No One Would Listen: A True Financial Thriller (54 page)

8.
Red Flag # 11
:
Two press articles, which came to print well after my initial May 1999 presentation to the SEC, do doubt Bernie Madoff’s returns and they are:

a. The May 7, 2001 edition of Barron’s, in an article entitled,
“
Don’t Ask, Don’t Tell; Bernie Madoff is so secretetive, he even asks his investors to keep mum,”
written by Erin Arvedlund, published an expose about Bernie Madoff a few years ago with no resulting investigation by any regulators. Ms. Arvedlund has since left Barron’s. I have attached a copy of the Barrons’ article which lists numerous red flags.

b. Michael Ocrant, formerly a reporter for
MARHedge
visited Bernie Madoff’s offices and wrote a very negative article entitled, “Madoff tops charts; skeptics ask how,” that doubted the source of BM’s returns. This article was published on May 1, 2001 and is attached [see Appendix A of this book]. Mr. Ocrant has graciously agreed to cooperate fully with the SEC and awaits the SEC’s telephone call to arrange a meeting. The SEC should contact him directly. Michael Ocrant is currently serving as the Director of Alternative Investments; Institutional Investor; New York, NY 10001; Telephone #
or
Email:

9. Fund of funds with whom I have spoken to that have BM in their stable of funds continually brag about their returns and how they are generated thanks to BM’s access to his broker-dealer’s access to order flow. They believe that BM has perfect knowledge of the market’s direction due to his access to customer order flow into his broker-dealer.

Red Flag # 12:
Yes, BM has access to his customer’s order flow thru his broker-dealer but he is only one broker out of many, so it is impossible for him to know the market’s direction to such a degree as to only post monthly losses once every couple of years. All of Wall Street’s big wire houses experience trading losses on a more regular frequency that BM. Ask yourself how BM’s trading experience could be so much better than all of the other firms on Wall Street. Either he’s the best trading firm on the street and rarely ever has large losing months unlike other firms or he’s a fraud.

10.
Red Flag
#
13:
I believe that BM’s returns can be real ONLY if they are generated from front-running his customer’s order flow. In other words, yes, if he’s buying at a penny above his customer’s buy orders, he can only lose one penny if the stock drops but can make several pennies if the stock goes up. For example, if a customer has an order to buy 100,000 shares of IBM at $100, BM can put in his own order to buy 100,000 shares of IBM at $100.01. This is what’s known as a right-tail distribution and is very similar to the payoff distribution of a call option. Doing this could easily generate returns of 30%-60% or more per anum. He could be doing the same thing by front-running customer sell orders. However, if BM’s returns are real but he’s generating them from front-running there are two problems with this:

a.
Problem # 1: front-running is one form of insider-trading and is illegal.

b.
Problem # 2: generating real returns from front-running but telling hedge fund investors that you are generating the returns via a complex (but unworkable) stock and options strategy is securities fraud.

Some time ago, during different market conditions, I ran a study using the Black-Scholes Option Pricing Model to analyze the value of front-running with the goal of putting a monetary value on front-running where the insider knew the customer’s order and traded ahead of it. When I ran the study the model inputs were valued at: OEX component stocks annualized volatility on a cap-weighted basis was 50% (during a bear market period), the T-bill rate was 5.80%, and the average stock price was $46. I then calculated the value of an at-the-money call options over time intervals of 1 minute, 5 minutes, 10 minutes, and 15 minutes. I used a 253 trading day year. The SEC should be able to duplicate these results:

1 minute option = 3 cents worth of trade information value
5 minute option = 7 cents worth of trade information value
10 minute option = 10 cents worth of trade information value
15 minute option = 12 cents worth of trade information value

 

Conclusion:
Bernie Madoff used to advertise in industry trade publications that he would pay 1 cent per share for other broker’s order flow. If he was paying 1 cent per share for order flow and front-running these broker’s customers, then he could easily be earning returns in the 30%-60% or higher annually. In all time intervals ranging from 1 minute to 15 minutes, having access to order flow is the monetary equivalent of owning a valuable call option on that order. The value of these implicit call options ranges between 3 - 12 times the one penny per share paid for access to order flow. If this is what he’s doing, then the returns are real but the stated investment strategy is illegal and based solely on insider-trading.

 

NOTE:
I am pretty confident that BM is a Ponzi Scheme, but in the off chance he is front-running customer orders and his returns are real, then this case qualifies as insider-trading under the SEC’s bounty program as outlined in Section 21A(e) of the 1934 Act. However, if BM was front-running, a highly profitable activity, then he wouldn’t need to borrow funds from investors at 16% implied interest. Therefore it is far more likely that BM is a Ponzi Scheme. Front-running is a very simple fraud to commit and requires only access to inside information. The elaborateness of BM’s fund-raising, his need for secrecy, his high 16% average cost of funds, and reliance on a derivatives investment scheme that few investors (or regulators) would be capable of comprehending lead to a weight of the evidence conclusion that this is a Ponzi Scheme.

11.
Red Flag # 14:
Madoff subsidizes down months! Hard to believe (and I don’t believe this) but I’ve heard two FOF’s tell me that they don’t believe Madoff can make money in big down months either. They tell me that Madoff “subsidizes” their investors in down months, so that they will be able to show a low volatility of returns. These types of stories are commonly found around Ponzi Schemes. These investors tell me that Madoff only books winning tickets in their accounts and “eats the losses” during months when the market sells off hard. The problem with this is that it’s securities fraud to misstate either returns or the volatility of those returns. These FOF professionals who heard BM tell them that he subsidizes losses were professionally negligent in not turning BM into the SEC, FSA and other regulators for securities fraud.

Red Flag # 15:
Why would a fund of funds investor believe any broker-dealer that commits fraud in a few important areas—such as misstating returns and misstating volatility of returns - yet believe him in other areas? I’d really like to believe in the tooth fairy, but I don’t after catching my mother putting a quarter underneath my pillow one night.

12.
Red Flag # 16:
Madoff has perfect market-timing ability. One investor told me, with a straight face, that Madoff went to 100% cash in July 1998 and December 1999, ahead of market declines. He said he knows this because Madofffaxes his trade tickets to his firm and the custodial bank. However, since Madoff owns a broker-dealer, he can generate whatever trade tickets he wants. And, I’ll bet very few FOF’s ask BM to fax them trade tickets. And if these trade tickets are faxed, have the FOF’s then matched them to the time and sales of the exchanges? For example, if BM says he bought 1 million shares of GM, sold $1 million worth of OTC OEX calls and bought $1 million worth of OTC OEX puts, we should see prints somewhere. The GM share prints would show on either the NYSE or some other exchange while the broker-dealers he traded OTC options thru would show prints of the hedges they traded to be able to provide BM with the OTC options at the prices listed on BM’s trade tickets.

13.
Red Flag # 17:
Madoff does not allow outside performance audits. One London based hedge fund, fund of funds, representing Arab money, asked to send in a team of Big 4 accountants to conduct a performance audit during their planned due diligence. They were told “No, only Madoff’s brother-in-law who owns his own accounting firm is allowed to audit performance for reasons of secrecy in order to keep Madoff’s proprietary trading strategy secret so that nobody can copy it. ” Amazingly, this fund of funds then agreed to invest $200 million of their client’s money anyway, because the low volatility of returns was so attractive!! Let’s see, how many hedge funds have faked an audited performance history?? Wood River is the latest that comes to mind as does the Manhattan Fund but the number of bogus hedge funds that have relied upon fake audits has got to number in the dozens.

14.
Red Flag # 18:
Madoff’s returns are not consistent with the one publicly traded option income fund with a history as long as Madoff’s. In 2000, I analyzed the returns of Madoff and measured them against the returns of the Gateway Option Income Fund (Ticker GATEX). During the 87 month span analyzed, Madoff was down only 3 months versus GATEX being down 26 months. GATEX earned an annualized return of 10.27% during the period studied vs. 15.62% for Bernie Madoff and 19.58% for the S&P 500. GATEX has a more flexible investment strategy than BM, so GATEX’s returns should be superior to BM’s but instead they are inferior. This makes no sense. How could BM be better using an inferior strategy?

15.
Red Flag # 19:
There have been several option income funds that went IPO since August 2004. None of them have the high returns that Bernie Madoff has. How can this be? They use similar strategies only they should be making more than BM in up months because most of these option income funds don’t buy expensive index put options to protect their portfolios. Thus the publicly traded option income funds should make more money in up markets and lose more than Madoff in down markets. Hmm
. . .
that Madoff’s returns are so high yet he buys expensive put options is just another reason to believe he is running the world’s largest Ponzi Scheme. A good study for the SEC would be to compare 2005 performance of the new option income funds to Bernie Madoff while accounting for the cost of Bernie’s index put option protection. There’s no way Bernie can have positive returns in 2005 given what the market’s done and where volatility is.

16.
Red Flag # 20:
Madoff is suspected of being a fraud by some of the world’s largest and most sophisticated financial services firms. Without naming names, here’s an abbreviated tally:

a. A managing director at Goldman, Sachs prime brokerage operation told me that his firm doubts Bernie Madoff is legitimate so they don’t deal with him.

b. From an Email I received this past June 2005 I now suspect that the end is near for BM. All Ponzi Schemes eventually topple of their own weight once they become too large and it now appears that BM is having trouble meeting redemptions and is attempting to borrow sizeable funds in Europe.