The Wizard of Lies: Bernie Madoff and the Death of Trust (22 page)

Just a month before the
Barron’s
article was published, an assistant enforcement director in the SEC’s New York office had received a referral about Madoff that had come from the agency’s Boston office. It was a complex, somewhat arcane complaint from a quantitative analyst who said he had analyzed Madoff’s returns mathematically and was convinced that Madoff was a fraud.

The accusation came from Harry Markopolos, a portfolio manager at Rampart Investment Management in Boston. Markopolos had become interested in Madoff’s returns a few years earlier, when a Rampart executive asked him to investigate why Rampart’s options hedging strategies could not achieve the kind of returns routinely posted by Bernie Madoff. The son of immigrant Greek restaurant owners in Erie, Pennsylvania, Markopolos had earned a bachelor’s degree in business administration from Loyola University of Maryland and a master’s degree in finance from Boston College. Along the way, he worked for his family’s restaurant chain, served in the U.S. Army Reserve, joined a family-affiliated brokerage firm, and worked at a small investment partnership before arriving at Rampart in 1991. By 1996 he had met the rigorous requirements for the chartered financial analyst credential and was active in the Boston Security Analysts Society.

Markopolos was an intelligent, slightly naïve man with a pronounced weakness for hyperbole and crude sexist humor. In his memoir, he reported teasing his future wife by offering to pay for her to get breast implants instead of the two-carat diamond engagement ring she wanted. “That way it’s something we both can enjoy,” he supposedly told her. In the memoir, he wrote, “We settled for a carat and a half.”

Even his friends agreed that he was a little odd. The man who would become his firmest ally in the SEC’s Boston office, the veteran investigator Ed Manion, observed that few people who met Markopolos were indifferent to him. “Either you like him or you don’t like him,” Manion said, adding that he thought Markopolos’s personality “fostered” that reaction. “Sometimes Harry is not too smooth” at handling the “people-to-people stuff,” he observed. Indeed, Markopolos would unashamedly joke that the difference between a male and female SEC staffer was that the female could count to 20 and the male “could count to 21—but only if he takes off his pants.” He added, “That usually irritates the women, until I add, ‘But that assumes that he can find it, and unfortunately at the SEC none of them can actually find it. That’s how clueless they are.’” As this anecdote suggests, he made no secret of his contempt for the market’s senior regulators.

When Markopolos analyzed Madoff’s returns, he found that they did not remotely track the performance of the blue-chip securities Madoff was supposedly buying. He saw no honest reason why Madoff would let his feeder funds reap the huge management fees while he got only the trading commissions. He doubted there were enough index options in the world to hedge a portfolio as big as Madoff’s. And he noticed that Madoff had lost money in only three of the eighty-seven months between January 1993 and March 2000, while the S&P 500 had been down in twenty-eight of those months. “That would be equivalent to a major league baseball player batting .966,” Markopolos noted later. (This analogy would have been less convincing to professional investors than it sounded to laymen. For one thing, the Gateway mutual fund, which pursued a similar strategy, had only fourteen losing months in the same period, so it had a batting average of .839—and even with twenty-eight losing months, the S&P 500 had been batting .678 during those years. These, too, would be implausible-sounding achievements for a baseball player, but both were indisputably the result of legitimate market activity, not fraud.)

Still, Markopolos immediately and accurately concluded that Madoff was cheating somehow—either running a Ponzi scheme or using his knowledge of incoming orders to trade ahead of his customers and thereby benefit from the price changes caused by their transactions, an illegal practice known as front-running. Excited by these findings, he brought them to Manion’s attention. In May 2000, Manion arranged for Markopolos to sit down with Grant Ward, the senior enforcement lawyer in the Boston office.

The meeting did not go well. “Harry tends to lose people,” Manion acknowledged later. Markopolos was a proud quantitative analyst—a “quant” in Wall Street lingo—who unfortunately overestimated his ability to explain things clearly to non-quants. Explaining a complex idea at a whiteboard, Markopolos would draw a circle here, then an arrow pointing to another circle there, then a third arrow pointing to yet another circle somewhere else. Manion described the experience as one of expanding mystification, adding: “And Harry would say: See, there it is, you know. And you look at the stuff and say, well, I don’t see it.”

At the meeting with Ward, Markopolos and Manion could tell that Ward’s eyes had glazed over before Markopolos had gotten past the first “exhibit” point in his analysis of Madoff’s returns. It probably did not help that Ward was just months away from leaving the agency for a job in private practice, but, to be fair, the opening point was an eye-crossing tangle of market jargon and mathematical terms that began like this:

For a non-quant like Grant Ward—indeed, for most regulatory attorneys—this might as well have been ancient Sanskrit.

Ward later assured a frustrated Ed Manion that he had sent the Madoff tip to the SEC’s office in New York for follow-up. But there is no public evidence that he ever did—and an official investigation would later conclude that he had not. When asked about it, Ward said he had no recollection of the meeting with Markopolos at all, although the official report concluded that this, too, was untrue.

For the next year, Markopolos continued to track Madoff’s statistically impossible success. In a note to Manion, he said, “These numbers really are too good to be true. And every time I’ve thought a company’s or a manager’s numbers were ‘too good to be true,’ there has been fraud involved.”

With Manion’s encouragement, Markopolos prepared an updated report on Madoff for a new Boston enforcement chief. This time, on April 3, 2001, Markopolos’s analysis was actually sent to the New York office, where it was referred to an assistant regional enforcement director, who was a competent and well-respected lawyer. A day later, she sent her supervisor an e-mail saying that she had reviewed the Madoff complaint but didn’t think it warranted further investigation. “I don’t think we should pursue this matter further,” she wrote dismissively.

Reading the Markopolos document years later, she was mystified by her decision, which she said she did not even remember making. “My impressions are that this is a document that I probably would have needed to consult somebody about,” she said. “I hope I consulted somebody. I honestly don’t remember.” She added, “I also would have thought that the author of this document was odd, to say the least. But I hope that would not have led me to dismiss this—but I just don’t recall.”

The terrorist attacks of September 11, 2001, shoved the nation’s attention away from the stock market and any possible SEC investigations and diverted the media’s attention away from the obvious follow-up stories suggested by the Ocrant and
Barron’s
articles and the persistent Wall Street whispers about Bernie Madoff. In fact, the New York staff of FINRA, the Financial Industry Regulatory Authority, was forced to evacuate its Wall Street offices after the attacks on the World Trade Center, and its legal staff took refuge in Madoff’s Midtown offices. When the stock market reopened on September 17, Bernard L. Madoff Investment Securities was standing ready with the rest of Wall Street, posting bids, taking orders, fighting back.

As the stock market gradually recovered and Americans tried to adjust to a new perception of world affairs, the hedge fund party that was helping to fuel Madoff’s fraud resumed in full force. The dollars entrusted to largely unregulated hedge fund managers increased by more than a third between 2001 and 2003. Institutional investors were adding hedge funds to their portfolios, drawn by profits that far outstripped those available in the public mutual fund world and sustained by the faith that they could accurately assess the increased risks that invariably accompanied these higher returns.

While hedge funds ostensibly remained off-limits to all but the rich and sophisticated, the perception that middle-income Americans “deserved” the right to share in their high returns, already given credence in some corners of academia, was gaining traction among policymakers and regulators. Little was said about whether middle-income investors had the same risk-assessment skills as their institutional counterparts—or, indeed, if the institutional investors were as good at weighing risks as they thought they were. It would not be long before ordinary working Americans would catch the hedge fund bug and seize the opportunity to send their money, directly or indirectly, to a hedge fund doing business with Bernie Madoff.

One way for middle-class investors to get into the hedge fund world was through something called a “fund of hedge funds,” a financial instrument that made its debut in the U.S. market in the summer of 2002. It was a concept borrowed from the mutual fund industry of the 1960s. Back then, investors could buy shares in a “fund of mutual funds,” paying a double dose of fees for the privilege of having someone else assemble a portfolio of top-performing funds. A fund of hedge funds was the same idea, dressed in Armani. Smaller investors could put as little as $25,000 into the publicly offered fund, whose managers would pass it along to a stable of promising private hedge funds. (Even that modest minimum was self-imposed; legally, these were mutual funds, which were not required by law to set a minimum investment.)

“Funds of hedge funds raise special concerns because they permit investors to invest indirectly in the very hedge funds in which they likely may not invest directly due to the legal restrictions,” SEC chairman William H. Donaldson said in congressional testimony in April 2003. They may not have been able to invest directly because the law allowed hedge funds to accept only “accredited investors,” those who had at least $1 million in net worth. By 2003, however, an increasing number of middle-income American families were meeting that requirement. Housing values were high and still climbing, giving many families substantial amounts of equity in their homes, and their IRAs and 401(k) retirement plans had been around long enough to have accumulated substantial assets. As a result, millions of Americans became potential hedge fund customers.

Indeed, a growing number of them had already moved their “self-directed” IRAs into the hands of Bernie Madoff. A self-directed IRA was typically one that contained investments other than the traditional (and traditionally regulated) stocks, bonds, and mutual funds. These alternatives ranged from commodities to real estate but prominently included hedge funds. Once the savers made their own investment choices, the tax code required them to use a support firm, called an IRA custodian, to follow the account holders’ directions, make the investment purchases, and do the administrative work. An early Madoff investor in Florida found a small firm called Retirement Accounts Inc. that would administer the IRA he had invested with Avellino & Bienes, despite the fact that the accountants’ loose operation was not registered, provided no prospectus, and maintained minimal records.

Word spread, and in time Retirement Accounts Inc. was the administrator for hundreds of self-directed IRAs invested with Madoff. After several takeovers and mergers, it became a unit of Fiserv Inc., a giant financial services company. By 2008 it would be handling roughly eight hundred self-directed IRAs invested with Madoff, the value of which was said to exceed $1 billion.

Another way for middle-income Americans to gain a stake in hedge funds and other private, lightly regulated investments—and, therefore, get a chance to fall into Bernie Madoff’s trap—was through their work-place pension funds.

For some years, giant public and corporate pension funds had been putting tiny fractions of their assets into “alternative investments,” including hedge funds. By 2003 countless smaller pension plans also were investing in these higher-risk “alternatives”—indeed, dozens of them were already investing in Bernie Madoff.

As early as 1989, six small labor unions in upstate New York had started investing pension assets with Madoff through an investment advisory firm on Long Island called Ivy Asset Management. The founders of Ivy had been introduced to Madoff in 1987 by one of their own clients, and they maintained a relationship with him for more than a decade. Other fledgling financial advisers were soon investing their pension fund clients’ money with Madoff through Ivy, which collected substantial fees in exchange for its advice and due-diligence examinations. Some new limited partnerships were formed solely to invest with Madoff via the Ivy firm, and a number of pension funds were attracted to their steady, reliable returns.