The Wizard of Lies: Bernie Madoff and the Death of Trust (21 page)

As the world celebrated the advent of a new century, Bernie Madoff was riding high. The 1990s had seen an extraordinary surge on Wall Street, including a red-hot rally in Internet technology stocks trading on NASDAQ. The automated OTC system Madoff had helped establish was now the hottest market on the planet. The electronic trading of stocks, which Madoff pioneered in the 1970s, had emerged as a powerful tool for individual investors, who increasingly relied on the financial markets for their retirement security. Legions of “day traders” began playing the market from their home computers, buying and selling stocks and learning that fortunes could be made through puts, calls, shorts, and other gambits once available only to established traders such as Madoff himself.

The democratization of the markets did not lessen the appeal of Bernie Madoff’s investing genius. Yes, fortunes could be made, but they could also be lost, and investors persisted in believing there was a way to lock in high returns without exposing themselves to high risk. When the tech-stock bubble burst in the opening months of 2000, it served to affirm Madoff’s reputation as a safe haven in turbulent times. By now he had established himself as one of the most exclusive, most successful money managers in the business. For some time he had cultivated the impression that new investors simply couldn’t get in—he had all the money he wanted; he wouldn’t even discuss the business with would-be clients. It was akin to winning the lottery if he agreed to add your hedge fund to his coterie of institutional clients. This approach was masterful, of course. It proved that Groucho Marx’s famous rule also worked in reverse: everyone wanted to join the club that wouldn’t let them in.

And the lucky ones who had already gotten in—Avellino & Bienes, Fairfield Greenwich, Cohmad Securities, Stanley Chais, Ezra Merkin, a host of charities and private foundations, an army of offshore hedge funds—did not want to annoy the fussy goose laying all those golden eggs. They had staked their reputations, their money, and their clients’ money on the premise that they could trust Bernie Madoff. They simply ignored or dismissed the quiet cautions and caveats that were starting to seep through the hedge fund community that Madoff’s returns were too consistently good to be credible.

Then, those whispered suspicions became public.

The May 2001 issue of a widely followed hedge fund industry publication called
MARHedge
carried a lengthy article by writer Michael Ocrant disclosing the stunning scale of Madoff’s extremely private money-managing business. Ocrant estimated that Madoff managed more than $6 billion. This actually was far less than he was pretending to manage, but even that sum would have made Madoff one of the largest individual investment advisers in the world, even though the money was ostensibly flowing in through hundreds of other investment advisers.

Ocrant wrote that more than a dozen credible people in the hedge fund world—none identified by name—were mystified by Madoff’s performance. They didn’t doubt the annual returns, but Ocrant observed that such results were “considered somewhat high for the strategy” Madoff claimed to be using. Ocrant reminded readers about Gateway, the small public mutual fund that had pursued a similar “split-strike” strategy since 1978 but “experienced far greater volatility and lower returns during the same period.”

The experts Ocrant consulted “asked why no one has been able to duplicate similar returns using the strategy and why other firms on Wall Street haven’t become aware of the fund and its strategy and traded against it, as has happened so often in other cases.” The article also questioned why Madoff agreed to take only the trading commissions the funds generated, allowing the fund managers to keep the lion’s share of the very hefty fees. His role, his fee structure, his secrecy—it all ran counter to the rules of the hedge fund game as they knew it.

Ocrant acknowledged that “four or five professionals” he interviewed understood the strategy and did not dispute its reported returns—further evidence that Madoff had at least selected a plausible cover story for his fraud, which had likely been in operation for at least a decade by now. But even those professionals doubted that Madoff could be pursuing the strategy the way he claimed, using S&P 100 stocks and options, especially with $6 billion under his management.

In a spontaneous, apparently relaxed after-hours interview with Ocrant at the Lipstick Building offices, Madoff dismissed those doubts, saying that the private funds were a little more volatile than they looked in the monthly and annual returns and that his deep experience and his firm’s trading strength and sophistication fully explained the results.

His trading strength had been affirmed barely a year earlier by some of the biggest names on Wall Street. As computer-driven trading networks multiplied across Wall Street, regulators pushed to eliminate the Big Board’s restrictions on where its members could trade its listed stocks. In anticipation of that liberated future, five brokerage houses banded together in 2000 to invest in a new trading system called Primex. The five were Goldman Sachs, Merrill Lynch, Morgan Stanley, Salomon Smith Barney, and Bernard L. Madoff Investment Securities, which was actually developing the new network. “Never in my wildest dreams did I think I would have partners like these,” Madoff told reporters when the consortium was announced.

Madoff was not arrogant or dismissive with Ocrant. Rather, he was charming and bemused. He took his time, showing Ocrant around the trading floor, easily and confidently discussing his disputed investment strategy, and casually offering plausible-sounding explanations for his success.

“Market timing and stock picking are both important for the strategy to work,” Ocrant wrote, “and to those who express astonishment at the firm’s ability in those areas, Madoff points to long experience, excellent technology that provides superb and low-cost execution capabilities, good proprietary stock and options pricing models, well-established infrastructure, market-making ability and market intelligence derived from the massive amount of order flow it handles every day.” All of this was certainly true—it was what gave Madoff such credibility on the Street; it just had nothing to do with his investment returns.

Madoff explained that he hadn’t set up his own hedge fund or demanded hedge fund fees because he believed his firm should stick to its “core strengths.” This explanation did not satisfy the “expert skeptics” Ocrant consulted. “Most continued to express bewilderment,” he wrote, “and indicated they were still grappling to understand how such results have been achieved for so long.”

The following week, a similarly skeptical view about Bernie Madoff’s money management operation was expressed by another writer, Erin Arvedlund, in
Barron’s
magazine, a mainstream financial publication likely to reach far more investors than Ocrant’s story.

After the two articles appeared, Madoff put aside his usual “take it or leave it” attitude toward his big investors and reached out immediately to reassure his largest feeder funds.

Jeffrey Tucker of Fairfield Greenwich had paid little attention to the Ocrant article and wasn’t rattled at all by the “somewhat critical” article in
Barron’s
. “Much of it I thought was, frankly, just irresponsible journalism,” he said later. But then he got a call from Madoff.

“Are you getting feedback from your clients?” he asked.

“We have some who are concerned,” Tucker answered, adding, “the principal concern I have is that the assets are there.”

“Come up this afternoon,” Madoff said.

When Tucker arrived for this impromptu due-diligence visit, Madoff was ready, thanks to Frank DiPascali’s creative efforts. Besides the phony trade confirmations and account statements that had been generated for more than a decade, he had set up the bogus “trading platform” that made it appear as if actual trades were being conducted with European counterparties, although the reciprocal trader was actually an employee on another computer terminal hidden in a different room. And he had the clincher: apparent proof that all the stocks he claimed to have purchased were safely held in Madoff’s account at Wall Street’s central clearinghouse, the Depository Trust & Clearing Corporation, officially called the DTCC but known informally among veteran traders as “the DTC.”

This was the acid test for DiPascali’s masterpiece, a computer simulation of a live feed from the DTCC. He had taken care to duplicate exactly the clearinghouse’s logo, the page format, the printer font and type sizes, and the paper quality of actual DTCC reports. Of course, these counterfeit DTCC records would always verify that the required number of shares were there in Madoff’s account, safe and sound. Only an authorized call to the DTCC itself would have proven otherwise, and the clearinghouse was careful to keep customer information confidential.

Tucker later told regulators about this pivotal visit with Madoff at the Lipstick Building. The executive office suite, now established on the nineteenth floor, was familiar to him. The computer screen behind Bernie’s sleek desk was accessible, and DiPascali was there with stacks of ledgers and journals.

Far from resenting any implied suspicions, Madoff encouraged Tucker on this occasion to be skeptical, to verify the trading being conducted for the Fairfield Sentry fund. Tucker was shown an official-looking “purchase and sale blotter” showing a record of each trade for his funds. Then he was shown a journal that supposedly contained stock records for the Madoff firm.

“Pick any two stocks,” Madoff said.

Any two? Tucker first picked AOL Time Warner, which he knew was among the Sentry fund’s holdings. Meanwhile, either Frank or Bernie had activated the computer screen, explaining that it would provide a live feed to Madoff’s account at the DTCC.

“They continued to move pages of the screen until they got to the AOL page,” Tucker recalled. In the stock journal, he could see the number of AOL shares that Madoff should have owned for his hedge fund clients; on the screen, he could see the number of shares credited to Madoff by the clearinghouse. The two numbers tallied.

Tucker had never actually seen a live feed from a broker’s DTCC account, as subsequent lawsuits would point out. Even if he had, it is unlikely he could have detected that this one was fake. After all, DiPascali had access to a real DTCC account screen every day—there was one available to the legitimate brokerage firm—and he had taken great pains to ensure that his imitation exactly matched the original.

Madoff encouraged Tucker to pick another stock, but Tucker was satisfied. The shares were there; there was no possibility of fraud. He left reassured that there was nothing to the
Barron’s
article, no reason at all to be concerned.

Even without the tour-de-force demonstration provided to Tucker, most of Madoff’s burgeoning collection of hedge fund clients apparently shrugged off the skeptical articles in May 2001, certain that their trust was justified by Madoff’s character and reputation. One of them, Ezra Merkin, kept a copy of the
Barron’s
article in his files for years but continued to invest hundreds of millions of dollars with Madoff.

Another copy of the
Barron’s
article would also rest for years in the files of the SEC’s Office of Compliance Inspections and Examinations in Washington, D.C. This was the branch of the federal agency responsible for inspecting brokerage firms like Bernie Madoff’s.

The office’s director had sent the clipping to her associate director, with a note on the top saying that Arvedlund was “very good” and that “This is a great exam for us!” But no examination of Madoff’s firm was ordered; apparently, the only action the associate took in response to the article was to file it.

Lack of action had become almost reflexive at the understaffed agency, uncertain of its mandate and unsure of itself. The 1990s had seen morale plummet at the SEC, as Congress passed laws that weakened the regulatory environment for financial firms. One disheartening piece of legislation was the Private Securities Litigation Reform Act of 1995, which made it more difficult for private lawyers to take companies to court over their accounting or management practices. Another came a year later, when Congress broadened the loophole that allowed hedge funds to avoid registration with the SEC. This naturally made it easier and more lucrative to launch a new hedge fund without much regulatory oversight. Thousands of money managers took advantage of this increased leeway.

For years, the quality of the SEC staff had been under relentless pressure, primarily because of tightfisted budgets. The staff turnover rate had climbed so high that it attracted the concerned attention of the General Accounting Office. The turnover rates for SEC lawyers, accountants, and investigators, which averaged 15 percent in 2000, were twice the average rate for comparable government positions. In a 2001 report, the GAO found that a third of the agency’s staff—more than a thousand employees, at least half of them attorneys—left the agency between 1998 and 2000. At the salaries available, it seemed unlikely that those spots would be claimed by anyone but raw recruits. In the years ahead, increasingly creative Wall Street criminals like Bernie Madoff would be policed by increasingly inexperienced and ill-trained SEC investigators. The dishonestly bullish reports that Wall Street analysts had turned out on flimsy technology stocks and the fraudulent accounting used by technology giants such as Enron and WorldCom in the 1990s would ultimately be exposed—but not through the SEC’s efforts or initiatives, and not in time to avoid massive damage to employees and investors. At a congressional hearing in the wake of those scandals, Senator Paul Sarbanes of Maryland would quote an unidentified observer’s assessment of the SEC: “Morale is at its lowest point. This place is a shambles of what it was 10 or 12 years ago.”