Wall Street Knew Madoff was a Fraud

In Harry Markopolos’ new book, “No One Would Listen: A True Financial Thriller,” he writes about how he and his investigative team uncovered Bernard Madoff’s $65 billion Ponzi scheme years before it fell apart. 

Markopolos, then a quantitative analyst (a “quant” as he calls himself) for Rampart Investment Management Company in Boston, Mass., writes how he slid into the investigation after Frank Casey, a marketing representative, asked Markopolos to “reverse engineer” Madoff’s strategy so they could market a product that would deliver similar returns. 

Markopolos writes that when Casey handed him copies of the revenue stream in 1999, “I knew immediately the numbers made no sense. … At the bottom of the page a chart of his 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.’"  

In May 2000, he gave evidence against Madoff to the Securities and Exchange Commission, but the SEC never satisfactorily investigated the scheme.  

“Five times I reported my concerns [to the SEC], and no one would listen until it was far too late.” 

In this excerpt, Markopolos writes how he, Casey, and Neil Chelo, another Rampart quant, began chasing Madoff. (Michael Ockrant, an investigative reporter, later joined the team.) 

There was no logical explanation for what we had discovered. It was like going out for a nice stroll and discovering the Grand Canyon. It was just so hard to believe. Neil and I didn’t have faith in the numbers, we didn’t believe in the numbers, we knew that numbers can’t lie. If our math was correct – the 6 percent correlation to the market (the relationship between Madoff’s returns and the movement of the entire Standard & Poor 100), the steady 45-degree return, the number of options Madoff would have to own to carry out his strategy – (and we continually checked our math) the largest hedge fund in history appeared to be a complete fraud.

We never actually initiated an investigation. We never discussed it. Suddenly we were in the middle of it. We had no specific objectives; we just wanted to figure out what was going on.

We started by gathering as much information as possible about Madoff’s operation. Frank, meanwhile, was continuing to meet with potential clients. Generally in those meetings the portfolio managers would outline their investment strategy and Frank would probe, looking for an opportunity. Among the managers he met with during this period was the Broyhill All-Weather Fund, a hedge fund of funds.

In 1980, the Broyhill family had sold its South Carolina furniture manufacturing business and established an investment fund. As the manager of that fund, Paul H. Broyhill, pointed out, “It’s a whole lot easier to make money when you’re not losing it.” Frank met several times with Broyhill representatives in the lobby of a New York hotel. They showed Frank their product, which they explained was steadily producing 1 percent a month, and they asked Frank if he could find a bank to guarantee it. As it turned out, the fund depended basically on two managers the Broyhill representatives would identify only as Manager A and Manager B. They handed Frank a promotional pamphlet and a single page showing Manager B’s returns.

Frank took one look at it and knew it was Madoff. Either this was an amazing coincidence and Frank had chanced upon two of the few funds investing in Madoff, or Madoff was much larger than we had imagined. We began to wonder how far into the industry his tentacles extended.

This material was the first solid evidence we had found. As soon as Frank handed it to me, I began breaking it down. “The manager’s investment objective is long-term growth on a consistent basis with low volatility,” Broyhill’s fund description began. It explained that the fund utilized “a strategy often referred to as a ‘split-strike conversion,’” which meant purchasing a basket of stocks with a high degree of correlation to the general market.  Madoff’s subtle – but unspoken – message was that he had access to trade flow information because clients were buying and selling through his brokerage, so he knew what stocks were going up. Well, I had already proven that was false. But then it continued, “To provide the desired hedge the manager then sells out of the money OEX index call options and buys out of the money OEX index put options. The amount of calls that are sold and puts that are bought represent a dollar amount equal to the basket of shares purchased.”

Well, that was interesting. Like many people, Neil and I had been actively trading OEX options, but we had stopped and substituted S&P 500 options in the mid-1990s when these options, called the SPX, came to dominate the market and the S&P 100 OEX index options fell by the wayside. We were trading large numbers of option contracts, as much as 30,000 options at one pop. When you do trades like that, it shows up in the market. Bloomberg reports how many contracts are traded and at what price, where the market was when the trade hit the floor, and where it was after the fact. All the details are there. And the market responds. You can’t do trades of that size and not be noticed.

If Madoff actually was purchasing these options, we would have seen the footprints of his trades. At the volume he had to be trading to produce the results he claimed, his trades should have been reflected in the market activity. But there was no sign of his presence in the market. He supposedly got in and got out, bought and sold, without leaving a trace. But then I began doing the math. I knew that there was in existence a total of $9 billion of OEX index put options on the Chicago Board Options Exchange (CBOE).

Madoff claimed to be hedging his investment with short-term (meaning 30 days or less) options. You can realistically purchase only $1 billion of these, and at various times Madoff needed $3 billion to $65 billion of these options to protect his investments – far more than existed. This was a breathtaking discovery. There simply weren’t enough options in the entire universe for him to be doing what he claimed he was doing. If that wasn’t sufficient proof, then assuming that those options actually existed, the cost of purchasing those puts would eat up the profits he was claiming.

I also knew that he wasn’t buying them in the over-the-counter (OTC) market. That would have been prohibitively expensive, and if he had bought them there those dealers would have laid off their risk in the listed markets, and that would have shown up. It hadn’t; he wasn’t buying them there.

The explanation in Broyhill’s marketing literature failed on so many levels. Broyhill’s Manager B, Madoff, claimed to be selling call options on individual stocks, which capped his potential profit. That meant that the best-performing stocks in his basket of 35 would be called away; he’d lose the stocks that were going up, leaving him with stocks that didn’t rise significantly, stayed at about the same level, or declined. As I pointed out one day to Neil, “You know, this is the only strategy I’ve ever seen that actually penalizes you for picking great stocks.”

Rampart had run similar strategies, although we never took the single stock risks that Madoff claimed to take. We would buy the entire index, all the stocks, and what we had discovered over time was that this strategy gave us about two-thirds of the market’s return with one-third the risk. It was a successful strategy – until the market really began rising. If the market went up more than 15 percent, for example, we would miss much or most of all returns above that.

In the 1990s, when the market went up as much as 30 percent (or more) in a year, we actually would lose customers, who complained, “The market was up 34 percent this year, and you were up only 22 percent.” They didn’t want to hear about protection; they wanted everything the market provided. I knew that Madoff would have run into a similar problem especially if his insider knowledge did allow him to buy the best-performing stocks.

Until this time, which was about two months after we had encountered Madoff, the only people I had discussed him with outside Rampart were Dan DiBartolomeo (founder of Northfield Information Services), Leon Gross (head of equity derivatives research at CitiGroup), a few other people whose opinions I valued, and my brother Louie, who was an over-the-counter block trader working for a firm in Miami. He knew the hedge fund world and had access to a lot of promotional material. He had agreed with me from the beginning that something was wrong with Madoff and immediately began contributing marketing literature to our growing pile.

The fortunate thing was that at that point we didn’t know enough to be scared. It never occurred to us that we were going to be stepping on some potentially very dangerous toes. So at the beginning, at least, I didn’t hesitate to ask people I knew throughout the industry about Madoff. After examining the Broyhill materials, for example, I began questioning some of the brokers I worked with on the CBOE. A lot of these guys were longtime phone friends; I did business with them regularly and had gotten to know them on that level. I began bringing up Madoff in our conversations. It didn’t surprise me that almost all of them knew about Madoff’s brokerage arm but knew nothing about his secretive asset management firm.

I asked numerous traders if they had ever seen his volume, and they all responded negatively. But a few people who were aware he was running a hedge fund asked us if we could give them his contact information. Everyone wanted to do business with him. But nobody admitted they were doing business with him. It was as if he had walked through Times Square naked in the middle of a summer afternoon and no one admitted seeing him. He was the ultimate mystery man.

My motive to continue this investigation was basically self-defense. My bosses had continued to pressure me to mirror Madoff so we could pick off some of that business. I knew it was impossible to compete with someone making up his own numbers, and I just wanted to get rid of the pressure. I wanted the intellectual satisfaction of proving to my bosses that they were wrong.

I certainly didn’t think of myself as a detective. I didn’t own a trench coat like Lieutenant Columbo, I had no physical handicap to overcome like Ironsides, and instead of a talking car to help me like Michael Knight had in the television show, “Knight Rider,” I had Neil and Frank. The only weapons we had were our knowledge of the numbers and our Rolodexes.

What I did have in addition, though, was my experience in a purloined fish case (my first fraud investigation catching thieves at the 12 Arthur Treacher’s Fish and Chips restaurants owned by my dad and two uncles) and very good military training. I had served 17 years as a commissioned officer in the Army’s reserve components, seven of those years in a special operations unit as a member of a civil affairs team. I had also served for many years under Major General Boyd Cook as he worked his way up the chain of command from the rank of colonel. In civilian life he was a Maryland dairy farmer, and I learned a lot from him.

General Cook didn’t tolerate fools, and he forced his officers to stretch themselves. He would ask his officers to describe their biggest failures. If you didn’t have a big enough failure, he would fire you for not having tried hard enough; his theory was that if you hadn’t failed big, then you couldn’t achieve bigger. As a result of that philosophy we had a high-performing unit because we were continually trying new things. Not all of them worked, but those that did achieved significant objectives. Oddly, I remember pleasing him one year with a failure, although I can’t remember specifically what it was. But he loved the fact that I took a chance, I hadn’t backed down, and at least I tried something new.

General Cook had a low tolerance for bullshit. He always wanted to know the bad news, not the good news, and he knew that he could determine the quality of his officers not by speaking with them, but rather by questioning the troops they commanded. Among the many things I learned from my military career that would prove invaluable during this investigation were persistence, human-based information-gathering techniques, interviewing skills, and the ability to maintain my composure.

We began by snooping. There are basically three ways to collect information in the financial industry. First, you can collect the publicly available information, including promotional literature, the pitchbooks firms distribute to create business, and everything on their Web sites. I took everything off Madoff ’s Web site, although there wasn’t much of value. Second, you can buy data from numerous sources that will provide you with whatever type of esoteric information you want. Everyone has access to this information. And third, as I’d taught Neil, you can get the truly vital information by talking to people, by listening carefully to the rumors and the gossip, the boasting, and the complaining.

We took all three routes. Once we started working with Access International Advisors, which was a large feeder fund to Madoff, we got a complete look at all its data. Frank Casey would collect material from his prospects, telling them, “I’m interested in placing money with Madoff,” and if we wanted something specific from a fund, my brother Louie would call and explain, “I’ve got a client who’s interested in getting into Madoff. Can you help me?”

Talking to Wall Street people was extremely informative. Most of these people I was talking with during the normal course of Rampart business, but whenever I had an opportunity I would ask a few questions about Madoff. I spoke with the heads of research, traders on derivatives desks, portfolio managers, and investors. Neil was doing the same thing, and both of us were doing it secretly, because if our bosses found out about it they would have demanded that we stop.

Probably what surprised me most was how many people knew Madoff was a fraud. Years later, after his surrender, the question most often asked would be: How could so many smart people not have known? How could he have fooled the brightest people in the business for so long? The answer, as I found out rather quickly, was that he didn’t. The fact that there was something strange going on with Bernie Madoff’s operation wasn’t a secret on Wall Street. As soon as I started asking questions, I discovered that people had been questioning Madoff’s claims for a long time; but even those people who had questioned his strategy had accepted his nonsensical explanations – as long as the returns kept rolling in.

The response I heard most often from people at the funds was that his returns were accurate – but he was generating them illegally from front-running. By paying for order flow for his broker-dealer firm, he had unique access to market information. He knew what stocks were going to move up, and that enabled him to fill his basket with them at a low price and then resell them to his brokerage clients at a higher price.

Several people confided in me that they didn’t really know what he was doing, then point out that no one else on Wall Street had access to the quality of information he had, and no one generated the consistent returns he did. When those two facts were considered together, it seemed to make a strong argument that he was using his customer order flow to subsidize his hedge fund. Neil, who had done some analysis of payment for order flow when studying for his master’s in finance, believed it could truly provide Madoff an edge – but certainly not enough of an edge to generate the types of returns he was delivering.

There were at least some people who told Neil and me, confidentially of course, that Madoff was using the hedge fund as a vehicle for borrowing money from investors. According to these people, Madoff was making substantially more on his trading than the 1 percent to 2 percent monthly that he was paying in returns, so that payout was simply his cost of obtaining the money. These were sophisticated financial people. When I heard something like this, I just shook my head and wondered if they actually believed what they were saying. There was no reason Madoff would have to pay 12 percent interest – there were many other ways he could have gotten money at a lower cost. The only sensible explanation for this scenario was that he couldn’t risk having one of the rating agencies – Moody’s Investors Service or Standard & Poor’s, for example – come in and look at his operation.

Some of the explanations I heard bordered on the incredible. These were sophisticated guys who knew they had a great thing going and wanted it to keep going. They were smart enough to see the potholes, so they had to invent some preposterous explanation to fill them. They knew, for example, that a split-strike strategy can’t produce a profit in all market environments, so they had to explain how Madoff always returned a profit.

“Here’s what I think it is, Harry,” a portfolio manager told me. “He’s really smart. It’s really important to him that he show his investors low volatility to keep them happy, so what he does when the market is down is he subsidizes them.” In other words, in those months when Madoff’s fund loses money, he absorbs the loss and continues to return a profit to the investors. “He can afford to eat the losses.” This explanation positioned Madoff as the greatest investment manager in the history of Wall Street. He made it impossible for the investor to lose.

Neil admitted to me once that this wasn’t an investment strategy that had ever been discussed at Bentley College, his alma mater. When we heard some of these explanations we’d just look at each other and laugh. There was no other sane way of responding. Not only did these people refuse to look behind the curtain, but they granted the wizard even greater powers than he personally claimed.

Apparently Madoff also had the ability to time the market perfectly. He said he invested in the market only six to eight times a year and even then for only brief periods of time ranging from a few days to maybe three weeks, tops. Fortunately, he had the ability to invest only when the market was going up. I had noticed in his return stream that the market had declined rapidly in July and December 1999. When I asked one of his investors to explain to me how he could have avoided a loss those months, I was told, “He wasn’t in the market. He goes 100 percent cash when he thinks it’s going to fall.” He had proof of that, this man told me. He had copies of Madoff’s trade tickets.

But of all the stories I heard those first few weeks, the one that probably shocked Neil and me the most was told to Frank by the representative of a London-based fund of funds. The majority of people we spoke with actually hadn’t invested with Madoff. Those people didn’t want to talk about it; they didn’t have Madoff, that’s all. No explanation. But a trader at one of Wall Street’s largest firms told me that Madoff had been up there trying to interest them in investing, but they’d turned him down when he refused to let them conduct the necessary due diligence. They wanted to conduct a standard financial investigation to make certain he was legitimate and had been turned down. That’s the brightest warning signal of all.

Due diligence can take many different forms. The object is to make sure the numbers are real. It can include everything from a complete audit of records, which involves matching trading tickets to exchange – reported time, price, and quantity for each trade, to extensive background checks on the fund managers. Conducting a thorough due diligence can take several months and cost more than $100,000. But when you’re investing hundreds of millions of dollars, it isn’t the time to try to save a few bucks.

A London-based hedge fund of funds told Frank a similar story. It was handling a substantial amount of Arab oil money, and before investing with Madoff it had asked his permission to hire one of the Big Six accounting firms to verify his performance. Madoff refused, saying that the only person allowed to see the secret sauce, to audit his books, was his brother-in-law’s accounting firm. Actually, we heard this from multiple sources. The fact is that Madoff’s accountant for 17 years, beginning in 1992, was David Friehling, who definitely was not his brother-in-law.

Friehling operated out of a small storefront office in the upstate New York town of New City. It seems likely that Madoff claimed he was a relative because it was the only plausible reason he could think of to explain why a sophisticated multibillion-dollar hedge fund would use a two-person storefront operation in a small town as its auditor. Brother-in-law or not, this certainly should have been a major stop sign. Even a marginally competent fund manager should have said, “Thank you very much, Mr. Madoff, but no thanks,” and run as fast as possible in the other direction. But this fund of funds didn’t. Instead, this firm, which had been entrusted by investors with hundreds of millions of dollars, handed Bernie Madoff $200 million. The firm knew enough to ask to see how the machine worked, but after it had been turned down flat, it still handed over $200 million.

None of us – Frank, Neil, or myself – was naive. We had been in the business long enough to see the corners cut, the dishonesty, and the legal financial scams. But I think even we were surprised at the excuses really smart people made for Bernie. The fact that seemingly sophisticated investors would give Madoff hundreds of millions of dollars after he refused to allow them to conduct ordinary due diligence was a tribute to either greed or stupidity.

The feeder funds – funds that basically raised money for a larger master fund -– knew. They knew as much as they wanted to know. They knew they could make money with him; they knew that if they kept their money with him for six years they basically would double their original investment, so they were betting against the clock. And he wasn’t that unusual.

It wasn’t like everybody else in the business was completely honest and he was the only one cheating. They all knew how much of Wall Street’s business was done in the shade. This was just another guy cutting some corners. They must have been assuming he was illegally front-running his brokerage arm’s order flows, but they accepted it because Madoff was their crook. And he was a crook they knew they could trust. It was a great deal; they were reaping the benefits of this financial theft without having any of the risk.

My guess, and this is just a guess, is they assumed that even if Madoff got caught, their ill-gotten profits would end but their money was safe. How could it not be safe? Bernie Madoff was a respected businessman, a respected philanthropist, a respected political donor, a self-proclaimed cofounder of NASDAQ, and a great man.

We were beginning to see him as he really was: a monster preying on others; a master con artist.

Unfortunately, we were only at the beginning of our investigation. We couldn’t even imagine how much of that we would encounter in the next eight years.

Excerpted with permission from the publisher, John Wiley & Sons, from “No One Would Listen,” by Harry Markopolos. Copyright © 2010 by Fox Hounds, LLC

Vindicated After Madoff is Arrested 

By Harry Markopolos, CFE, CFA

On the morning of Dec. 11, 2008, a New York real estate developer on a JetBlue flight from New York to Los Angeles was watching CNBC on the small seat-back television. A crawl across the bottom of the screen reported that Bernard Madoff, a legendary Wall Street figure and the former chairman of NASDAQ had been arrested for running the largest Ponzi scheme in history. The developer sat silently for several seconds, absorbing that news. No, that couldn’t be right, he thought, but the message streamed across the screen again. Turning to his wife, he said that he knew that she wasn’t going to believe what he was about to tell her, but apparently Bernie Madoff was a crook and the millions of dollars that they had invested with him were lost. He was right – she didn’t believe him. Instead, she waved off the thought. “That’s not possible,” she said, and returned to the magazine she was reading.

The stunned developer stood up and walked to the rear of the plane, where the flight attendants had gathered in the galley. “Excuse me,” he said politely, “but I’m going to be leaving now. So would you please open the door for me? And don’t worry – I won’t need a parachute. ”

At about 5:15 that December afternoon, I was at the local dojo in my small New England town watching my 5-year-old twin boys trying to master the basic movements of karate. It had been a gloomy day. Rain continued intermittently, and there was a storm in the air. I noticed there were several voice mails on my cell phone. That’s curious, I thought; I hadn’t felt it vibrate. I stepped into the foyer to retrieve the messages.

The first one was from a good friend named Dave Henry, who was managing a considerable amount of money as chief investment officer of DKH Investments in Boston. “Harry,” his message said clearly, “Madoff is in federal custody for running a Ponzi scheme. He’s under arrest in New York. Call me.” My heart started racing. The second message was also from a close friend, Andre Mehta, a “super-quant” (a quantitative analyst) who is a managing director of alternative investments at Cambridge Associates, a consultant to pension plans and endowments. I could hear the excitement in Andre’s voice as he said, “You were right. The news is hitting. Madoff’s under arrest. It looks like he was running a huge Ponzi scheme. It’s all over Bloomberg. Call me and I’ll read it to you. Congratulations.”

I was staggered. For several years I’d been living under a death sentence, terrified that my pursuit of Madoff would put my family and me in jeopardy. Billions of dollars were at stake, and apparently some of that money belonged to the Russian mafia and the drug cartels – people who would kill to protect their investments. And I knew all about Peter Scannell, a Boston whistle-blower who had been beaten nearly to death with a brick simply for complaining about a million-dollar market-timing scam. So I wouldn’t start my car without first checking under the chassis and in the wheel wells. At night I walked away from shadows and I slept with a loaded gun nearby; and suddenly, instantly and unexpectedly, it was over. Finally, it was over. They’d gotten Madoff. I raised my fist high in the air and screamed to myself, “Yes!” My family was safe. Then I collapsed over a wooden railing. I had to grab hold of it to prevent myself from falling. I could barely breathe. In less time than the snap of my fingers I had gone from being supercharged with energy to being completely drained.

The first thing I wanted to do was return those calls. I needed to know every detail. It was only when I tried to punch in the numbers that I discovered how badly my hand was shaking. I called Dave back, and he told me that the media was reporting that Bernie Madoff had confessed to his two sons that his multibillion-dollar investment firm was a complete fraud. There were no investments, he had told them; there never had been. Instead, for more than two decades, he had been running the largest Ponzi scheme in history. His sons had immediately informed the Federal Bureau of Investigation (FBI), and agents had shown up at Madoff’s apartment early that morning and they’d taken him out in handcuffs. It looked like many thousands of people had lost billions of dollars. It was exactly as I had warned the government of the United States approximately $55 billion earlier.

And as I stood in the lobby of that dojo, my sense of relief was replaced by a new concern. The piles of documents I had in my possession would destroy reputations, end careers, and perhaps even bring down the entire Securities and Exchange Commission, the government’s Wall Street watchdog – unless, of course, the government got to those documents before I could get them published. I grabbed my kids and raced home.

The Association of Certified Fraud Examiners assumes sole copyright of any article published on www.Fraud-Magazine.com or ACFE.com. Permission of the publisher is required before an article can be copied or reproduced.