“That idiot from Barron’s…”
That’s how Bernie Madoff – the recently deceased psychotic mastermind behind the world’s biggest and most infamous Ponzi scheme – referred to my friend Erin Arvedlund.
That insult, though, is a badge of honor… Madoff – whose body count ultimately amounted to more than 40,000 ripped-off investors who were deceived into thinking they’d accrued $65 billion in profits over more than 40 years – knew Erin was on to him.
In May 2001 – a little less than eight years before Madoff’s insanely simple and deviously smart scheme was exposed and he was sentenced to 150 years in prison – Erin wrote an article for weekly finance and investment newspaper Barron’s that questioned Madoff’s practices and returns. It was the first time in a widely distributed forum that anyone had dared to question a man who – it’s easy to forget now – had for years been a prince of Wall Street.
Erin later wrote Too Good to Be True: The Rise and Fall of Bernie Madoff, the definitive book about Bernie Madoff. She’s appeared on CNBC, Bloomberg Television, Fox Business News, C-SPAN, and National Public Radio, and presented her insight to asset management firms, law schools, and others.
I met Erin in the late 1990s, when she was a reporter at the Moscow Times in Russia and I was a stock analyst at a local investment bank. We’d often swap gossip about Russian markets, stocks, and politics.
Erin later went on to write for the Wall Street Journal, the New York Times, and TheStreet.com. Today, she’s a personal finance and investing reporter and columnist at the Philadelphia Inquirer.
When Madoff died in prison on April 14 at age 82 of kidney disease, I spoke with Erin about why Madoff did it, how being a journalist in Russia helped her, whether it could happen again, and what we can learn from it all.
How Did Madoff’s Scam Work?
A Ponzi scheme, also known as a pyramid scheme, pays earlier “investors” with funds contributed by more recent victims. As it grows in scope and size, a Ponzi scheme requires ever-greater volumes of cash to continue – so that earlier investors, as well as later ones, can all be paid. Madoff started his scheme in the late 1960s, so over time he had a lot of people to pay off.
The cover for Madoff’s Ponzi scheme was that he was running a hedge fund – and, by all appearances, an extraordinarily successful one, which returned between around 10% and 12% every year, regardless of market conditions. (Madoff’s main business – see below – was a successful, and legitimate, share brokerage.)
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In a world of bubbles, where what-started-as-a-joke Dogecoin is now up nearly 17,000% this year so far, that might not sound like much. But low volatility – that is, minimal swings in performance – and very respectable long-term double-digit returns are the purple unicorn dancing on a rainbow of the asset-management world… It’s an impossible fantasy beyond achievement.
“One of the biggest red flags was the consistent performance,” Erin told me. “It was totally unaffected by market conditions.” Madoff’s fund posted down months – which, of course, weren’t down months at all, since there was no actual trading going on – only an absurdly tiny 4% of the time.
Who Was Ripped Off?
The otherworldly performance of Madoff’s fund was like crack cocaine to the marketing and distribution agents, private bankers, and brokers who were unwitting partners to Madoff’s scheme.
His investors spanned the grandest names in old-money Europe… from supposedly savvy bankers at UBS and Merrill Lynch to charities and pension funds… They all fed the Madoff Ponzi maw.
His most important partner was the Fairfield Greenwich Group, a tony marketing agent whose principals took home hundreds of millions of dollars from funneling money to Madoff.
Madoff spared no one, as Erin wrote…
For decades, Madoff looked his investors in the eye with a smile, shook their hands, and never showed any indication – let alone remorse – that he was robbing them blind. He fooled his closest friends and family, as well as hundreds of university endowments, charities, and pension funds; he stole people’s hard-earned savings, their futures, and their dreams…
Steven Spielberg, Zsa Zsa Gabor, John Malkovich, and Larry King were among the higher-profile victims of Madoff’s scam. The owner of the New York Mets lost hundreds of millions of dollars, and two years later announced plans to sell a stake in the team. Jim Simons of Renaissance Technologies, one of the world’s most successful (real) hedge funds, recommended Madoff to a university endowment.
Most of Madoff’s victims, though, were people who were well-off but by no means rich… and who suffered life-altering wealth destruction when Madoff’s scheme collapsed.
What Madoff Said He Was Doing
Madoff discouraged investors in his fund from talking about it, and he avoided any kind of publicity for it. This was part of his “velvet rope” approach, as Erin calls it – to create the impression of exclusivity, in order to heighten the appeal of getting access to his fund. Madoff even sometimes turned money away – figuring that over the longer term he’d wind up attracting a lot more investors by making them want in all the more.
When pushed to discuss the fund’s strategy – and as disclosed in offering memorandums at the time – Madoff said that he used a “split-strike conversion strategy” that involved “buying stocks in the Standard & Poor’s 100 index and buying and selling options against those same index stocks,” Erin wrote in Too Good to Be True.
This explanation had the benefit of causing non-finance types, whose eyes tend to glaze over at the first whisper of investment jargon, to tune out because it sounds complicated and confusing. And when Madoff was pressed – as Erin did – he hid behind the shield of “proprietary”: In other words, it’s my secret sauce – think McDonald’s Big Mac special sauce dressing or the recipe for Coca Cola – and I don’t have to tell you, so bug off.
Of course, the reality was that for over 45 years, Madoff’s fund (a total misnomer) didn’t make a single trade. “[Madoff] was simply taking investors’ money, depositing the money into his Chase Bank in Manhattan – account number 140081703 – and sending it back out to earlier investors,” Erin reported. (One of the many extraordinary regulatory cracks that Madoff somehow managed to slip through was that Chase Bank never asked questions about a bank account – the entire Madoff Ponzi operation was all run through a single account – that saw tens of billions of dollars pass through it.)
An Unlikely Fraudster
In the aftermath, it’s easy to forget that for years, Madoff was a Wall Street star. With his brother Peter, Madoff set up a pioneering electronic-trading brokerage. He pushed Nasdaq into the forefront of share trading (and was chairman of the exchange in the early 1990s).
He laid the groundwork for the instantaneous trading that we know today. Madoff paid customers to attract their orders – also called payment for order flow – a practice that was revolutionary at the time but became commonplace. At its peak, Madoff’s brokerage house accounted for as much as 10% of total New York Stock Exchange share trading volume.
“Madoff helped create the modern market structure,” Erin told me. “He could have had that as his legacy. But at the same time, he was building a huge fraud.”
Thanks to his ahead-of-its-time work on Wall Street, Madoff was on Securities Exchange Commission (SEC, the market regulator) regulatory committees. Madoff “kept his enemies close,” Erin said.
In a public forum in 2007, Madoff said (there’s an actual video of this): “In today’s regulatory environment, it’s virtually impossible to violate the rules. It’s impossible for a violation to go undetected, certainly not for a considerable period of time.”
Only he knew how wrong he was.
Moscow and Madoff
Erin developed a unique skill set for plumbing the murky depths of Bernie Madoff by covering markets and companies in Russia in the 1990s…
In Russia back then… lots of companies kept multiple sets of books, depending on who they were showing them to. They’d understate income for tax purposes – and overstate them for borrowing purposes. At that time, in the former Soviet Union, there was little data available and almost no transparency, from the government or from companies.
(Needless to say, this was also a big challenge for me as a stock analyst.)
The level of non-transparency – that is, stonewalling investors, fund distributors, regulators, journalists, and anyone else who asked questions – in Madoff’s scheme was one of its biggest red flags. So Erin had a lot of practice in finding information a different way. “Instead of getting through the front door, a lot of times I had to go in the side door,” she told me.
Are Ponzi Schemes Still Happening?
To butcher the opening line of Leo Tolstoy’s Anna Karenina: Good investments are all alike, but every fraudulent investment commits thievery in its own way.
As a Madoff scholar, Erin knows something about pyramid schemes and what they look like. “These kinds of Ponzi schemes will continue to happen,” she told me. “They won’t be on the same scale, though. And no two frauds are ever the same, either.”
One of the ways Madoff was able to get away with his fraud was that at the time, funds could hold custody of shares themselves… There was no requirement for a third party to hold actual ownership of shares. Partly in response to the Madoff fraud, that was changed.
It’s not unusual for regulators – after the fact – to tighten the rules in response to someone who found, and exploited, a loophole or gap in the rules. The SEC emerged from the Madoff scandal looking as competent as the Three Stooges with a hangover.
After the dust settled, an SEC inspector general report of the commission’s failure to uncover Madoff said…
Between June 1992 and December 2008 when Madoff confessed, the SEC received six substantive complaints that raised significant red flags concerning Madoff’s hedge fund operations and should have led to questions about whether Madoff was actually engaged in trading. Finally, the SEC was also aware of two articles regarding Madoff’s investment operations that appeared in reputable publications in 2001 and questioned Madoff’s unusually consistent returns.
And a decade and a half later, the SEC is still only just noticing that the barn door is open well after the horse has bolted. “I’m guessing that after Archegos, we’ll see regulation on equity swaps,” Erin told me. (As I wrote last month, Archegos was a big family office and hedge fund that caused investment banks to post losses upwards of $10 billion.) Those new rules – like those implemented after the Madoff meltdown – won’t help the banks (and their shareholders) that lost billions of dollars.
Finance doesn’t have a monopoly on fraud, either. Blood-testing startup Theranos, founded in 2003 by Elizabeth Holmes, was kind of a “medical Madoff.” Theranos reached a private market valuation as high as $9 billion, but the entire underlying idea – technology that required only a small pinprick of blood to run a range of medical tests – was completely bogus.
The similarities with Madoff are startling. “Holmes used jargon and fuzzy language. She offered no transparency at all,” and hid behind the claim of “proprietary” ideas, Erin told me. Like Madoff, Holmes had powerful backers – Oracle founder Larry Ellison and legendary venture capitalist Tim Draper were among the investors in the company. Holmes took investors on the condition – also similar to Madoff – that they not ask too many questions.
Investing is similar to science, in that a result is only worth something if it’s able to be replicated. If a scientific experiment can be repeated – multiple times by multiple people – it’s a lot more likely to be correct. And it can be used as the basis of something much bigger. But if no one can derive the same results, using the same inputs and process? That’s called a fluke.
And Madoff’s investment results were simply mathematically impossible. “There were those who suspected Madoff’s magic was just an illusion. Among Wall Street option traders, the conventional wisdom was that Madoff’s strategy could not be replicated by anyone in the marketplace – at least not so it generated the double-digit returns he claimed,” Erin wrote. That red flag derailed Theranos, while Madoff got away with it for years.
Lessons From Madoff
“Anyone can be a swindler,” Erin told me. Madoff was a market innovator and enjoyed enormous (honest) success. He had a Rolodex beyond compare… and enjoyed immense credibility among market participants and regulators.
If someone like that can be a “financial serial killer,” as Erin describes him… well, couldn’t anyone? Madoff was the investment equivalent of the auto mechanic who glances under your car hood, then declares that he’ll need to fix your car’s lower piston’s bipolar tricuspid and replace the dynamic wipe tank’s sparker wrapper.
Ask questions. No one likes to feel dumb. By shutting down questions about his (nonexistent) investment strategy with the claim that “it’s proprietary,” Madoff was the investment equivalent of the auto mechanic who glances under your car hood, then declares that he’ll need to fix your car’s lower piston’s bipolar tricuspid and replace the dynamic wipe tank’s sparker wrapper. Rather than display your ignorance, you fork over $2,000 and hope he’s not bluffing.
One of the ways that Madoff got away with his Ponzi for so long is the people who were supposed to ask questions – and get the answers – simply didn’t. Madoff created a paper trail of trades that were never made… And no one on Wall Street could ever recall doing a trade with the Madoff fund, despite the fact that, based on its size and its alleged investment strategy, it would have been an enormous player in the options market.
Similarly, visitors to Madoff’s offices were shown the buzzing brokerage floor rather than the quiet Ponzi scheme offices. Investors in Madoff’s funds assumed that everyone else had done their homework about Madoff… and the fact that Madoff was a Wall Street star (and that the vendors of his funds were profiting so handsomely from their relationship with him) meant that anyone inclined to ask questions was encouraged to look away.
Not everyone is driven by money. Feeder funds, bankers, and glad-handing door-openers of every shape and size fell over themselves to market Madoff’s fund because of the unusual fee structure. He didn’t charge a hedge-fund-standard 2% management fee – which allowed distributors of his fund to collect enormous commissions. (In 2008 alone, fund distributor Fairfield Greenwich collected fees of an incredible $1.2 billion.) Every year, Madoff left tens of millions of dollars on the table.
Of course, Madoff wasn’t wanting. He traveled extensively, schmoozed with the rich and famous, and lived in an $8 million penthouse in the swanky Upper East Side 60s of New York’s Manhattan. In 1986, a finance magazine listed Madoff as one of the 100 best-paid Wall Streeters, estimating his compensation that year at $6 million (that’s equivalent to nearly $15 million today).
But he could have been far wealthier, by many orders of magnitude… meaning plain-vanilla greed wasn’t his motivation. So, why?
It’s a question that still puzzles Erin. She thinks that it’s mostly simply because he could. “He enjoyed getting one over on people,” Erin told me. “And he was getting away with it.”
In Madoff’s office was a telling sign: His prized piece of artwork was a replica of a 1976 four-foot sculpture of a screw, called “Soft Screw,” by Swedish-born sculptor Claes Oldenburg (it’s in the National Gallery of Art collection, though it’s not displayed).
It would be comforting, in a way, if there were some evidence that Madoff had a chip – in this case it would be an entire tree trunk, considering the extent of his “revenge” – on his shoulder. The armchair psychologist could get some satisfaction – and reassurance – if Madoff had grown up poor, or bullied, or from a broken home. Then, there would be something to point to… some underlying cause, no matter how tenuous, that would at least seem to partly explain Madoff’s ruthlessness and his inhumanity.
But there isn’t… And it’s more disturbing that Madoff seems to have been motivated by just… well, nothing in particular.
Hail the whistleblower. Accountant Harry Markopolos, who worked for a rival hedge fund, tried to understand how Madoff could post such strong returns so consistently. When he couldn’t, he made multiple detailed filings to the SEC, alleging that Madoff was either running a Ponzi scheme or cheating his brokerage clients to benefit his hedge fund (the November 2005 submission, for example, itemized 29 red flags).
The SEC, incredibly, ignored Markopolos… repeatedly.
One of the reforms implemented by the SEC in the wake of the Madoff scandal was a whistleblower program, which protects whistleblowers from retaliation and pays awards to whistleblowers based on the size of the fraud uncovered. If this had existed at the time, it wouldn’t necessarily have changed the SEC’s non-response to Markopolos – but it was at least a positive change to improve the odds of uncovering fraud sooner.
Subsequently, Markopolos in August 2019 – perhaps with his eyes on the whistleblower prize – alleged that General Electric (GE) was committing nearly $40 billion in fraud relating in part to its insurance business. So far, no charges have been filed against GE… but, as Markopolos learned from his Madoff experience, fraud can be a long game.
Follow your gut – when it tells you not to invest. There are entire chapters of behavioral finance books dedicated to the downfalls of investing with your emotions. “I have a feeling this stock is going to go up” is right up there with “This time it’s different” and “She said she isn’t angry” in the hall of fame of stupid things we choose to believe on the basis of what our gut, rather than hard logic, tells us.
But the flip side of that indicator – something that our gut tells us doesn’t feel right – is worth listening to. An alley that looks a bit too dark… a potato salad that may have been out in the sun a bit too long… or an investment record that looks a bit too good to be true… even if it’s based on nothing more than a gut feeling, listen to your tingling Spidey sense.
“Some folks knew better,” Erin told me. Salomon Brothers, one of the top Wall Street brokerages during the Madoff era, as well as Goldman Sachs, didn’t do business with him. For her 2001 Barron’s article, Erin talked with a number of well-placed Wall Street players who sensed that something was awry. And the fact that Madoff’s fund was using a two-person accounting firm to audit its books – rather than a brand-name accountancy that delivers automatic credibility – should have set off alarm bells.
Market corrections show who’s swimming naked. In late 2008, markets were tumbling as the global economic crisis kicked into gear. Investors scrambled to sell anything they could… including their Madoff fund holdings. By its nature, a Ponzi scheme constantly needs new money coming in the door… and if there’s too much flowing out, well, that’s a problem. Madoff gave himself up when he knew he wouldn’t be able to meet redemptions.
But if not for the market collapse then, Madoff’s fund could have continued… indefinitely.
If something seems too good to be true… A 2006 Fortune magazine article described Bill Miller as “one of the greatest investors of our time.” The $20 billion mutual fund that Miller managed had outperformed the S&P 500 Index for 15 straight years, a feat never before accomplished.
But then mean reversion reared its ugly head. The next five years – the magazine-cover curse at work – Miller’s fund lost over 30%. Fund research firm Morningstar ranked Miller’s fund dead last among the 1,187 similar U.S. equity funds it tracked over the period.
The thing is, Miller didn’t change his investment strategy. His investment team didn’t change. Markets didn’t go haywire. The boring reality is probably that Miller’s luck simply ran out… and his performance reverted to the mean.
But unlike Miller, who was honest and lucky (for a while), Madoff never – ever – experienced even a single down year at all since, well, he wasn’t investing.
That’s not good luck… It’s too good to be true.