Paranoia helped prompt Madoff probe
The whistleblower who exposed Bernie Madoff’s Ponzi scheme investigated his suspicions in part due to paranoia.
Harry Markopolos is the guy who blew the whistle on Bernie Madoff’s Ponzi scheme.
Harry wasn’t an auditor. He was a financial competitor, an analyst tasked by his firm with matching or beating Madoff’s achievements.
After modelling every imaginable scenario, including retrospective selection of the best actual results, Markopolos still could not approximate what Madoff was doing. So without setting foot in Madoff’s firm and without observing any fraudulent transactions, he knew that what was reported was impossible.
Further, the consistency of the results, even if such a result was possible in the short term, was impossible. Markets are volatile. No one can have 12 flawless months let alone years of consistently excellent results. When the whole market tanks, if you are still producing positive results there has to be fraud.
Markopolos, along with David Fisher, tells the story in the book No One Would Listen: A True Financial Thriller.
Because Markopolos was a competitor, and to be honest because he was a bit paranoid, and because the Securities Exchange Commission (SEC), the agency established after the Great Depression to protect the public, was blindingly inept, no one acted.
After five neglected warnings to the SEC from Harry across nine years, Madoff, with the Ponzi scheme collapsing around him because of its size and the pressures of the global economic crisis, handed himself in, reporting the biggest fraud in history.
Harry hadn’t just identified a possibility or even probability; he had nailed it as fraud. Like Sherlock Holmes in the Silver Blaze story, when the fact that the guard dog that didn’t bark in the night was a clue to an inside job, Harry had shown that there was no footprint of trades to match what Madoff was doing. In fact Madoff wasn’t doing anything but taking in money and feeding it back to earlier investors. No footprint, no one on the other side, therefore a hollow fund.
And how could it go unnoticed for so long? Human nature being what it is, Ponzi schemes have happened before Madoff and will surely happen again.
Smart guys on Wall Street thought they knew what Madoff was doing. One hypothesis was that Madoff had propriety software, a black box that had all his data and all his maths and experience and it could beat the market. So who was his mathematician-magician? There was no one. We all know how demanding economic or business models are and anyone who has built one knows how bad they are, sometimes good for the macro results but hopeless for micro and always hopeless with timing.
Another hypothesis was that Madoff was “front running”, taking an order from a client, buying it himself and then re-selling to the client and taking a profit on the way. This is of course insider trading and illegal but such is the tolerance for corruption in market trading in Wall Street that this lesser offence was taken as a credible explanation, blinding critics from the reality that there was a Ponzi scheme running.
Typically a Ponzi scheme has a relativity short life. Funds come in. The rewards are excellent. This attracts more investors. All the investors take their dividends but don’t seek their capital back (why would they?) and often plough back their dividends as well. They tell their friends who also invest to get this too-good-to-be-true result. And one day the financial genius is gone and so too the victims’ funds.
It’s typically an unsophisticated investor who gets duped into investing in a Ponzi scheme. It’s inconceivable that an investment fund, having done due diligence, could be caught. In fact one of Harry’s friends offered to put $50m into a trust account for Madoff to work his magic on. The fund manager would see the trades, rather than handing over the funds in blind faith. Madoff walked away. So did they, but no market alert was issued.
No matter how delusional Madoff might have been, even a moderate intelligence can foretell that if the return to investors is so much higher (1–2% per month) than the real earnings of the scheme (in this case nothing) and the cost of operating are more than trivial, then within a few monthly cycles, perhaps as few as five, surely no more than 10, the capital will be used and the scheme collapse.
In Madoff’s case the fraud lasted for almost 20 years, fuelled by unprecedented growth, investor greed and investors being prepared to be part of something a bit dodgy such as insider trading, but never thinking that someone they so much admired could be duping them.
Most investors were individuals, but others were investments funds in the USA and Europe. They each thought that they had a special personal relationship with Madoff and were accessing something not available to the public. They were the chosen ones, onto a good thing that was a secret and wasn’t to be talked about.
What about the auditors? Madoff changed them regularly, including big names, and took them along for the ride. Several times a year he cashed out, moving to Treasury bills for ease of audit and valuation. Harry’s observation on this was that it also meant that Madoff wasn’t even in the market for the full year, how could he possibly achieve brilliant results. And why would you cash up just to make life easy for an auditor? No one else does.
Surely though there is more to an audit than verifying the existence and ownership of assets at balance day. What about testing the reliability of the income and testing the internal controls on the trades. There is an element of stock and flow in such a business and audit testing both is surely fundamental.
Both auditors and analysts failed. When Markopolos first spotted the Ponzi scheme there was $7 billion in it. Nine years later at the crash there was $65 billion. He now kicks himself for having been ineffective and as I read his warnings it seemed to me that he did contribute to the problem by losing focus, by lecturing on the “red flags”, all 30 of them, instead of simply stating that the results could not be replicated ex post and that there was no footprint of trades.
What was going on in Madoff’s head when he started, a desire to defraud for personal gain or just vanity, thinking that he was too smart to be caught? Once started, every day must have been loaded with stress thinking is today the day it all comes tumbling down. Madoff did a lot of damage.
As of April 2011 the trustee liquidating Madoff’s defunct investment firm has recovered $7.6 billion and charged fees of $175.5 million for the work involved.
December 2011
- By John Gill FCA.