No One Would Listen: A True Financial Thriller (34 page)

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Authors: Harry Markopolos

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Amit told Neil that it was an interesting question, then claimed he’d never really thought about it. In other words, he just plain didn’t know.
 
Neil eventually focused on Madoff’s split-strike conversion strategy. It had become obvious to him that Vijayvergiya didn’t understand that this strategy couldn’t produce the rates of return Madoff claimed. “What am I missing here?” Neil asked. “You basically need to have some directional bias, whether the market’s up or down or flat. Is there some kind of arbitrage I don’t know about? I have to tell you, Amit, I don’t understand how he does it.”
 
This was a question Amit had been prepared to answer. He told Neil that Madoff was market-timing the entry and exit of all his trades. “Bernie’s got a proprietary model that helps him decide when to put trades on and when to take them off,” he said. “It’s got three core factors—momentum, volatility, and liquidity. That allows him to be long when the markets go up and out of the market when it is not favorable.”
 
“Let me be clear,” Neil pressed. “When you put a trade on, you have to put it on with some kind of bias, right? What I want to know is how is he doing that?”
 
“Well, he’s got a market-timing model.”
 
Neil asked him why, if this strategy had been so incredibly successful, other people had not been able to duplicate it. Amit attempted to answer that question, pointing out that no one else had Madoff’s proprietary model, which told him when to enter and exit split-strike trades.
 
The conversation grew increasingly more absurd. Given that Madoff had this perfect knowledge of the market, Neil asked, why does he need all these other funds? According to the model, Madoff was actually earning considerably less than those funds. So why didn’t he just eliminate the middlemen, set up his own hedge fund, and charge 1 percent or 2 percent fees and 20 percent of the profit? Neil told me that when Vijayvergiya said seriously that “Madoff doesn’t have the operational capability to set up a hedge fund structure,” he had to consciously stop himself from laughing out loud.
 
This guy actually expected Neil to believe that Bernie Madoff, who had helped found NASDAQ and who had built his own market-making operation, couldn’t set up his own hedge fund. It probably takes about $50,000, a computer, and some office furniture to open a hedge fund. There are no barriers to entry into the hedge fund world. All you have to do is copy someone else’s documents and file a few papers, and you’re in business.
 
Neil finally replied, “Well, I can’t believe Bernie couldn’t just open a hedge fund and hire all the people he needs around the world for less than $20 million a year and keep all the rest for himself. He wouldn’t have to deal with all the headaches that come with these other funds and he would keep most of the money himself. It makes sense. Why wouldn’t he do that?”
 
Vijayvergiya literally did not answer. Instead, he continued pitching the same nonsense we’d been reading about for almost eight years. Neil had to wonder how many people had listened to it and accepted it without questioning it, instead being seduced by the returns. Well, at least $7 billion worth. Obviously, there had been many other people who had heard it and walked away from the table; for example, none of the major New York investment houses had bought it. But this time Vijayvergiya was talking to someone who intended to call him on it. “Would you explain that to me? I’ve got to tell you, I’ve never heard anything like that before. Are you telling me that Madoff literally knows when the market’s going to go up and when it’s going to go down?” And basically, Vijayvergiya claimed that was true. Neil wondered, do you actually believe that? It’s been proven over and over and over by academic studies that no one can time the market, let alone time the market consistently for 17 consecutive years. It made no sense, so Neil asked, “Are you telling me Bernie basically has had perfect market timing every month for the last 17 years?”
 
Vijayvergiya didn’t respond directly to that.
 
“I just don’t get it,” Neil continued. “If you had perfect market timing like Madoff says he does, a split-strike conversion is the last strategy you’d use. I mean, if you really knew which way the market was going, you’d be buying leveraged futures or options. You could make a killing with a lot of other strategies, but this one actually limits you.”
 
Vijayvergiya basically had no answer for that.
 
Neil then asked him why Madoff traded over the counter (OTC) rather than doing listed trades. Again, he didn’t have an answer.
 
Neil asked him the cost of trading OTC against listed stocks. He had no answer.
 
Later, when Neil was telling me about this, he just kept repeating, “It was comical. This guy didn’t know anything. I kept asking him about how the trades actually get executed, and I was drilling him every which way. Are they instantaneous, does he do the options all at once, does he package trade, does he toss in a third market?—every possible question you could ask about how a trade is implemented. I was firing away at him and eventually he says, ‘There might be a three-or four-hour time lag from the time he actually does the stock trade verses the options.’ He estimated that about 20 percent of Madoff’s trades were done that way.”
 
Neil told me, “Immediately I was like, ‘Well, when you leg into a trade, when you only do one side and not the other side instantaneously, there’s always the risk of it going against you before you get the other side of the trade off. I’ve done that, and I know you can get burnt really hard, really fast. So how does he protect himself?”’
 
Vijayvergiya basically had no answer for that question, either.
 
Neil spent about 45 minutes on the phone with him. In hindsight, he was sorry he hadn’t stayed on the phone for hours and run through all our questions. But 45 minutes was all Neil could take. When he hung up, he was frustrated and angry. After all these years, Neil still thought there was a small possibility it was front running rather than a Ponzi, but this call settled that for him once and for all. He e-mailed me, “I can’t believe they have kept this Ponzi scheme going on for this long.”
 
Probably the only thing about this conversation that surprised us was the reality that Fairfield had so little respect for the people with whom it was dealing that they hadn’t even bothered to make up some sort of plausible answers to these questions. The attitude was, you want these returns? Then you accept what I’m telling you—or rather what I’m not telling you.
 
All you have to do to get rich is believe in Bernie.
 
Even after that disastrous phone conversation, the third party marketer called Neil and asked if he was still interested in giving several million dollars to FGG to handle. Neil made him an offer. “Tell you what,” he said. “I’ll give him fifty million dollars right now. I’ll cut you a check for fifty million bucks. I can get it done next week—but it’s gotta be done in my separate account with my prime broker and only with listed OEX options. He can charge me his two and twenty, whatever he wants to charge me, but my fifty million has to go in my separate account in Goldman Sachs.” Neil said this knowing it was an offer they had to refuse.
 
Maintaining a separate account meant that Neil would be able to see the execution of all the stock trades with the prime broker. And since no trades were being made and there would be nothing for him to see, there was no way Madoff could allow this. The marketer said, “Honestly, I don’t know if he’s done that before. I have to check.”
 
He called back the next day and as expected told Neil it wasn’t possible. Neil responded, “No shit. He can’t do it because his whole operation is a fraud.” Neil didn’t mention my name or tell him that he had been investigating Madoff for years. Instead he pointed out that no legitimate manager would refuse a $50 million separate account. The fees would more than offset the hassle. But this marketer refused to believe him. Like so many other people, he just had too much at stake to accept it.
 
When Neil e-mailed me with this response, I wrote back, “My belief is that the HFOFs [hedge funds of funds] like Fairfield are either in on the scheme or willfully blind. Willful blindness is not a defense.”
 
And when Neil offered, “Feel free to pass my notes on to SEC. Just remove my name,” I pointed out it would do no good. “I’m not sure sending the SEC anything would help those morons solve the case. They’re so lame, I’ll bet they don’t even catch colds in winter.”
 
I’d finally given up on the SEC. A month earlier I’d sent it my final submission—and as usual I’d gotten no response. I’d sent a prospectus from Prospect Capital’s Wickford Fund, another fund that channeled money to Madoff through Fairfield Sentry. But what made this one different was the fact that Madoff had started accepting leveraged money, a strong sign that he was running out of cash.
 
Frank Casey had found it in early June. He had been searching an Internet database for stable managers, trying to keep up to date with what Benchmark’s competitors were doing. As he remembers, “Eventually the Wickford Fund popped up as a fund of funds. I got on their web site and discovered that it was offering a three-to-one swap written with a counterparty bank that was willing to lend two dollars for every dollar invested in a manager strategy.”
 
Frank called me right away and said, “Madoff’s got to be running short of cash. He’s doing a three-to-one triple leveraged product with [and he named the bank].”
 
“My God,” I said. “He’s in trouble. He’s gotta be getting close because he’s willing to take in leveraged money. That means he’s running out of money. He’s getting desperate.” Equally interesting was the fact that one of the two Wickford Funds was offshore, registered in the Cayman Islands, which made it attractive to American citizens who wanted to hide money from the IRS.
 
The 3:1 offer was a big red flag that Madoff was in trouble. This was a win-win-win-win situation—everybody wins except the investor. Normally, the investor would put up one dollar, Fairfield would get one dollar, and Madoff would get one dollar as well. But they were able to find a bank stupid enough to lend the investor two additional dollars for every dollar invested, so the investor was then on the hook for three dollars. Prospect Capital would give three dollars to Fairfield and take triple its management fees. That’s one win. Prospect Capital is happy. Fairfield would invest three dollars in Madoff, so it is making three times its fees and profits. That’s two wins. Bernie would get the same three dollars instead of one dollar. That’s three wins. And the bank gets the interest rate spread, so it wins. If this were a legitimate investment, the victim would get three times the return minus the interest and fees that he or she is paying to borrow the money and invest. In a legitimate investment that would be a big win, but because this is a fraud, in addition to the initial investment the victim could possibly lose double that investment that he or she borrowed from the bank. In fact, I doubt the victim would ever have to repay the bank. The investor probably would have a strong lawsuit against the bank, but the best thing that would happen is a substantial loss and years of lawsuits.
 
“This is so odd,” I wrote to Neil. “If you’re a Ponzi scheme, why would you allow leverage? You end up paying well over double for each new dollar ‘invested.’ Is this a signal that Bernie is at the end of his rope and needs to offer juicier returns in order to keep the Ponzi scheme going? Is he this desperate for cash? My bet is Bernie is nearing the end of his run if he’s allowing triple leverage.”
 
With the possible collapse of his scam now somewhere just beyond the horizon, I began to wonder what the fallout might be—and if it was possible for him to ever get out of this without going to prison. I continued writing to Neil, “Let’s see now, if BM is a fraud and I am your typical dumb (bank) client and purchase the total return swap, when the underlying returns are found to be bogus, does that mean I receive nothing back or do I get my principle back and nothing else? What if BM is waiting for a systemic market crisis to occur and then says, ‘Oops, sorry, I bet wrong and lost 90 percent of your money, so, sorry, here’s the 10 percent that’s left. We’re closing down and we want you to have it back.’ That would be a great way out for him.”
 
I also wrote to Citigroup’s Leon Gross to see if he agreed with my prediction: “If Madoff is allowing a third party marketer to pitch this sort of product, my guess is that he’s running low on new investors’ cash inflows and needs to feed the Ponzi scheme or face ruin. Any insight on your part on what you might be hearing? Is Madoff running short of new cash?
 
“We all know how Ponzi schemes turn out.”
 
While I don’t remember his response, he certainly said nothing to change my opinion.
 
We found out after Madoff’s collapse that we were right; he was desperate for cash. He was running out of big fish, so he had started casting a much wider net. Banks in Europe and Asia had begun offering certificates that allowed small investors to buy into Bernie for as little as $150. To promote sales, some of these banks actually offered a 3:1 leverage; for example, the Fairfield Sigma 3X Leveraged Certificates sold by Japan’s largest brokerage for 10,000 included a loan that boosted the investment to 30,000, contributing to that bank’s $300 million loss.

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