No One Would Listen: A True Financial Thriller (18 page)

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Authors: Harry Markopolos

BOOK: No One Would Listen: A True Financial Thriller
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Rampart and Access moved the trader to Boston. But the more time Frank spent with him, the less he liked him. I think his precise words were: “This guy is an arrogant son of a bitch with an ugly personality.” And Rampart was about to place a sizable aspect of its business in his hands—without giving Neil and myself a legitimate chance to review the nuts and bolts of the strategy.
 
Nobody on Wall Street has ever let a poor personality stand in the way of profit, but Frank just didn’t trust this guy. So he decided to conduct his own investigation. This trader had shown up at a dinner one night wearing an Olympic team jacket. When Frank asked him about it, the trader revealed that he had sailed with legendary star class yachtsman Paul Cayard on the Olympic squad. Well, to a man who loves sailing like Frank does, that was impressive—even if he didn’t quite believe it. When he began his investigation he contacted the Olympic sailing committee. They had never heard of the trader, although they suggested he might have been a volunteer worker. But he was never a member of any Olympic team.
 
Frank remembered a conversation they’d had about bike racing. Hanging in the trader’s office was an impressive photograph of him racing around a track wearing an aerodynamic helmet. When Frank asked about it, the trader claimed that he’d won a Masters race—a racing division for competitors over 30 years old. So Frank called the Bicycling Hall of Fame in Newport, Rhode Island. After some research they reported that the trader had indeed competed in a Masters race—but he hadn’t placed.
 
Now Frank had caught him in two lies. He reported that to two principals at Rampart. Remember, this is the financial industry; they didn’t care if his nose grew every time he opened his mouth, as long as his product could generate profits.
 
In fact, the management at Rampart basically considered Frank, Neil, and me the wet blankets, pessimists always trying to stomp on their best ideas.
 
To Frank’s credit, he continued to try to stop them from making this deal. He told Thierry about his discoveries. Thierry then had his own compliance manager investigate—and when he found nothing negative about the trader on the Internet he reported that he was clean. Thierry then asked the trader and Frank to submit handwriting samples for Access’s graphologist in France to examine. Both men did, and both men passed.
 
But Thierry also hired a well-known private detective to conduct an in-depth investigation. And he discovered that this trader had been convicted of interstate wire fraud, had worn a wire in an FBI sting operation, and was still on probation and not supposed to be traveling outside the state of California to places like Boston, for example.
 
Thierry, Rampart management, and Frank confronted the trader. He admitted that he had been convicted, but claimed he had fallen on his sword to protect his employees. In fact, what he was doing was taking licensed software, duplicating it, and selling it retail. He was fired before he walked out of the room—but he challenged Access and Rampart to sue him. Both companies decided the negative publicity wouldn’t be worth the potential recovery, so the trader walked away with more than $100,000.
 
Neil and I remained curious about his strategy, though. We continued talking about it, trying to find the fallacy in it. We explained it roughly to a lot of brokers, each of whom had an opinion about it. Some of them did think it would work. But a broker whom I consider one of the best options traders in the world, Jeff Fritz at Oxford Trading Associates, finally put it in perspective, telling us, “Yeah, maybe he can do that once or twice, but after you screw the market maker a few times he’s not gonna bend over and take it again. People learn pretty quickly when they lose money.” That made sense to us. You can’t continually fleece someone and expect them to continue picking up the other side of the trade. And when you’ve got no trading partner, you’re done.
 
Several months later, though, when Frank learned that a Chicago options firm was about to make the same mistake, he called and told them to contact the private eye. They purchased a copy of the original report—and ended negotiations with the trader.
 
But for Frank, the damage to his relationship with Rampart’s management was irreparable. Who knows if they were more upset that he had brought in this trader or that he had discovered the fraud. It didn’t matter; it was pretty obvious that Frank was on his way out. Frank’s anger was directed almost exclusively at the trader. He decided to leave Rampart before management had a chance to make that decision. It wasn’t a big deal, as few people in the financial industry stay at one firm for their career. It’s a very fluid industry, with tremendous movement, and for Frank it was just time to make his next move.
 
It was also obvious that I needed to give them a product to replace the trader’s scheme. Rampart and Access were now working together, and both companies needed something to sell. Financial products aren’t like big-screen TVs; you can’t just pull a big one off the shelf and deliver it. Every new financial product has to be tailored specifically to accomplish certain goals to fit a narrow set of market realities. What Rampart needed was a low-risk product that delivered high returns with low volatility.
 
Who didn’t?
 
Finally, I accepted the challenge. They wanted me to create an option-based product that returned 1 or 2 percent a month. I’d had a lot of experience running these types of option-sensitive products. It took several months of playing with numbers to fulfill those parameters. Neil, of course, was a major contributor, and I got a lot of data from various major firms. From Citigroup for example, I got the complete S&P 500 price return histories from 1926 to the day I received it. Then I began putting things in, taking things out, testing and retesting and back-testing to see how each package would perform in various market environments.
 
I did this knowing full well that Bernie hadn’t bothered to do any of this. He just sat down and made it up. It’s considerably easier that way—and you always get the results you want!
 
Eventually I developed a product we named the Rampart Options Statistical Arbitrage. It was a product that would do extremely well in a market environment with low to moderately high volatility. As long as the market didn’t move more than 8 to 10 percent over a 10- to 15-day trading period, it would perform very well.
 
Of course, if there was extremely high volatility or if the market did make a substantial move in either direction over that period, it was possible to lose about 50 percent of its value.
 
To mitigate the risk, we had to be able to transition quickly from short volatility to long volatility to stem our losses, and doing that successfully required having a strategy in place. Whatever the market did, we had to have a prepackaged plan thought out well in advance. For every action the market took we had to have a counteraction already in place, because there would be no time to think when the inevitable occurred.
 
Obviously, that was impossible because there is an infinite number of things the market can do. So I prepared several basic strategies that would cover as many different scenarios as we could imagine. I tested these scenarios against historical markets going back to 1926. The worst-case scenario for this product was a period from 1929 through the early 1930s, but that was also the worst period for almost everything else in the market. Almost all of the trading plans I developed for these positions were based on market moves in the 1930s, because there was tremendous volatility during that decade. So for several months I was living in the past trying to figure out how to prevent losses in the future.
 
Admittedly, it wasn’t the greatest financial product ever created on Wall Street. In October 2001, Frank finally left Rampart and moved to New Jersey, where he began selling a fund called Benchmark Plus. By this time we had become good friends and stayed in close contact. In his new job he continued digging up Madoff material. When I created this product he thought he might be able to find some investors, so I went down to see him. He read the prospectus and said correctly, “Harry, this is horseshit. Basically, what you’re saying is you have to wake up on the right side of the bed and make every right move to protect your ass because you could lose everything. Who’s gonna buy this?”
 
“They wanted something, and I had to give it to them,” I said, not at all defensively. I knew what it was.
 
What I did not know was that I had made one slight mistake in my math. Unfortunately, I discovered that mistake at the worst possible time.
 
Rampart and Access initially raised about $6 million. Firms were sort of testing the product, to see how it would perform in actual market conditions before making any substantial investment. For several months it did quite well, but then volatility started getting very low so options lost value. It got kind of rocky. Then we had one month where there was some extremely high volatility. I had a plan in place for that situation, and I successfully traded out of the market. Neil and I were feeling pretty good about it—it was working even better than we had anticipated. I began thinking,
Well, maybe this is a product we really can push.
We’d gone through one of my bad scenarios and come out profitably.
 
Then we ran into a problem. One morning the market opened way down and our positions started working against us. The markets were getting crushed right before our options were expiring, and our positions were moving against us fast. I had a strategy for this type of situation. It meant taking a loss, but certainly it was survivable. As the day progressed, though, the market got a little worse than I had anticipated. Suddenly a manager of one of the funds who had about $500,000 in it called. He was in a complete panic. “Where am I? What’s my loss?” His potential loss was capped at $250,000, but he was still far from that figure, I thought. As the market plunged he called back several times, and finally he told me (actually he ordered me), “Close me out right now.”
 
I hung up the phone and told Neil, who pointed out, “Taking an order from a client in a situation like this is probably never a good thing. We should get him to fax us his instructions.”
 
I sold his position and he took a substantial loss. The way I had modeled this strategy allowed me to close out the position that was going against me while the position going for me continued to run. That cut my losses substantially. So I went into the market and started trading. As I made each trade I told it to Neil, who logged the trade ticket and updated the portfolio. I finished the trade that basically closed me out of my losing position and hung up the phone. I figured we were okay. But I could see that Neil was confused, almost in a panic, about something. He was looking over the models and the portfolios as they updated rapidly with each market change. “What’s the matter?” I asked.
 
“Harry, there’s something wrong here,” he said, looking at the numbers. “This isn’t adding up.”
 
He showed me his calculations. “Either we’re doing something wrong, or we didn’t think about this scenario.”
 
That’s when I discovered my mistake. As I looked at his calculations I realized I’d made a math error. As a result, instead of being down the maximum 50 percent, I was actually down more than 100 percent. Potentially, I was looking at a financial disaster. The only hope I had was that the market would move in favor of the positions I’d kept. Typically when you make a mistake the market goes against you, but this time it was moving to our benefit. Neil was running spreadsheets trying to find that point at which we would come out whole. I was on the phone, placing orders, trying to ride this wave out of danger. I placed my orders and hung up. Neil and I sat there silently, staring at the screen, holding our breaths and twiddling our thumbs as we watched the market proceed to save my ass. We had traded out of the position perfectly. In fact, every one of our clients, except the fund manager who bailed, ended up with a slight gain. We’d been breathtakingly close to losing several million dollars.
 
So we had successfully proved that this product had some potentially serious problems. But Thierry and Tim Ng were sold on it. They believed it could be a viable alternative for those clients too deeply invested with Madoff. I thought I had done my part by creating it; I wasn’t a salesman. But in early December 2001, Rampart’s senior investment officer, George Devoe, who normally would have sold it, was diagnosed with a fatal form of brain cancer. That was stunning, devastating. George sat a few feet away from Neil and me. George was a runner and a biker and a hiker; he was a mountain climber; he was the epitome of good health. At lunch he would sit there making fun of Neil, who was devouring a sauce-dripping sub sandwich for lunch and eight or nine sodas and never gaining one ounce, while he was eating a healthy salad and taking his vitamins and washing it all down with mineral water. But one day he told us he wasn’t feeling too great and went to his doctor. He had an MRI and was told he had inoperable brain cancer. Three months later he was dead. It was really an awful situation, and it left me as the senior investment manager. So when Thierry wanted to market my product to European hedge funds in June 2002, I was really the only person who could go with him.

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