22 June 2010

Who Made Madoff?

From Diary of a Very Bad Year

In the fall of 2007, after two Bear Stearns-owned hedge funds trading in subprime debt suddenly went bankrupt, I sat down with a friend of a friend who worked in finance to see if he could explain it to me. That conversation became the first in a series, which we began publishing at n+1. The conversations continued through the crisis and after, following the trajectory of one financier facing the hardest days he’d yet seen. This week HarperPerennial is publishing Diary of a Very Bad Year, the book that resulted from those conversations. We hope it’s a valuable contribution to the growing literature on the crisis. All this week on the site we’ll be featuring excerpts and outtakes from the book. —Keith Gessen

n+1: So the Madoff thing—what was interesting about that?

HFM: The Madoff thing was incredible. What was incredible was that it was one of these situations where kind of everybody knew except the people who needed to know. When the news came across the tape here, the trading day was over, and there weren’t that many people in the office. It said: “Bernie Madoff arrested.” I had never heard of Bernie Madoff, OK? But one of the guys here who is very active in the options world, which is what Bernie Madoff was allegedly trading, as soon as the headline came across—it didn’t say what he was arrested for—he said two things. He said, “I knew it, I knew that guy was a fraud.” And the second thing he said was, “This is going to be huge. This is going to be the biggest thing ever.” So here is a guy who happens to trade options in our office—just seeing the words “Bernie Madoff arrested,” he knew exactly what had happened.

So I immediately went to the guy in our office who does the black-box trading. Because what Bernie Madoff did, it sounded to me a little bit like black-box trading, and I said to him, “Gosh, Bernie Madoff was arrested, if it turns out that his book needs to be unwound tomorrow, is this going to cause big disruptions in our market, should we just turn off our machine?” And that guy, he had also heard of Bernie Madoff, and he said, “No, no, of course not.” I’m like, “Why?” He’s like, “He doesn’t have any book. It was all a Ponzi scheme, I’m sure of it.” So these people had known forever, it was something that people in that world knew—they heard about his returns, and they said, “There’s just no way that anybody has returns that stable.” Doing the strategy that he alleges he was doing, which was what he calls split-strike conversion—which is basically you are buying stock, and selling calls, and buying puts, so it’s sort of like you’re buying stock and your downside is limited by options and your upside is limited by options. It’s quite easy to simulate it, and you can tell that there’s no way that if you just did that mechanically, you could generate the returns that he generated. Of course, to be fair to the people who fell for it, he didn’t say he was doing this all the time. He said, “Sometimes I’m in the market, sometimes I’m out of the market,” his market timing could be the source of the returns, but everybody who’s a professional investor knows there’s no way that somebody would have over that period of time such good market timing ability that he could generate the stability of returns that he did.

So it was quite obvious to professionals that this guy was a fraud. But the source of the fraud, there was some disagreement. Some people said, “Oh it’s just a Ponzi scheme.” Other people said, “No it’s not a Ponzi scheme. Bernie Madoff also runs a market-making operation.” Which means, if you or I put an order at Fidelity to buy stock, Fidelity routes that order to a market maker, Bernie Madoff was one of those market makers, he paid for order flows, so he saw people’s order flows. One thing you worry about, with a market maker, is that market marker will use the information about customer order flow to trade in front of the customers. So, for example, if I say, “I’d like to buy 100 shares of IBM at 100,” and the market maker gets that order, he knows I’m not going to withdraw that order, I’m just leaving that order out there all day, he effectively has an option to sell IBM at 100. Because he can just fill my order. So what he does—illegally—is he goes out there and he buys IBM at, you know, 100 spot 01, and he just waits and hopes that it goes up. If it goes up to 103, he sells it, and then he tells me, “Sorry, your order didn’t get filled.” If, in fact, something bad happens, and IBM trades down to 98, he just fills my order at 100. So he has no downside.

That’s illegal, that’s known as front-running. So some people thought that that’s what Bernie Madoff was really doing, that’s how he generated these returns, it was by front-running. And that’s sort of plausible, that you could make the kinds of returns that he made, if you committed that particular illegal act. But not on 50 billion dollars of capital. You could make those kinds of returns on some small amount of money, or some amount of money that’s proportional to the order flow you’re seeing, but he wasn’t seeing tons and tons of order flow. 

So it was like an open secret, and yet he was still able to raise all this money and evade the scrutiny of the regulators. It was pretty amazing.

n+1: And when we say it’s been huge, what does that mean exactly?

HFM: In other words, the magnitude of the losses would be enormous. It’s funny: The implications for the financial markets is surprisingly small, given the size of the fraud, because there were no stocks, there were no positions, there’s nothing to liquidate, there was nothing there. But there are longer-term implications for the hedge-fund world, because the way that he raised a lot of his money was through fund-of-funds. And many hedge funds, their biggest investors are fund-of-funds. And I think the fund-of-funds model has been very seriously damaged by the Madoff affair. These fund-of-funds charge fees, and the value proposition they offer to investors is, “Look, you’re not a professional investor, you don’t want to spend all your time figuring out which hedge fund to invest in, and monitoring them. We do all that for you. We do tons of due dilligence, we separate the real investors from the flim-flam artists, and we make sure that you’re only invested in the best hedge funds.” Some very high-profile fund-of-funds got stung by Madoff. Now, does it mean that they don’t do any due dilligence? Well, clearly there are some fund-of-funds out there that are pure marketing organizations, and they just have some suave, well-connected people who are able to inspire confidence among the wealthy and separate them from their assets. But many fund-of-funds that do have real due dilligence still got stung by Madoff. And it makes people quesiton the value proposition: “If a number of fund-of-funds were stung by Madoff, what are these fund-of-funds really doing? Forget it, I’m pulling my money from fund-of-funds.” And if that happens, then the fund-of-funds have to pull their money from hedge funds, who had nothing to do with Madoff, Madoff wasn’t even really a hedge fund—the structure that he used — managed accounts — is not even a hedge fund—then it has implications for hedge funds, because a big source of capital for hedge funds is damaged reputationally.

Now, clearly anybody who invested, it was a due dilligence failure of some magnitude or another. But it was probably apparent to a number of them that there was no way Madoff could have generated the returns that he said he was generating merely by doing split-strike conversion. And this gets to the point that: you cannot cheat an honest man. They probably believed that really what was going on, was that he was front-running his order flow. He couldn’t tell you that, but the fund-of-funds must have thought, “Yeah… he’s really generating these returns, not the way he says he is, but I can figure out how he is, and I understand, given what he’s doing, that he can’t really talk about it, but I’m still going to invest, because I want to be part of that scam.” And that’s, in its own way, disappointing.

Image: Bernie Madoff by Yan Pei-Ming at San Francisco Art Institute. 2009. Photo by Steve Rhodes. Creative commons license, via Flickr.

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