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January 7, 2009

How Madoff Did It

By Spear's

It was so simple – that is why he got away with it. Here is how he did it. By Stephen Hill

In the middle of all the mayhem one man in Manhattan came clean that he had been running his own celebrity crunch party. As the end of 2008 approached, the biggest scandal ever inevitably became compulsive viewing on breaking news.

Bernie Madoff, pronounced Made-off, aged 70, had done just that with $50 billion of investors money, but over 48 long years! Madoff who had been chairman of the Nasdaq Exchange in his time, cut a modest figure, short, quietly normal, rather like a small town attorney from Hicksville who is respected by all as an unassuming solid citizen, but with the face of an owl on the prowl.

He had operated a so-called Ponzi scheme: Charles Ponzi was a Sicilian immigrant in the 1920s who carried out a form of pyramid selling scheme, where the last money in to the investment fund goes, not into investments, but as returns to those already invested in the “fund”, so they think they are collecting “income” from their investments, while the Ponzis and Madoffs take the bulk of the receipts for themselves.

This is profitable work if you can get it, just so long as the income keeps rising exponentially and no one finds out what’s really going on, until the economy suddenly worsens unexpectedly and there’s no way back. Madoff paid investors 12% p.a., earning his funds the sobriquet of “the Jewish Bonds”.

The list of those conned could fill several editions of both Hello! and OK! magazines and included fund managers, banks, celebrities, charities and Hedgies, who seem to turn up just about everywhere where there’s a money-party on.

The truly astonishing aspect of the world’s biggest fraud is that none of the professionals and investors had done the slightest Due Diligence on Madoff’s scam operations, run from the seventeenth floor of the curvaceous pink Lipstick Building on Manhattan’s Third at 53rd.

Madoff’s two sons ran his genuine brokerage business on the two floors above and claimed to have no knowledge of their father’s criminal activities on the floor below.

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The international and prestigious Fairfield Greenwich Group, for example, lost $60 million of its directors own money, but took nearly ten times that in fees from its clients whom they had put into Madoff’s private vaults to the tune of $7.3 billion, for some of which they are now being sued.

Many other Funds of Funds sent money Madoff’s way and took their clients fees for managing the money themselves, a bad practice called ‘Pig on Pork’, which will no doubt cause writs to fly.

If any of them had done their DD, they would have found that Madoff’s Compliance Officer was his brother Peter, his Chief Attorney was his niece Shana, whose husband Eric Swanson used to have responsibility for compliance inspections at the SEC, which received a report in 1999 from rival market-maker Harry Markopolos labelling Madoff Securities as “the world’s largest Ponzi scheme” and another in 2005 entitled The World’s Largest Hedge Fund is a Fraud, which were both shelved with no action taken… one would like to know why.

Or why no one knew that Friehling & Horowitz, supposed auditors to this vast pile of now non-existent money, were a two-man team complete with secretary and a dog in a 104 square foot office in Rockland County in upstate New York, and that the elder boss of this fine duo was a 78 year-old retiree sunning himself in Florida, well away from Hurricane Bernie. And Madoff had no recognised US prime broker such as Goldman Sachs or UBS, which is normally the case.

Others whose brokers’ Due Diligence was suspect and their approximate potential losses, subject to any future recoveries, were:

In the US:
Carl Shapiro personally ($400 million) and his charity ($145 million);
Walter Noel of Fairchild and his extended family ($?);
Mort Zuckerman’s, of The New York Daily News, personal charity ($34 million);
Steven Spielberg’s Wunderkinder Foundation ($1.0 million).

In the UK:
Hampshire Pension Fund (£7.1 million);
Naomi Hospice for Children (£6.0 million);
for Arpad Busson’s – that’s Uma Thurman’s fiancé’s – EIM Hedge Fund (£145 million);
HSBC (£653 million);
RBS (£388 million);
Man Group (£235 million);
Merseyside Fund (£2.0 million);
RAB Capital (£5.0 million);
Nicola Horlick’s Bramdean Asset Management (£21 million).

In the EU and Switzerland:
Banco Santander (£2.0 billion);
Union Bancaire Privée (£666 million);
AXA (£235 million);
M&B Capital Advisors’ clients (£140 million);
Medici Bank (£1.3 billion);
L’Oreal heiress Liliane Bettencourt.

How did Madoff pull off the biggest fraud in history, over such a long time? Until the Official Investigation and trials are over, we can only guess, and even that may still leave us guessing as the records might simply not exist and Madoff might get a bout of Ernest Saunders’ Guinnessgate-type post-deal alzheimers.

So here’s a guess as to what may have happened, based on what little facts we know:
> Madoff sets up a small brokerage and works away at it and achieves actual success on a modest basis;
> the business keeps growing nicely and he meets an ever more sophisticated clientele and the brokerage develops a modest fund business before regulation arrived;
> this business slowly moves across into being an unregulated hedge fund;
then disaster strikes during some crisis, and Madoff reckons he can survive by diverting incoming funds into returns;
> to his surprise, it works and no one spots it;
> then he hasn’t got enough money to revert to the proper model and it just develops into a growing Ponzi scheme;
> he needs an investment strategy to justify his returns, so he claims to trade only in large American companies and hedging the exposure by buying options on the S&P 500;
> that, and he only charges $1 for every option trade and just 4 cents for every share traded and the investors just love his returns at these rates, but Madoff needs the new investments coming in rather than the fees;
> then comes Global Crunch, investors want their money back but there’s now no new money coming in;
> so Madoff is making ever increasingly desperate phone calls to his first major investor Carl Shapiro to chase a promised cheque which hasn’t arrived;
> but the game is up!

Meanwhile the old auditor can’t be bothered to flap his wings and head north any more and, anyway, he’s probably too old now to bother too much about it now anyway – he’ll be fried to death by the Florida sun before they unravel all those unaudited non-existent files.

Finally, some money managers hedged their exposure to individual Hedgies via the widely followed Credit Suisse/Tremont Hedge Fund Index, which unfortunately had Madoff in its composition. On restating the Index post-Madoff, the returns of market-neutral funds went from 0.85% positive YTD to a loss of 40%!

At this point it is worth considering another possibility that may well run alongside the story so far.

Madoff did indeed have a pot of blue chip equities, but not nearly as big as it should have been, and sold Call options at say one dollar twenty and hedged this trade by buying Put Options at, say, eighty-five: if the market rose and these options were called, well the portfolio would have risen by the same percentage, while if the portfolio fell, he could exercise his puts and recover his losses, and probably at a profit in either case.

Now let’s make a dramatic assumption, that somewhere during the great bull ride he stopped buying the Puts, in the naïve belief that they were an unnecessary insurance cost, the kind of error a fool or a swindler might easily make, and then the market fell 50% as it did in Q4 2008, and he is caught stranded without any downside protection.

Even this obvious strategy, however, could not have generated returns at anywhere near 1% per month, and may have just been an idea in Madoff’s imagination and not an actuality in the markets, as someone, surely, would have seen that the volumes into Puts and Calls could never have generated these unheard of returns. And then the Ponzi scam fails anyway as there’s hardly any new money coming in.

Well, these scenarios might easily fit some part of the murky picture that has emerged so far…

Truly, the Fund of Hedge Fund management business must now be dead in the water, or possibly the lipstick.

For incisive analysis and comment on the Madoff scandal, click here for our special section.

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