Save No One Would Listen

This is a sensational story about the largest Ponzi scheme ever facilitated by the most incompetent financial regulator: the SEC. Congress is currently undertaking financial reform. But, Markopolos warns regulations are only as good as the regulators.

The best way to read this book is to start with Appendix B where Markopolos makes his case to the SEC and explains clearly why Bernie Madoff (BM) is running a Ponzi scheme. Next, move on to Attachment 1: that shows the unreal 15 year investment track record of Fairfield Sentry, a large feeder fund that invested all its assets with BM. Thus, Fairfield Sentry's disclosure is a perfectly transparent window on BM's claimed performance. Next, move on to Appendix A to read the excellent article by Michael Ocrant written in 2001. It is one of the first public article that raises worrisome questions about BM. Ocrant will become a member of Markopolos four-man investigative team. After reading this material at the end of the book, you will have an insider understanding of this Ponzi scheme.

Markopolos uncovering this Ponzi scheme boils down to two basic concepts. BM virtually never experienced any material losses. To do that he had to buy Puts very close to being in the money. Those would be financed by selling Calls also close to being in the money. As a result, Markopolos knew he could only earn T-Bills like returns instead of the15% per year before fees. The second impossibility is that BM funds required option positions that were at all times a lot greater than the entire volume outstanding S&P 100 index options he claimed he used. That is just not possible.

Markopolos investigation has a clear motivation. The manager of the Rampart hedge fund where he worked puts relentless pressure on Markopolos to come up with a competing product to BM. No matter how often Markopolos tells his boss, you can't compete against fake numbers the latter orders Markopolos to come up with a competing product anyway. Tired of this situation, Markopolos decides to uncover Madoff.

No one would listen to Markopolos. Besides the SEC, he shared his findings with The Wall Street Journal, Forbes, and Eliot Spitzer, the former NY Attorney General. They all did not listen to his stuff. In the case of Spitzer, Markopolos suspected it may be because Spitzer invested in the BM funds. Yet, all the U.S. investment banks did not touch BM because they all understood he was running a Ponzi scheme. If among the outsiders no one would listen... among the insiders no one would speak up. Markopolos was determined to change that. He quits his job at Rampart and becomes a full time fraud investigator in 2004.

The SEC just won't listen to Markopolos. Markopolos fully informed the SEC about Madoff's Ponzi scheme in 1999, 2000, 2001, 2005, and 2007. The SEC would have to just obtain records of Madoff trades and confirm those were fictitious to arrest him. But, the SEC did only one meaningless investigation in 2006 where they just requested Madoff to register as an investment advisor. Only the financial crisis brought Madoff down. In December 2008, Madoff investors requested $8 billion in redemption that he could not meet. He confessed to his family the whole thing was a Ponzi scheme. And, his sons turned him in to authorities. The FBI arrested Bernie Madoff. The SEC made no difference.

Markopolos states the SEC has the wrong set of skills. SEC staffers are lawyers instead of financial experts. Thus, in our complex world the SEC is not equipped to protect investors. Markopolos makes 13 recommendations on how to restructure the SEC and its governing the securities industries. Some of those include replacing lawyers with financial experts, increase pay scale to attract top talent, overhaul the SEC examination process, relocate the SEC headquarter from Washington DC to New York where the expertise is, and develop a whistle blower program similar to the ones of the IRS and DOJ. It all makes good sense.

Markopolos takes down the SEC hierarchy. After Bernie Madoff was caught, Markopolos makes a Congressional testimonial that is devastating to the SEC. He demonstrates the SEC incompetence and illicit cooperation with the industry it is deemed to regulate. Within days of his Congressional hearing many of the senior SEC executives resign. Within less than five months they are all gone. And, their replacements conduct an honest internal investigation of why they did not listen to Markopolos. They interview Markopolos at length.

Why did Bernie Madoff's Ponzi scheme succeeded for so long? It is because he offered everyone a deal to good to pass up.

For investors, he offered irresistible returns. Over the period 1990 to 2005 described in Attachment 1, BM funds earned 10.93% per year net of fees and beat the S&P 500. More importantly, BM funds bore only 24% of the risk of the S&P 500 with a standard deviation of only 4.24% vs 17.88% for the S&P 500. Gateway fund that used a strategy most similar to the BM funds earned only 4.54% per year over the same period hardly beating T-Bills at 4.15%. And, Gateway's risk was still a bit higher than BM funds at 5.13%. The Efficient Market Hypothesis dictates that higher returns are associated with higher risk. But, BM funds combination of high returns with impossibly low risk were so far above the Efficient Frontier as to be unreal. But, his investors decided to believe in BM's superior market timing, black box model, and even his front-running instead of deducing the obvious: this could only be a Ponzi scheme.

For investment managers, he offered an irresistible deal. The standard hedge fund charges 1% of assets and 20% of yearly returns. The feeder funds that diversify over several hedge funds usually tag on very small fees on top of the hedge funds very high fees. But, Bernie Madoff gave away the entire 1%/20% fee to the feeder funds. Thus, feeder funds were making as much with BM as if they were the original hedge fund! The feeder funds fees represented a fat 4% of assets. This indicated that BM returns before fees had to be a staggering 15% over the long term. Indeed, 15% times (1 - 20%) - 1% = 11% or BM return net of fees.

Investors losses were massive. Since 1991, David Sheehan, chief counsel of the trusteeship that resolved the BM affairs, gathered that investors invested about $36 billion. The $36 billion invested at different times rose to $65 billion in funny money by December 2008. Of the original $36 billion, investors got back $18 billion (or half). Remember in a Ponzi scheme not all funds are wiped out. The later investors repay the earlier investors in the fund.

So how much did the SEC failure cost investors? If the SEC had acted upon Markopolos first investigation in 1999, at that point BM had about $5 billion under management. Assuming investors would have received back close to half that amount in redemption as they did later, the loss to investors would have been $2.5 billion or only 1/7th the loss they incurred a decade later.

Markopolos finds out fraud is prevalent. As a fraud investigators he uncovers 20 market-timing frauds. That's when an investment fund buys international stocks after the U.S. market has ran up and closed but before the international market has opened and captured the upcoming rise in price. He reports those 20 cases to the SEC. They don't act on any of them. Markopolos also indicates front-running is rampant. That's where a broker/dealer places his own order just before the ones of his clients to benefit from the upcoming pick up in prices. Markopolos has also investigated pharmaceutical and other medical frauds exploiting the Medicare fund. He says Big Pharma makes Wall Street look good. Hopefully, the health care and financial reforms will curb those abuses.Get more detail about No One Would Listen.