusted whichever prominent accountant, lawyer, or pension fund adviser opened the door to Madoff. Then they invested with prominent individual investors who knew Madoff, such as J. Ezra Merkin and Sonja Kohn, or in feeder funds such as Fairfield Greenwich and Tremont Partners, whose founders knew him. Now people who had never heard of Bernie Madoff were tying their fate to his because they trusted the giant banks that were selling these complicated contracts, banks whose chief executives probably had never heard of Madoff either.
Looking at the fine print for these derivatives with sceptical hindsight makes the investors’ trust seem quite remarkable. Bank lawyers had worked a long time on these complicated agreements to protect the banks’ interests and insulate them from liability. Investors were warned repeatedly that they should be prepared to lose all the money they invested in these contracts.
In the final terms for the contracts sold by JPMorgan Chase in December 2006, some variation of the word risk is used 139 times. One of those citations went like this:
Possibility of Fraud and Other Miscon
duct: There is a risk that the manager of the fund or a hedge fund could divert or abscond with the assets, fail to follow agreed-upon investment strategies, provide false reports of operations or engage in other misconduct.
In other words, caveat emptor: buyer, beware.
Of course, similar warnings were scattered through the paperwork for almost every hedge fund in the marketplace. Apparently, people who had invested far more than they could afford to lose did not seriously believe they actually could lose everything. Besides, all those clever, well-compensated managers running these funds were doing the due diligence that would detect a fraud, right?
The notion inherent in these warnings—that you paid for the higher profits the hedge funds produced by taking on much higher risks—was apparently dismissed as just so much legalese. Nothing to lose sleep over.
The final manoeuvre Bernie Madoff used to pull his Ponzi scheme out of the nosedive of November 2005 was to substantially increase the rates of return his feeder funds could offer, making the funds more attractive to investors. For example, the return on the Fairfield Sentry fund in 2006 was nearly a third higher than its 2005 results. It was a gutsy gamble. If Madoff had guessed wrong about where investors were in their perpetual journey between fear and greed, the move could have been disastrous—if withdrawals had continued, a higher rate would instantly have accelerated the evaporation of his cash.
But the financial landscape in early 2007 made the risk look less worrisome. Home values had been climbing for years, and it seemed they always would. The S&P 500 index had almost regained the ground it lost after the tech-stock collapse in 2000. Even the battered NASDAQ composite index was back where it had been in January 1999, before the last puff of air went into the Internet bubble. Financial deregulation still looked like an excellent idea. So did all the creative financial engineering that produced the Fairfield Sentry derivative notes and the countless other complicated derivatives that were being embraced by institutional investors everywhere.
Bernie Madoff, The Wizard of Lies Page 23