No One Would Listen: A True Financial Thriller (53 page)

4. Here’s what smells bad about the idea of providing equity tranch funding to a US registered broker-dealer:

a. The investment returns passed along to the third party hedge funds are equivalent to BM borrowing money. These 12 month returns from 1990 - May 2005 ranged from a low of 6.23% to a high of 19.98%, with an average 12 month return during that time period of 12.00%. Add in the 4% in average annual management & participation fees and BM would have to be delivering average annual returns of 16% in order for the investors to receive 12%. No Broker-Dealer that I’ve ever heard of finances its operations at that high of an implied borrowing rate (source: Attachment 1; Fairfield Sentry Limited return data from December 1990 - May 2005). Ask around and I’m sure you’ll find that BM is the only firm on Wall Street that pays an average of 16% to fund its operations.

b. BD’s typically fund in the short-term credit markets and benchmark a significant part of their overnight funding to LIBOR plus or minus some spread. LIBOR + 40 basis points would seem a more realistic borrowing rate for a broker-dealer of BM’s size.

c.
Red Flag # 2
:
why would a BD choose to fund at such a high implied interest rate when cheaper money is available in the short-term credit markets? One reason that comes to mind is that BM couldn’t stand the due diligence scrutiny of the short-term credit markets. If Charles Ponzi had issued bank notes promising 50% interest on 3 month time deposits instead of issuing unregulated Ponzi Notes to his investors, the State Banking Commission would have quickly shut him down. The key to a successful Ponzi Scheme is to promise lucrative returns but to do so in an unregulated area of the capital markets. Hedge funds are not due to fall under the SEC’s umbrella until February 2006.

5. The third party hedge funds and fund of funds that market this hedge fund strategy that invests in BM don’t name and aren’t allowed to name Bernie Madoff as the actual manager in their performance summaries or marketing literature. Look closely at Attachment 1, Fairfield Sentry Ltd.’s performance summary and you won’t see BM’s name anywhere on the document, yet BM is the actual hedge fund manager with discretionary trading authority over all funds, as agent.

Red Flag # 3: Why the need for such secrecy?
If I was the world’s largest hedge fund and had great returns, I’d want all the publicity I could garner and would want to appear as the world’s largest hedge fund in all of the industry rankings. Name one mutual fund company, Venture Capital firm, or LBO firm which doesn’t brag about the size of their largest funds’ assets under management. Then ask yourself, why would the world’s largest hedge fund manager be so secretive that he didn’t even want his investors to know he was managing their money? Or is it that BM doesn’t want the SEC and FSA to know that he exists?

6. The third party FOF’s never tell investors who is actually managing their money and describe the investment strategy as: This hedge fund’s objective is long term growth on a consistent basis with low volatility. The investment advisor invests exclusively in the U.S. and utilizes a strategy often referred to as a “split-strike conversion.” Generally this style involves purchasing a basket of 30-35 large-capitalization stocks with a high degree of correlation to the general market (e.g. American Express, Boeing, Citigroup, Coca-Cola, Dupont, Exxon, General Motors, IBM, Merck, McDonalds). To provide the desired hedge, the manager then sells out-of-the-money OEX index call options and buys out-of-the-money OEX index put options. The amount of calls that are sold and puts that are bought represent a dollar amount equal to the basket of shares purchases.

7. I personally have run split-strike conversion strategies and know that BM’s approach is far riskier than stated in 6 above. His strategy is wholly inferior to an all index approach and is wholly incapable of generating returns in the range of 6.23% to 19.98%. BM’s strategy should not be able to beat the return on US Treasury Bills. Due to the glaring weakness of the strategy: A. Income Part of the strategy is to buy 30-35 large-cap stocks, sell out-of-the-money index call options against the value of the stock basket. There are three possible sources of income in this strategy.

1. We earn income from the stock’s dividends. Let’s attribute a 2% average return to this source of funds for the 14½ year time period. This explains 2% of the 16% average gross annual returns before fees and leaves 14% of the returns unexplained.

2. We earn income from the sale of OTC OEX index call options. Let’s also assume that we can generate an additional 2% annual return via the sale of OTC out-of-the-money OEX index call options which leaves 12% of the 16% gross returns unexplained. On Friday, October 14, 2005 the OEX (S&P 100) index closed at 550.49 and there were only 163,809 OEX index call option contracts outstanding (termed the “open interest”). 163,809 call option calls outstanding x $100 contact multiplier x 550.49 index closing price = $9,017,521,641 in stock equivalents hedged.

3. We can earn income from capital gains by selling the stocks that go up in price. This portion of the return stream would have to earn the lion’s share of the hedge fund strategy’s returns. We have 12% of the return stream unexplained so far. However, the OTC OEX index puts that we buy will cost AT LEAST <8%> per year (a lot more in most years but I’m giving BM the benefit of every doubt here). Therefore, BM’s stock selection would have to be earning an average of 20% per year. That would mean that he’s been the world’s best stock-picker since 1990 beating out such luminaries as Warren Buffet and Bill Miller. Yet no one’s ever heard of BM as being a stock-picker, much less the world’s best stock-picker. Why isn’t he famous if he was able to earn 20% average annual returns?

Red Flag # 4
:
$9.017 billion in total OEX listed call options outstanding is not nearly enough to generate income on BM’s total amount of assets under management which I estimate to range between $20-$50 billion. Fairfield Sentry Ltd. alone has $5.1 billion with BM. And, while BM may say he only uses Over-the-Counter
(OTC) index options, there is no way that this is possible. The OTC market should never be
several
times larger than the exchange listed market for this type of plain vanilla derivative.

B. Protection Part of the strategy is to buy out-of-the-money OEX index put options. This costs you money each and every month. This hurts your returns and is the main reason why BM’s strategy would have trouble earning 0% average annual returns much less the 12% net returns stated in Fairfield Sentry Ltd.’s performance summary. Even if BM earns a 4% return from the combination of 2% stock dividends and 2% from the sale of call options, the cost of the puts would put this strategy in the red year in and year out. No way he can possibly be delivering 12% net to investors. The math just doesn’t support this strategy if he’s really buying index put options.

 

Red Flag # 5
:
BM would need to be purchasing at-the-money put options because he has only 7 small monthly losses in the past 14½ years. His largest monthly loss is only <0.55%>, so his puts would have to be at-the-money. At-the-money put options are very, very expensive. A one-year at-the-money put option would cost you <8%> or more, depending upon the market’s volatility. And <8%> would be a cheap price to pay in many of the past 14½ years for put protection!! Assuming BM only paid <8%> per year in put protection, and assuming he can earn +2% from stock dividends plus another +2% from call option sales, he’s still under-water <4%> performance wise. <8%> put cost + 2% stock dividends + 2% income from call sales = <4%>. And, I’ve proven that BM would need to be earning at least 16% annually to deliver 12% after fees to investors. That means the rest of his returns would have to be coming from stock selection where he picked and sold winning stocks to include in his 35-stock basket of large-cap names. Lots of luck doing that during the past stock market crises like 1997’s Asian Currency Crises, the 1998 Russian Debt / LTCM crises, and the 2000-2002 killer bear market. And index put option protection was a lot more expensive during these crises periods than 8%. Mathematically none of BM’s returns listed in Attachment 1 make much sense. They are just too unbelievably good to be true.

C. The OEX index (S&P 100) closed at 550.49 on Friday, October 14, 2005 meaning that each put option hedged $55,049 dollars worth of stock ($100 contract multiplier x 550.49 OEX closing index price = $55,049 in stock hedged). As of that same date, the total open interest for OEX index put options was 307,176 contracts meaning that a total of $16,909,731,624 in stock was being hedged by the use of OEX index puts (307,176 total put contracts in existence as of Oct 14th x $55,049 hedge value of 1 OEX index put = $16,909,731,624 in stock hedged). Note: I excluded a few thousand OEX LEAP index put options from my calculations because these are long-term options and not relevant for a split-strike conversion strategy such as BM’s.

 

Red Flag # 6:
At my best guess level of BM’s assets under management of $30 billion, or even at my low end estimate of $20 billion in assets under management, BM would have to be over 100% of the total OEX put option contract open interest in order to hedge his stock holdings as depicted in the third party hedge funds marketing literature. In other words, there are not enough index option put contracts in existence to hedge the way BM says he is hedging! And there is no way the OTC market is bigger than the exchange listed market for plain vanilla S&P 100 index put options.

D. Mathematically I have proven that BM cannot be hedging using listed index put and call options. One hedge fund FOF has told me that BM uses only Over-the-Counter options and trades exclusively thru UBS and Merrill Lynch. I have not called those two firms to check on this because it seems implausible that a BD would trade $20 - $50 billion worth of index put options per month over-the-counter thru only 2 firms. That plus the fact that if BM was really buying OTC index put options, then there is no way his average annual returns could be positive !! At a minimum, using the cheapest way to buy puts would cost a fund <8%> per year. To get the put cost down to <8%>, BM would have to buy a one-year at-the-money put option and hold it for one-year. No way his call sales could ever hope to come even fractionally close to covering the cost of the puts.

 

Red Flag # 7:
The counter-party credit exposures for UBS and Merrill would be too large for these firms credit departments to approve. The SEC should ask BM for trade tickets showing he has traded OTC options thru these two firms. Then the SEC should visit the firms’ OTC derivatives desks, talk the to heads of trading and ask to see BM’s trade tickets. Then ask the director of operations to verify the tickets and ask to see the inventory of all of the stock and listed options hedging the OTC puts and calls. If these firms can’t show you the off setting hedged positions then they are assisting BM as part of a conspiracy to commit fraud. If any other brokerage firms equity derivatives desk is engaged in a conspiracy to cover for BM, then this scandal will be a doozy when it hits the financial press but at least investors would have firms with deep pockets to sue.

 

Red Flag # 8:
OTC options are more expensive to trade than listed options. You have to pay extra for the customization features and secrecy offered by OTC options. Trading in the size of $20-$50 billion per month would be impossible and the bid-ask spreads would be so wide as to preclude earning any profit whatsoever. These BrokerlDealers would need to offset their short OTC index put option exposure to a falling stock market by hedging out their short put option risk by either buying listed put options or selling short index futures and the derivatives markets are not deep and liquid enough to accomplish this without paying a penalty in prohibitively expensive transaction costs.

 

Red Flag # 9
:
Extensive and voluminous paperwork would be required to keep track of and clear each OTC trade. Plus, why aren’t Goldman, Sachs and Citigroup involved in handling BM’s order flow? Both Goldman and Citigroup are a lot larger in the OTC derivatives markets than UBS or Merrill Lynch.

E. My experience with split-strike conversion trades is that the best a good manager is likely to obtain using the strategy marketed by the third-party FOF’s is T-bills less management fees. And, if the stock market is down by more than 2%, the return from this strategy will range from a high of zero return to a low of a few percent depending upon your put’s cost and how far out-of-the-money it is.

F. In 2000 I ran a regression of BM’s hedge fund returns using the performance data from Fairfield Sentry Limited. BM had a .06 correlation to the equity market’s return which confirms the .06 Beta that Fairfield Sentry Limited lists in its return numbers.

 

Red Flag # 10:
It is mathematically impossible for a strategy using index call options and index put options to have such a low correlation to the market where its returns are supposedly being generated from. This makes no sense! The strategy depicted retains 100% of the single-stock downside risk since they own only index put options and not single stock put options. Therefore if one or more stocks in their portfolio were to tank on bad news, BM’s index put would offer little protection and their portfolio should feel the pain. However, BM’s performance numbers show only 7 extremely small losses during 14½ years and these numbers are too good to be true. The largest one month loss was only - 55 basis points (-0.55%) or just over one-half of one percent! And BM never had more than a one month losing streak! Either BM is the world’s best stock and options manager that the SEC and the investing public has never heard of or he’s a fraud. You would have to figure that at some point BM owned a WorldCom, Enron, GM or HealthSouth in their portfolio when bad or really bad news came out and caused these stocks to drop like a rock.