No One Would Listen: A True Financial Thriller (56 page)

24.
Red Flag # 28:
BM’s Sharpe Ratio of 2.55 (Attachment 1: Fairfield Sentry Ltd. Performance Data) is UNBELIEVABLY HIGH compared to the Sharpe Ratios experienced by the rest of the hedge fund industry. The SEC should obtain industry hedge fund rankings and see exactly how outstanding Fairfield Sentry Ltd.’s Sharpe Ratio is. Look at the hedge fund rankings for Fairfield Sentry Ltd. and see how their performance numbers compare to the rest of the industry. Then ask yourself how this is possible and why hasn’t the world come to acknowledge BM as the world’s best hedge fund manager?

25.
Red Flag # 29:
BM tells the third party FOF’s that he has so much money under management that he’s going to close his strategy to new investments. However, I have met several FOF’s who brag about their “special access” to BM’s capacity. This would be humorous except that too many European FOF’s have told me this same seductive story about their being so close to BM that he’ll waive the fact that he’s closed his funds to other investors but let them in because they’re special. It seems like every single one of these third party FOF’s has a “special relationship” with BM.

26.
Red Flag # 30:
BM’s largest one month loss of -0.55% using index puts does not fit in with the prohibitively high cost of the extremely short-dated OTC OEX put options he would have to be buying to protect his portfolio from losses such that those monthly losses never exceeded -0.55% in any one month.

a. Previously with Red Flag # 4, I mentioned that the cheapest possible put cost for BM would be 8%. That very conservative assumption assumes that he could get away with buying one OTC, at-the-money put per year. However, mathematically that one year at-the-money put would have a delta of .50, meaning that for each 1 point drop in the OEX index, the put’s price would only increase .5 of half that amount or 50 cents. Therefore if the market dropped 1.1%, a .50 delta put would increase in price by 0.55%, resulting in a -0.55% loss for the fund.

b. However, for all market drops greater than 1.1%, BM would experience a larger than -0.55% monthly loss and there were numerous instances of monthly market losses greater than -1.1 % during the time period.

c. Therefore, BM, in order to limit his losses would be forced to buy a series of shorter dated, higher delta put options with high gamma (a 2
^nd
derivative term denoting that for each $1 change in index price, how much the 1st derivative term delta would change. Gamma is the change in price of Delta and Delta is the change in price of the Option with respect to the Index’s Price). If you aren’t intimately familiar with calculus, the English translation is that BM would need to be buying a continuing series of 1 day put options because these options and only these options would have the high gamma he would need to ensure that his delta changed rapidly enough to protect his portfolio enough so that he could never experience a greater than 0-0.55% monthly loss. If you’ve gotten this far, then if a one-year at-the-money OTC OEX index put option cost 8%, a continuing series of 253 (because that’s how many trading days are in a year) one-day, at-the-money puts, would cost the square root of 253 or 15.9 times the cost of the one-year put. 15.9 times 8% the one year put’s cost = 127.2% is the cost of a continuing series of one-day, at-the-money index put options if a one-year, at-the-money index put’s cost is 8%. And this is a very conservative set of calculations! Consider that one would be carrying over stock positions in this strategy over weekends, so therefore you’d want 365 one-day, at-the-money put options and the square root of 365 is 19.1, so a truer cost of put protection would be 19.1 x 8% = 152.8%. That would mean BM’s stock picking ability is not only the world’s best but that he’d likely have to be an alien from outer-space to be able to pick stocks that went up over 152.8% per year + the 16% gross returns to the HFOF investors + an assumed 4% he’s making in commissions. Therefore his stock picking ability would need to return 170% or so per year in order for him to be carrying out his strategy as he says he is in the HFOF third party marketing materials.

d. 170% per year from stock-picking is not likely for any human born on the planet earth so if BM’s achieving these types of returns then he may be an alien species from another planet. A DNA test would be sufficient to determine whether this might be the case. However, if BM is an alien being possessing superior stock-picking skills of this magnitude, this would be seen as an unfair advantage in the marketplace and likely would panic the financial markets. Or maybe he’s human and just a fraudster - take your pick.

e. Anyone capable of earning 170% per year from stock-picking would not need nor want any investors.

Conclusions:

1. I have presented 174 months (14½ years) of Fairfield Sentry’s return numbers dating back to December 1990. Only 7 months or 4% of the months saw negative returns. Classify this as “definitely too good to be true!” No major league baseball hitter bats .960, no NFL team has ever gone 96 wins and only 4 losses over a 100 game span, and you can bet everything you own that no money manager is up 96% of the months either. It is inconceivable that BM’s largest monthly loss could only be -0.55% and that his longest losing streaks could consist of 1 slightly down month every couple of years. Nobody on earth is that good of a money manager unless they’re front-running.

2. There are too many red flags to ignore. REFCO, Wood River, the Manhattan Fund, Princeton Economics, and other hedge fund blow ups all had a lot fewer red flags than Madoff and look what happened at those places.

3. Bernie Madoff is running the world’s largest unregistered hedge fund. He’s organized this business as “hedge fund of funds private labeling their own hedge funds which Bernie Madoff
secretly
runs for them using a split-strike conversion strategy getting paid only trading commissions which are not disclosed.” If this isn’t a regulatory dodge, I don’t know what is. This is a back-door marketing and financing scheme that is opaque and rife with hidden fees (he charges only commissions on the trades). If this product isn’t marketed correctly, what is the chance that it is managed correctly? In my financial industry experience, I’ve found that wherever there’s one cockroach in plain sight, many more are lurking behind the corner out of plain view.

4. Mathematically this type of split-strike conversion fund should never be able to beat US Treasury Bills much less provide 12.00% average annual returns to investors net of fees. I and other derivatives professionals on Wall Street will swear up and down that a split-strike conversion strategy cannot earn an average annual return anywhere near the 16% gross returns necessary to be able to deliver 12% net returns to investors.

5. BM would have to be trading more than 100% of the open interest of OEX index put options every month. And if BM is using only OTC OEX index options, it is guaranteed that the Wall Street firms on the other side of those trades would have to be laying off a significant portion of that risk in the exchange listed index options markets. Every large derivatives dealer on Wall Street will tell you that Bernie Madoff is a fraud. Go ask the heads of equity derivatives trading at Morgan Stanley, Goldman Sachs, JP Morgan and Citigroup their opinions about Bernie Madoff. They’ll all tell the SEC that they can’t believe that BM hasn’t been caught yet.

6. The SEC is slated to start overseeing hedge funds in February 2006, yet since Bernie Madoff is not registered as a hedge fund but acting as one but via third party shields, the chances of Madoff escaping SEC scrutiny are very high. If I hadn’t written this report, there’s no way the SEC would have known to check the facts behind all of these third party hedge funds.

Potential Fall Out if Bernie Madoff turns out to be a Ponzi Scheme:

1. If the average hedge fund is assumed to be levered 4:1, it doesn’t take a rocket scientist to realize that there might be anywhere from a few hundred billion on up in selling pressure in the wake of a $20 - $50 billion hedge fund fraud. With the hedge fund market estimated to be $1 trillion, having one hedge fund with 2% - 5% of the industry’s assets under management suddenly blow up, it is hard to predict the severity of the resulting shock wave. You just know it’ll be unpleasant for anywhere from a few days to a few weeks but the fall out shouldn’t be anywhere near as great as that from the Long Term Capital Management Crises. Using the hurricane scale with which we’ve all become quite familiar with this year, I’d rate BM turning out to be a Ponzi Scheme as a Category 2 or 3 hurricane where the 1998 LTCM Crises was a Category 5.

2. Hedge fund, fund of funds with greater than a 10% exposure to Bernie Madoff will likely be faced with forced redemptions. This will lead to a cascade of panic selling in all of the various hedge fund sectors whether equity related or not. Long-short and market neutral managers will take losses as their shorts rise and their longs fall. Convertible arbitrage managers will lose as the long positions in underlying bonds are sold and the short equity call options are brought to close. Fixed income arbitrage managers will also face losses as credit spreads widen. Basically, most hedge funds categories with two exceptions will have at least one big down month thanks to the unwinding caused by forced redemptions. Dedicated Short Funds and Long Volatility Funds are the two hedge fund categories that will do well.

3. The French and Swiss Private Banks are the largest investors in Bernie Madoff. This will have a huge negative impact on the European capital markets as several large fund of funds implode. I figure one-half to three-quarters of Bernie Madoff’s funds come from overseas. The unwinding trade will hurt all markets across the globe but it is the Private European Banks that will fare the worst.

4. European regulators will be seen as not being up to the task of dealing with hedge fund fraud. Hopefully this scandal will serve as a long overdue wake-up call for them and result in increased funding and staffing levels for European Financial Regulators.

5. In the US Fairfield
, Access International Advisors, Tremont and several other hedge fund, fund of funds will all implode. There will be a call for increased hedge fund regulation by scared and battered high net worth investors.

6. The Wall Street wire house FOF’s are not invested in Madoff’s strategy. As far as I know the wire house’s internal FOF’s all think he’s a fraud and have avoided him like the plague. But these very same wire houses often own highly profitable hedge fund prime brokerage operations and these operations will suffer contained, but painful nonetheless, losses from loans to some hedge funds that go bust during the panic selling. As a result, I predict that some investment banks will pull out of the prime brokerage business deeming it too volatile from an earnings standpoint. Damage to Wall Street will be unpleasant in that hedge funds and FOF’s are a big source of trading revenues. If the hedge fund industry fades, Wall Street will need to find another revenue source to replace them.

7. US Mutual fund investors and other long-term investors in main stream investment products will only feel a month or two’s worth of pain from the selling cascade in the hedge fund arena but their markets should recover afterwards.

8. Congress will be up in arms and there will be Senate and House hearings just like there were for Long Term Capital Management.

9. The SEC’s critics who say the SEC shouldn’t be regulating private partnerships will be forever silenced. Hopefully this leads to expanded powers and increased funding for the SEC. Parties that opposed SEC entry into hedge fund regulation will fall silent. The SEC will gain political strength in Washington from this episode but only if the SEC is proactive and launches an immediate, full scale investigation into all of the Red Flags surrounding Madoff Investment Securities, LLC. Otherwise, it is almost certain that NYAG Elliot Spitzer will launch his investigation first and once again beat the SEC to the punch causing the SEC further public embarrassment.

10. Hedge funds will face increased due diligence from regulators, investors, prime brokers and counter-parties which is a good thing and long overdue.