In early 2000, Harry Markopolos, a math whiz and former career soldier in the U.S. army, was employed as an equity derivatives portfolio manager at the Rampart Investment Management Co. in Boston. Tasked with developing a financial product that might compete with Bernie Madoff’s legendary hedge fund, Markopolos examined Madoff’s numbers backwards and forwards, only to conclude the returns Madoff was claiming to get for his investors were quantifiably impossible. When Markopolos’s employers kept pushing him — the implication being that he wasn’t a strong enough mathematician to replicate Madoff’s model — he grew frustrated and took it upon himself to launch an independent investigation into Madoff’s operation with the help of a crack team of financial sleuths. Over a span of eight years, Markopolos lobbied the U.S. Securities Exchange Commission and major news organizations for an investigation into Madoff, presenting them with a steady stream of damning evidence, only to be ignored. By the time Madoff’s scheme collapsed under its own weight in 2008, it was too late. The former Wall Street bigwig had carried out the largest Ponzi scheme in history, defrauding his investors out of $65 billion. Now, Markopolos works full-time investigating fraud and conflicts of interest in Fortune 500 companies. In his newly published memoir, No One Would Listen: A True Financial Thriller, he details his whirlwind eightyear whistle-blowing campaign, which began with a set of numbers that wouldn’t add up.
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%, Bernie returned 14.55%; in 1999 the S&P 500 returned 21.04%, and there was Bernie at 16.69%. 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. Bernie Madoff was among the most powerful and respected men on Wall Street. 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.
During the next few weeks, I began modelling 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. 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. But that’s not what he was reporting. Whatever the index did, up or down, he returned the same 1% per month.
Modelling 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%, but it could have been anywhere between 30% and 80% and I would have accepted it naively. Instead Madoff was coming in at about 6%. Six per cent! 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. I asked my colleague Neil Chelo to check my numbers. 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. 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% 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. Bernie Madoff was a fraud. And whatever he was actually doing, it was enough to put him in prison.
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.
Frank really pushed me to work on the new product. At times, we both got a little testy. He was pretty blunt about it. His deal with Rampart guaranteed him a percentage of the business he brought in, and he had a client who could raise hundreds of millions of dollars if he provided the right product. “C’mon, Harry, I need a product to sell. Rampart needs the product. Let’s just build the frickin’ thing and get it out the door. ”
But each time he asked me if I was making progress, I explained to him that it was impossible to compete with a man who simply made up his numbers. I couldn’t do it. Nobody could. I thought this was a complete waste of my time and did my best to avoid working on it. I had a lot of responsibilities at Rampart. But Dave Fraley kept banging on me hard.
Finally, one afternoon as he walked past my desk I stopped him. “Hey, Dave, you know what? I think I’ve got it figured out. I know how we can duplicate it.” “OK,” Fraley said, sitting down at my desk. “How’s it work?” “Well, actually we have a choice. We can either front-run our order flow or just type in our returns every month. It’s probably a Ponzi scheme, and that’s the only way we can compete with him.” Fraley stood up. “What?” I’d done what they had asked. I’d figured out Madoff’s magic formula, but they didn’t believe me. They thought I was blowing smoke with my accusations.
I was really starting to get pissed off. Neil and I had no doubt that Madoff was running some kind of scam, but at least two of the three principals in the firm and maybe Frank Casey weren’t so sure. My pride was at stake. I knew my math was better than Bernie’s, but even then, even at the very beginning, people just refused to believe me. This was the legendary Bernie Madoff we were talking about. And I was just the slightly eccentric Harry Markopolos.
At that point, I still had no idea how much money Madoff was handling or for how many clients. Nobody did. As we rapidly discovered, that secrecy was key to his success. Because this operation was so secret, everybody thought they were among a select few whose money he had agreed to handle. Madoff had not registered with the SEC as an investment advisory firm or a hedge fund, so he wasn’t regulated. He was simply a guy you gave your money to, to do whatever he wanted to do with it, and in return he handed you a nice profit.
Madoff practically swore his investors to secrecy. He threatened to give them back their money if they talked about him, claiming his success depended on keeping his proprietary strategy secret. Obviously, though, his goal was to keep flying below the radar. Madoff’s clients believed he was exclusive to only a few investors, and that he carefully picked those few for their discretion. When I started speaking with his investors, I discovered that they felt privileged that he had taken their money.
Madoff’s unique structure gave him substantial advantages. As far as we knew at the time, the only entrance to Madoff was through an approved feeder fund. That meant his actual investors couldn’t ask him any questions, and they had to rely completely on their funds—who were being well rewarded—to conduct due diligence. I knew about the world’s biggest hedge funds: George Soros’s Quantum Fund, Julian Robertson’s Tiger Fund, Paul Tudor Jones’s Tudor Fund, Bruce Kovner’s Caxton Associates and Lewis Bacon’s Moore Capital. Everybody did, and we estimated they each managed about $2 billion. So when we started trying to figure out how much money Madoff was running, we were stunned. According to what we were able to piece together, Madoff was running at least $6 billion—or three times the size of the largest known hedge funds. He was the largest hedge fund in the world by far—and most market professionals didn’t even know he existed!
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. I began questioning some of the brokers I worked with on the Chicago Board of Exchange. 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 Bernie Madoff in our conversations. It didn’t surprise me that almost all of them knew about Bernie’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. He was the ultimate mystery man.
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 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 was not a secret on Wall Street. 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 accuratebut 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.
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% to 2% monthly that he was paying in returns, so that payout was simply his cost of obtaining the money.
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. “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.” 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 Casey by the representative of a London-based fund of funds. 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.
None of us—Frank, Neil, or myself—was naive. We had been in the business longenough 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 it wasn’t like everybody else in the business was completely honest and he was the only one cheating. This was just another guy cutting some corners. 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 Bernie 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 co-founder 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.
