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Authors: Harry Markopolos

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BOOK: No One Would Listen: A True Financial Thriller
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Each summer Rampart would bring in an unpaid intern from a local college and I would mentor him or her. In the summer of 1993 that intern was Neil Chelo, a confident, wiry young man from Bentley College, a business school in Waltham, Massachusetts. Several years later Neil was to become a member of my Madoff team. Neil almost didn’t take the intern job. Although his father encouraged him to work for the experience, telling him that Wall Street people were smart and that if he got down in the trenches with them, eventually he would make a lot of money, his mother was strongly against it. “Be something respectable,” she told him. “Be a doctor or a lawyer.” He pointed out to her that they were Turkish-Albanian, not Jewish. But what really upset her was the fact that her Turkish-Albanian son was going to work for a Greek! She told him, “Oh, my God, Neil. That’s why you’re not getting paid. The Greeks always take advantage of the Turks!”
 
Of course, as I would occasionally point out to Neil, that’s not exactly the way Greeks interpret the Greek-Turkish relationship.
 
When Neil began his internship, he assumed he was going to sit down at the trading desk and learn by participating in the business. Instead, I handed him a reading list of about 14 books and told him his job that summer was to read all of them so we could discuss them. Among the books on my list were
Market Wizards
by Jack Schwager (New York Institute of Finance, 1989); Justin Mamis’s
The Nature of Risk
(Addison-Wesley, 1991); and
Minding Mr.
Market (Farrar Straus & Giroux, 1993) by James Grant. My objective was to provide him with the education he wasn’t going to get in an academic curriculum. Although I don’t dislike business schools, I believe half of what they teach students will be obsolete within five years and the other half is just outright false. Generally, they teach formulas that no one uses, case studies that no longer apply in the real world, and concepts that are just going to get people into trouble if they try to apply them. These formulas are an attempt to model the financial world in a simplified form, but they can’t possibly take into account the extraordinary complexity of the markets. It’s important to know these formulas, though; once you’ve mastered them you can begin to make the necessary adjustments for the real world.
 
Neil spent about half his time helping prepare monthly statements, confirming trades, tracking dividends, downloading reports, and doing all the other work done in the back office. The other half was spent reading books on my list. He sat across the desk from me, and I literally would quiz him. If he didn’t know the answer, I’d expect him to find it. And I insisted he do all the math by hand. Neil remembers (I don’t) that one afternoon I gave him the Dow Jones Industrial Average for 30 stocks and their price fluctuations for a day and asked him to calculate the actual point change in the Dow. It was not difficult to pull it up on a calculator, but I insisted he do the math.
 
Neil was obviously smart, but even as an intern, he was headstrong and opinionated. If he disagreed with something I said, he would not hesitate to let me know quickly and forcefully. And like a pit bull, once he got his teeth into an argument he wouldn’t let it go. Now, I had spent 17 years in the military. Among the lessons I had learned was that you can raise an objection once, maybe twice; but once a command decision was made, you didn’t continue to question it. Neil hadn’t learned that lesson, so when he believed he was right he wouldn’t let go. But these weren’t frivolous arguments; he knew his stuff. That’s what made him so valuable when we began to analyze Madoff’s numbers.
 
Math came naturally to Neil. Like me, maybe even more than me, he could glance at numbers and draw meaningful conclusions from them. At Bentley College, he played a lot of poker, ran a small bookie operation, and came to believe firmly in the efficient markets hypothesis. Believing that concept was where Neil and I differed most. The efficient markets hypothesis, which was first suggested by French mathematician Louis Bachelier in 1900 and was applied to the modern financial markets by Professor Eugene Fama at the University of Chicago in 1965, claims that if all information is simultaneously and freely available to everyone in the market, no one can have an edge. In this hypothesis having an edge means that for all intents and purposes you have accurate information that your competitors don’t have. It basically means that you can’t beat the market, that there is no free lunch.
 
After the first few weeks, Neil and I began going out to lunch together, to a local Greek place, naturally. The most important thing I taught Neil that summer was that what he learned in the office was not going to determine his success in this business. The only possible way of gaining an edge in the financial industry is by gathering information that others don’t have. There are so many smart people in this business that it’s impossible to outsmart them, so you simply have to have more and better information than they do. Information on a database that can be purchased is available to everyone; there’s no advantage to having it, but the knowledge that one day might make a difference is best obtained from others in simple conversations. It’s stuff you can’t buy from a database provider; you have to learn it one relationship at a time. In the army we called it human intelligence gathering.
 
I had established the one-third rule: For every three hours you spend at work you have to spend at least one hour outside the office on professional development. That might mean reading material that might improve your life, but more likely it meant—just as I had learned at Darien Capital—social networking. I encouraged Neil to take advantage of the pub culture in Boston, to go to professional association meetings, and to go to dinners. As I explained to him, that’s where the information that one day may make the difference is learned. That’s where you find out what other firms are doing to be successful and where they are failing, what their problems are, and how they’re dealing with them. For example, in those social conversations you hear about the idiosyncrasies of different traders, so when you see them making a move you know how to properly interpret it. I taught him that it is important to know everything that’s going on in your field, in your industry, and in your sector in the industry, and that the only real way to do that is going to lunches and dinners and happy hours and meetings and getting there early and staying late. I taught him that ignorance begins where knowledge ends, so to be successful he needed to be a gatherer and a hoarder of information.
 
These were the tools we depended on throughout our investigation.
 
When Neil returned to college in the fall of 1992 to earn credit for his work as an intern, he had to write a paper. This will tell you what you need to know about Neil: The paper he wrote criticized the basic investment strategy we used at Rampart because it violated the efficient markets hypothesis.
 
Three years later, after working in various jobs at several different types of investment companies, Neil returned to Rampart. Initially he was hired to upgrade our accounting system, with the unspoken hope that eventually it might become something more. For several months Neil ran two accounting systems—our legacy system and the new system—in parallel, and reconciled everything to the penny. If he couldn’t get that last penny to balance, he’d work at it until it did. But what he really wanted to do was portfolio management. Eventually our desks were back-to-back; so we sat directly across from each other, separated only by a divider about 18 inches high, for nine hours a day, five days a week. Over several years we got to know each other better than we knew our families. Neil and I were both research geeks who loved the hunt, and we spent considerable time searching for ways to optimally create portfolios that had the highest chance of beating the benchmark with the lowest risk. We pushed each other. So when we first encountered Bernie Madoff it was only logical that we would see it as an academic exercise, as another strategy to be taken apart and analyzed to help us develop a strategy that would benefit our clients, and not as the largest fraud in Wall Street history. We weren’t looking for a crime; we simply wanted to see how he made his numbers dance.
 
It was Frank Casey who first brought Bernie Madoff to my attention. Frank Casey worked on the other side of the ledger; years ago he would have been known as a customer’s man, but now he was a marketing representative. Frank is a gregarious Irishman, a man who attacks life and has combined his gift of language with his effervescent personality to become a successful salesman. In addition to selling our financial products, he also would find needs in the market that we might fill. On Wall Street a salesman is an interpreter of numbers. While Frank isn’t a quant, being the middleman between the customers and the quants meant that he had to have enough understanding of the market to bring needs and products together.
 
Frank had been working in the industry doing a great variety of jobs for more than a quarter century when we met. He grew up with a love for the market, using money he earned running a jackhammer on a summer job while still in high school to buy his first stock, Botany 500, a men’s clothier. At that time he didn’t own a suit, but he had the stock. He doubled his money, and he was hooked. He remembers spending much of his junior and senior years in high school reading the stock market pages and books about investing—and writing poetry. He learned the realities of the market less than a year later; when the 1967 Israeli-Arab War started, he figured American Jews would become patriotic, so he invested in Hebrew National—and watched as the stock sat unmoved. But after that there was no doubt in his mind where he wanted to work. After four years in the military, finishing as an army captain, Airborne Ranger qualified, he started as a trader at Merrill Lynch in 1974 with an interesting strategy: “I figured everybody else who was starting as I was, cold-calling from the Yellow Pages, went from the front to the back. My buddy and I split the book in the middle, he worked middle to the back and I worked middle to the front. We called every business in the Boston Yellow Pages. That was our sophisticated strategy.” By 1987 Frank was hedging more than a billion dollars in mortgages for banks. Because during most of his career he has earned his paycheck from commissions rather than from a fixed salary, mostly by creating and executing sales of his own products, he has developed an intuitive feeling about the people working on Wall Street and the products they market. So while at the very beginning he couldn’t quite figure out what Bernie Madoff was doing, whatever it was, it just didn’t feel right to him.
 
Frank Casey and Rampart cofounder Dave Fraley had met while both of them were working at Merrill Lynch in the mid-1970s. Like many relationships on Wall Street, their paths had crossed several times through several companies since then. When Frank found out that Rampart was specializing in options, an area in which he had a lot of experience, he approached Fraley, the managing partner in charge of marketing our products, and began working on commission. He was a Wall Street prospector, finding companies that would benefit from Rampart’s products. In return, Dave Fraley directed me to execute trades through Frank, for which he earned a small commission. That’s how we met. To me, he was an aggressive marketer. As I later found out, to him I was just another geek portfolio manager. It was a typical Wall Street retail versus institutional relationship. We needed each other, so we got along. That began changing in February 1998 when Fraley hired him to market products and develop new business.
 
It was impossible not to know Frank was there. His office was right next to the trading room and he was salesman-loud. At first we simply shut his door; but his voice boomed right through that closed door, so eventually management had to erect a glass wall so we could concentrate. I got to know him pretty quickly because he would sit down at my desk and ask me to explain our products to him. He understood the marketing aspect, but he wanted to understand exactly how they worked. Frank wanted to know the nuts and bolts of each product, how it worked under various market conditions, and where it fell short. He asked endless questions. What are the trading rules? What are your stop losses? What triggers a trade? What causes you to sit on a position? He wasn’t a mathematician, but he wanted us to explain the math to him until it made sense. This was his way of getting that edge over the competition.
 
There are few things quants like more than explaining their math to an interested listener. And Frank does have that Irishman’s way of making you feel comfortable with him. So it was only a matter of time before we were continuing our discussions after work in the better pubs of Boston. Over time we discovered several things we had in common, including the fact that although I was a reserve army officer while he had been regular army, both of us had been commissioned as second lieutenants in the infantry, which allowed us to tell plenty of funny stories about military life; and neither of us had a lot of respect for the corner-cutting ways business was often done in the financial industry.
 
BOOK: No One Would Listen: A True Financial Thriller
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