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Authors: Harry Markopolos

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BOOK: No One Would Listen: A True Financial Thriller
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Thierry brought him into another room, where two clerks were busy typing these statements into a computer. “I want to make sure when I get the monthly statement that all of these trades actually show up on that statement,” he said. “I’m also trying to reverse engineer what he’s doing. I want to see where his edge is.”
 
Frank was incredulous. Access wasn’t receiving any electronic confirmation on execution from Madoff. It was simply getting sheets of paper with numbers on them, typing them into a computer, and logging them on a spreadsheet. “Thierry, basically you told me you give this guy your money. I don’t know him from a hole in the wall, but I know he’s got full discretion and he’s the primary market maker. He writes his own trade tickets. It’s not like you have an account at Charles Schwab or Fidelity; this guy is executing his own trades. He produces the trade tickets and the statements. I mean, there aren’t even commissions on any of these things, right?”
 
Thierry agreed that everything was done in-house. Unfortunately, it was Bernie Madoff’s house.
 
Frank may have been the first person to ask Thierry this question about Bernie Madoff: “Let me ask you this, Thierry. What if he’s phonying up records? What if he’s just printing these tickets?”
 
“No, no, no,” Thierry responded quickly. “It’s not possible. Listen, we know this guy. We’ve been doing business with him for a while and everything has always balanced out. It’s got to be real, because I check to see that all the trades match against the monthly statement.”
 
Frank suggested to Thierry that rather than having two men spend their time processing data that Madoff had generated, he should hire one person who should sit down on Friday night and confirm that every stock had actually sold for a price within the day’s highs and lows. “If the ticket reports that a stock sold outside the day’s highs and lows, you know he isn’t doing what he says he’s doing. But I don’t see the value in what you’re doing.”
 
Several months later, we discovered another method Access used to conduct due diligence. When we started to work on another project, Thierry asked Frank and another man to submit handwriting samples, which were then sent to a handwriting analyst in France. This analyst supposedly could determine from an individual’s handwriting whether he or she were honest. This pseudo science is called graphology, and in the United States it definitely is not admissible as evidence in the courtroom. In fact, voodoo magic probably has more credibility as a crime-fighting tool than graphology. We were never able to confirm that Madoff had submitted a handwriting sample; but as Access was very serious about it, we assumed that he did. Incredibly, that was the level of Access’s due diligence, that and the fact that a check arrived every month, every single month. And money always makes a strong statement.
 
Frank came away from that meeting believing there was a real opportunity to do business with de la Villehuchet and Access. Madoff was too risky, and Frank didn’t want Rampart to get involved with him; but Thierry was different. Although he didn’t know precisely how much Access had placed with Madoff—we estimated it at about $300 million but eventually learned it was considerably more, roughly 45 percent of its total investments, about $540 million—Frank believed that if we could create an options strategy that would enable Access to diversify its risk away from Madoff without sacrificing too much profit, Thierry would be able to sell a lot of it to the private banks of Europe.
 
As Frank has occasionally pointed out, Mother Teresa did not work on Wall Street. The object of the business is to use money to make money; there is no interest in saving souls. Whatever Madoff was doing and precisely how he was actually doing it didn’t concern Frank as much as his results. When Frank got back to the office, he handed Dave Fraley copies of Access’s revenue stream for at least the last year that Thierry had given him. “Look at this. Access has a guy who’s producing one percent, one and a quarter percent a month with a split-strike conversion strategy.”
 
Fraley looked it over. He didn’t speak numbers like a quant, but he didn’t need that kind of expertise to understand the kind of returns that Madoff was producing. The bottom line was right there. As Fraley stared at it, Frank suggested, “You know, if we can come up with something that’ll produce anywhere near those returns, Access can raise a lot of money.”
 
A few minutes later, Frank handed me the copies of the revenue stream. This comes from that manager in New York we were wondering about, he said. He’s running a split-strike conversion. And then he added, “Harry, if we do something similar we can make a lot of money.”
 
I glanced at the numbers. I’d spent countless thousands of hours preparing for this moment. And I knew immediately that the numbers made no sense. I just knew it. Numbers exist in relationships, and after you’ve studied as many of them as I had it was clear something was out of whack. I began shaking my head. I knew what a split-strike strategy was capable of producing, but this particular one was so poorly designed and contained so many glaring errors that I didn’t see how it could be functional, much less profitable. At the bottom of the page, a chart of Madoff’s return stream rose steadily at a 45-degree angle, which simply doesn’t exist in finance. Within five minutes I told Frank, “There’s no way this is real. This is bogus.”
 
As I continued examining the numbers, the problems with them began popping out as clearly as a red wagon in a field of snow. There was a stunning lack of financial sophistication. Anyone who understood the math of the market would have seen these problems immediately. A few minutes later I laid the papers down on my desk. “This is a fraud, Frank,” I told him. “You’re an options guy. You know there’s no way in hell this guy’s getting these returns from this strategy. He’s either got to be front-running or it’s a Ponzi scheme. But whatever it is, it’s total bullshit.”
 
And that’s when we began chasing Bernie Madoff.
 
Chapter 2
 
The Slot Machine That Kept Coming Up Cherries
 
Month after month, year after year, no matter how wildly the market performed, Madoff’s returns remained steady. He reported only three down months in more than seven years. His returns were as reliable as the swallows returning to Capistrano. For example, in 1993 when the S&P 500 returned 1.33 percent, Bernie returned 14.55 percent; in 1999 the S&P 500 returned 21.04 percent, and there was Bernie at 16.69 percent. His returns were always good, but rarely spectacular. For limited periods of time, other funds returned as much, or even more, than Madoff’s. So it wasn’t his returns that bothered me so much—his returns each month were possible—it was that he always returned a profit. There was no existing mathematical model that could explain that consistency. The whole thing made no sense to me. Bernie Madoff was among the most powerful and respected men on Wall Street. He had founded and operated an extremely successful broker-dealer firm. How could he be perpetrating such a blatant fraud? And if it was so obvious, why hadn’t other people picked it up? I kept looking at these numbers. I had to be missing something.
 
I didn’t obsess over this, but I was really curious. It was like trying to solve a jigsaw puzzle using pieces that didn’t fit. In certain markets a split-strike conversion strategy actually could produce the returns Madoff was delivering, but it can’t make money in all types of markets as de la Villehuchet had claimed. You can’t take whatever you want from the market; you have to take what it gives you—and sometimes that means a down month. Every product in the entire history of the financial industry has a weakness—except for Bernie Madoff’s. He was the slot machine that kept coming up cherries. And I wanted to figure out how he was doing it.
 
During the next few weeks I began modeling his strategy. He claimed that his basket of about 35 securities correlated to the S&P 100. Right from the beginning that made no sense to me, because it meant he had single stock risk. He couldn’t afford for even one of his 35 stocks to go down substantially, because it would kill his returns. So he needed all 35 stocks to go up or at least stay the same. While I knew that in reality it was impossible to successfully pick 35 stocks that would not go down, I accepted the dubious assumption that information from his brokerage dealings allowed him to select the strongest 35 stocks. But because this basket represented about a third of the entire index, there still should have been a strong correlation between his returns and those of the underlying index. When the whole index went up, his stocks would rise; when the index fell, so would his stocks. But that’s not what he was reporting. Whatever the index did, up or down, he returned the same 1 percent per month. In almost seven and one-half years he reported only three down months.
 
Modeling his strategy was complex. It had a lot of moving parts—at least 35 different securities moving at different rates of change—so it required making some simplifying assumptions. For this exercise I assumed he was front-running, using buy and sell information from his brokerage clients to illegally buy and sell securities based on trades he knew he was going to make. That meant that he knew from his order flow what stocks were going to go up, which obviously would have been extremely beneficial when he was picking stocks for his basket. We found out later that several hedge funds believed he was doing this. I created hypothetical baskets using the best-performing stocks and followed his split-strike strategy, selling the call option to generate income and buying the put option for protection. The following week I’d pick another basket. I expected the correlation coefficient—the relationship between Bernie’s returns and the movement of the entire S&P 100—legitimately to be around 50 percent, but it could have been anywhere between 30 percent and 80 percent and I would have accepted it naively. Instead Madoff was coming in at about 6 percent. Six percent! That was impossible. That number was much too low. It meant there was almost no relationship between those stocks and the entire index. I was so startled that the legendary Bernie Madoff was running a hedge fund that supposedly produced these crazy numbers that I didn’t trust my math.
Maybe I’m wrong,
I figured.
Maybe I’m missing something.
 
I asked Neil to check my numbers. If I’d made an obvious mistake, I was confident he would find it. Neil went through my math with the precision of a forensic accountant. If I’d made any mistakes, he decided, he couldn’t find them.
 
By this time I had been working in the financial industry for 13 years and had built up a reasonably large network of people I knew and respected. In this situation I turned to a man named Dan DiBartolomeo, who had been my advanced quant teacher. Dan is the founder of Northfield Information Services, a collection of math whizzes who provide sophisticated analytical and statistical risk management tools to portfolio managers. He’s a super-brilliant mathematician who has probably taught half the quants in Boston and is a lot smarter than Neil or I will ever be.
 
Neil and I went across the street to see him. Dan is an eccentric, a bow-tie-wearing East Coast surfer with a photographic memory who revels in math. I told him that I thought we’d discovered a fraud, that Bernie Madoff was either front-running or running a Ponzi scheme. I could almost see his brain cells perk up when I said that. Every mathematician loves the hunt for the sour numbers in an equation. After going through my work, Dan told us that whatever
Madoof,
as he referred to him, was doing, he was not getting his results from the market. Pointing to the 6 percent correlation and the 45-degree return line, he said, “That doesn’t look like it came from a finance distribution. We don’t have those kinds of charts in finance.” I was right, he agreed. Madoof’s strategy description claimed his returns were market-driven, yet his correlation coefficient was only 6 percent to the market and his performance line certainly wasn’t coming from the stock market. Volatility is a natural part of the market. It moves up and down—and does it every day. Any graphic representation of the market has to reflect that. Yet Madoff’s 45-degree rise represented a market without that volatility. It wasn’t possible.
 
Bernie Madoff was a fraud. And whatever he was actually doing, it was enough to put him in prison.
 
I knew that was true, but it was just so hard to believe. Several months later I showed another manager’s marketing explanation to Leon Gross, at that time the head of equity derivatives research at Citigroup. I don’t think I identified Manager B as Madoff to him; I just asked his opinion about the strategy. Leon is way up there on the smart chart, and 30 seconds after looking at the material he said, “No way. This is a loser. If this is what this guy is really doing, he can’t beat zero. The way this is designed it’s impossible to make money.” He shook his head in dismay. “I can’t believe people are actually investing in this shit. This guy should be in jail.”
 
That might have been the end of it for me. I might have filed a complaint with the Boston office of the Securities and Exchange Commission (SEC), and it would have made great pub conversation: “I’ll bet you didn’t know Bernie Madoff—you know, Madoff Securities—is running some kind of scam,” and it wouldn’t have gone any further. But this was the financial industry, and there was money to be made following Bernie—potentially hundreds of millions of dollars.
BOOK: No One Would Listen: A True Financial Thriller
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