Book Excerpt: Investigating Bernie Madoff
In 1999, local financial analyst Harry Markopolos was asked to figure out how Wall Street titan Bernard Madoff managed to achieve his spectacular investment returns. After concluding it was impossible — that Madoff was a fraud — Markopolos reported his findings to the SEC. Over the next nine years, Markopolos would warn the SEC four more times, to no avail. As this exclusive excerpt from Markopolos’s new book details, the audacity of Madoff’s scheme was matched only by the SEC’s unwillingness to investigate it.
During the next few weeks I began modeling his strategy. Madoff claimed that his basket of securities correlated to the S&P 100. Right from the beginning that made no sense, because it meant that he couldn’t afford for even one of his stocks to go down substantially; it would kill his returns. He needed all his stocks to go up or at least stay the same. But it is impossible to pick 35 stocks that won’t go down. Even after I accepted the dubious notion that Madoff’s brokerage dealings allowed him to select the strongest stocks, there still should have been a correlation between his returns and those of the index. But that’s not what he was reporting. Whatever the index did — up or down — he returned the same 1 percent per month.
I was so startled by the numbers that I didn’t trust my math. Maybe I’m wrong, I thought. By then I had been working in the industry for 13 years, and I had built up a reasonably large network of people I could go to for help. I turned to a man named Dan diBartolomeo, a brilliant mathematician who is the president and founder of Northfield Information Services in Boston. After going through my work, Dan confirmed my conclusions: Whatever Madoff was doing, he wasn’t getting his results from the market. Later, I showed Madoff’s numbers to Leon Gross, at that time the global head of equity-derivatives research at Citigroup. Thirty seconds after looking at the material, Gross said, “No way. This is a loser.”
What surprised me most when I talked to Wall Street people was how many of them knew Madoff was a fraud. Years later, the question most often asked would be: How could so many smart people not have known? The answer was that they did know. People had been questioning Madoff’s claims for a long time, but even those who questioned his strategy often accepted his explanations — as long as the returns kept rolling in.
I had no doubt that Madoff was running a multibillion-dollar scam, but the question that Neil Chelo (a Rampart portfolio manager), Frank, and I continued to debate was: What kind of scheme was it? There were several reasons I believed it was a Ponzi scheme. (We found out quickly that Madoff was continually on the prowl for new money; by definition a Ponzi scheme requires a continuous flow of new investors to pay old ones.) Frank disagreed. He was certain Madoff was front-running — illegally taking advantage of his position as a market maker to know how certain stocks would move. Neil was ambivalent, but when pressed he leaned toward front-running. Why would Bernie Madoff risk everything in his life to steal money he didn’t need?
That might have been the end of it for me, but my bosses began pushing me hard to deconstruct Madoff’s strategy so that Rampart could market a product that would deliver similar returns. “Can’t you develop something that we could run at Rampart that would compete against Madoff?” Frank asked me.
Creating a financial product wasn’t the problem — it was creating a product that could compete with a Ponzi scheme. And in the spring of 2000, my anger over the situation led me to the SEC. Bernie Madoff was my competition. He was playing on my field, and I knew he was a dirty player. I decided it was time to go to the referee and get him thrown out of the game.