The Wizard of Lies: Bernie Madoff and the Death of Trust (11 page)

There were two vivid threads of agreement weaving through these differing recollections.

First, there was a common perception that Bernie subtly and humorously, but persistently, belittled his younger brother. There may have been nothing more to it than the age-old friction between a successful man and a promising kid brother trying to find his place at the table. Despite Peter’s law degree—a credential that Bernie had decided wasn’t worth his own time—he started out as a salaried employee of his brother’s brokerage firm, albeit an increasingly well-paid one. Nearly forty years later, he would still be only a salaried employee, working for a brother who never made him a partner in the primary business to which he had devoted his entire working life. For decades, his only ownership stake in the primary Madoff firm was a sliver of equity in the firm’s London subsidiary, formed in 1983, with his brother retaining an ownership stake of more than 88 percent of that unit.

It is possible that Bernie’s treatment of Peter simply echoed the dynamics of their childhood. By 1970, their father, Ralph Madoff, had taken an interest in Bernie’s firm, and he and Sylvia would sometimes help Bernie by riding out to inspect some company he was considering as an investment. Ralph’s occasional presence at the firm could have reinforced Bernie’s and Peter’s childhood roles of Big Brother and Baby Brother. If so, the influence did not last long. In July 1972, Ralph Madoff died of a heart attack at age sixty-two. Two and half years later, in December 1974, Sylvia Madoff died suddenly as well, after suffering an asthma attack during a vacation cruise in the Caribbean. She was just weeks shy of her sixty-third birthday.

Even with the lower actuarial expectations of the early 1970s, it was a shock to the Madoff brothers to lose both parents so early and so young. Friends from that era would recall that Bernie became more fatherly toward his younger brother, stepping into Ralph’s shoes as the family patriarch.

The second common perception from those who knew him well is that Peter Madoff was the essential force that propelled his brother’s firm into the vanguard of marketplace computer technology, keeping it competitive and drawing favorable regulatory attention. In one account of Wall Street’s automation, the authors introduced the Madoff brothers like this: “Bernard (who founded the firm) and Peter (the company’s computer genius).” Even one of the lawsuits filed against him after his brother’s fall credited Peter with developing the trading technology on which the firm’s trading desk relied.

Bernie Madoff embraced the larger idea that technology was clearly going to reshape the stock market and had to reshape the Madoff firm, too. But his brother grasped all the nuts and bolts it would take to get there. As Peter’s expertise grew, he took a larger role in overseeing the firm’s trading operation, where the new technology hit the road every day.

If some insider accounts are right, Peter’s contribution to his brother’s firm was even more significant. These chronicles credit Peter as the one who saw the potential for making a market in stocks that normally traded on the New York Stock Exchange. “And it was that decision,” one report noted, “that catapulted the firm into the big leagues of wholesaling.”

The over-the-counter trading of exchange-listed stocks was called the “third market,” a name that some scholars said was derived from Wall Street’s view that the Big Board and other traditional stock exchanges were the “first market” and the OTC market was the “second market.” The big Wall Street firms that were members of the New York Stock Exchange were obligated by its rules to trade the shares of NYSE-listed stocks only on the Big Board. So the third market—the trading of NYSE-listed stocks among dealers in the over-the-counter market—was a niche that smaller non-NYSE firms could exploit easily without being jostled by giants. As institutional investors flocked to the third market, where commissions were lower than on the Big Board, the increased trading volume generated new revenues for the smaller firms handling third-market trades. It was here that the Madoff firm first began to increase its share of Wall Street trading volume and build its reputation with other Wall Street leaders. And getting into the third market, according to many, was Peter Madoff’s idea.

Peter’s role during this turbulent decade of cascading technological change made him as influential in regulatory circles as his brother. He also became an increasingly important figure within the firm itself, taking on a host of important duties, including regulatory compliance.

It is beyond the world of trading technology that the mysteries arise. As chief compliance officer, how much did Peter know about what was going on in the private customer accounts opened at the firm? How much did Peter learn about what Bernie did with all the money that Ruth Madoff’s relatives were sending to him through her father’s old accounting firm? How much did Bernie share with him about the financial condition of those parts of the firm that Peter didn’t see? In short, how much did Bernie tell Peter about his evolving fraud?

Absolutely nothing, according to Madoff himself and Peter’s lawyer, commenting after Bernie’s arrest and responding to questions in the years that followed—years in which Peter remained under investigation but was not arrested or charged with any crime.

Peter Madoff had his own investment accounts, managed by his brother, and those accounts would generate millions in profits for him and other members of his family over the years. Didn’t he ever suspect that his returns were too good to be true? Records would later show a number of backdated trades in those accounts that had enriched him enormously. Didn’t Peter ever sit down and check the paperwork on those accounts with Bernie to see how such remarkable profits were possible?

His answer, from the day of his brother’s arrest, was “no.” His legal defense in a string of lawsuits was that he, like thousands of other people, believed he could trust his spectacularly talented brother to manage the family’s personal money—just as his brother trusted him to run the firm’s core stock trading business and keep it ahead of the technology curve.

If Bernie entrusted Peter with anything beyond the firm’s high-tech trading business, there was little on paper to publicly document it.

By the late 1970s, Frank Avellino and Michael Bienes realized that they simply had to do something about their arrangement with Bernie Madoff.

The process that Saul Alpern had begun a decade earlier—receiving checks from investors, logging in the individual profits, mailing out checks for the withdrawals, noting when the money was reinvested—had gotten far too cumbersome, according to Bienes. The accountants were suffering under the same sort of paperwork crunch that had bedeviled Wall Street a decade earlier, but they did not have access to the mainframe computers that would have solved their problems, and personal computers were still a few years away. Besides, the partners still had an accounting firm to run.

Avellino & Bienes had inherited nearly all of Saul Alpern’s accounting clients after the older man’s retirement, but one important account did not make the trip: Bernard L. Madoff Investment Securities. The Madoff firm’s books had been handled by Jerome Horowitz, another accountant in the Alpern firm who was sufficiently well-established that Bienes expected he would soon break off to set up his own practice—as he did. Despite the Alpern family connection, it actually was Horowitz who handled the annual tax accounting and audit chores for Madoff’s brokerage firm. When Horowitz left the Alpern firm to strike out on his own in the late 1960s, he took Madoff’s accounting business with him.

There were apparently no hard feelings about the move, as Bernie Madoff continued to invest money for the clients of Avellino & Bienes after his father-in-law retired. The number of accounts grew slightly “to accommodate IRA accounts and family members of their accounting clients,” Madoff said in a letter from prison, but never exceeded a half-dozen accounts, all of which he said were involved in his hallmark arbitrage trading.

“It was my understanding that all of these Avellino & Bienes [accounts] would operate in the identical manner as the original account of my father-in-law,” he said—in other words, money from many investors would be pooled in a few accounts at the Madoff firm, and the profits would be allocated appropriately by the accounting firm. He claimed to have warned the two accountants to keep the number of investors below the level that would require them to register as a public mutual fund—a claim Michael Bienes stoutly disputed in his public account of these years.

While the returns were attractive for Avellino, Bienes, and their clients—regulators would later say they ranged in the high teens, but there is no firm evidence of Madoff’s track records in these years—the paperwork logjam was threatening to bury them. Bienes credits Avellino with the breakthrough idea: “Four words: Let’s pay them interest. It’s simple. You give them a stated rate. You pay it to them calendar-quarterly. They can roll it over if they want, or they can take a check if they want.”

This step was noteworthy because it was the first big change in the way Avellino & Bienes handled the money invested with Madoff, a change that Madoff said was made without his knowledge or approval. It was also one that simplified the process enough so that the tiny accounting firm could handle an enormous number of customers and a stunning amount of money. There was no formal partnership structure or separate business unit created to mark this new approach by the two accounting partners. It was all very casual, but the accounting firm “always stood behind it,” Michael Bienes said years later.

“That’s how much we believed in Bernie,” he stated.

It was an era when people desperately wanted something solid to believe in. The 1970s seemed like the decade that would ruin Wall Street. The contrast between Wall Street’s dismal state and Madoff’s apparent success with his arbitrage trading only enhanced his reputation.

“The stock market crashed in the 1970s, and no one noticed,” the financial writer Jerry Goodman observed. Unlike the crash of 1929, the 1970s crash occurred in slow motion. As Goodman memorably summed up, “If the first crash was a dramatic leap from a sixty-story building, the second was like drowning in a bubble bath. The bubble-bath drowning sounds less scary, but you end up just as dead.”

Inflation—fed by the government’s pursuit of an expensive foreign war in Vietnam and an ambitious welfare program at home—was shredding the value of paper money. When Bernie Madoff opened for business in 1960, inflation was less than 2 percent a year. When President Richard Nixon took office in 1969, the annual inflation rate was 5 percent. In the first nine months of 1979, it would hit 10.75 percent. “Inflation this high during peace time was unprecedented in American history,” one Federal Reserve scholar observed.

The dismal decade knocked the stock market to its knees; the previous decade’s giddy go-go market was utterly gone. There seemed to be no safe place to stand in this storm. Stock prices gyrated wildly—no one could remember mood swings like this, month in and month out. Bonds didn’t hold their value, especially late in the decade, as the Federal Reserve stepped up its effort to break the inflation fever by sharply increasing interest rates. American retail investors learned new words to worry about:
volatility
and
stagflation
.

Putting money in the bank, once the safest option, no longer seemed sensible. For years, Treasury rules had capped the rates that small savers could get; only the big institutions could earn interest rates high enough to keep ahead of inflation. When rates finally inched up for small savers, the nation’s savings and loans went on a risky lending binge that promised to end badly. Even if you could find a bank or thrift institution that seemed stable, stability alone wasn’t enough. The inflation of the 1970s was eroding the purchasing power of every dollar that careful savers had put into the bank or had used to buy bonds.

The hunger for yield became almost an obsession for an entire generation. You had to find something that would pay you more than the cost of living, or you were forever falling behind. Investors stampeded into the newly created money market mutual funds. Some even turned to complex partnerships investing in oil and gas reserves or silver and other precious metals, whose prices were soaring.

Prudent investors had once accepted the ironclad link between the level of risk and the rate of return: to get higher returns, you had to take greater risks. Corporate bonds paid a higher rate than Treasury bonds because corporate bonds were riskier; Uncle Sam wouldn’t go out of business. Small OTC stocks climbed many times faster than the blue chips, but were also far more likely to wind up worthless. That was just the way it was. The price the brave paid for high yields included high risk and sleepless nights. Don’t fool yourself, the wise men said: those who want sound sleep and more safety have to settle for lower yields.

Perversely, the greater risk now seemed to be to accept too low a yield on your investments. Apparently, the law that higher-paying investments were riskier than lower-paying ones had somehow been repealed. The 1970s had turned the traditional formula of risk and reward upside down. What you needed was safety
and
yield—the robust profits of speculation without all that nail-biting volatility, and the security of low-risk investments without the slow erosion of your savings.