The Wizard of Lies: Bernie Madoff and the Death of Trust (16 page)

Black Monday was the day investors learned that the NASD did not require its “market-making” dealers actually to maintain a continuous market in the over-the-counter stocks they traded, as the traditional stock exchanges did. Many of the smaller market makers were losing ruinous amounts of money and could not keep buying shares that they could sell only at a loss, if they could sell them at all. Instead, they limped to the sidelines. The NASD’s rules allowed them to stop trading. For many, the alternative was bankruptcy.

More troubling, the trading technology that NASDAQ had touted as the face of the future had been utterly unequal to the pressures of this extraordinary day. Traders feared that the bids shown on computer trading screens were unreliable and out of date, and they were right. Even large firms refused to trade blind, and by the next day the over-the-counter market was blasted by the storm that hit the traditional exchanges on Black Monday. The damage prompted a senior NASDAQ staff member to tell the
Wall Street Journal
, “We’re scared. Of course we’re scared. We’re looking at conditions in the marketplace that are indescribable; gigantic losses, it’s staggering.” It seemed that the much-ballyhooed market of the future—one in which Bernie Madoff had made his reputation—had utterly and unexpectedly failed.

The Madoff firm, dealing as a wholesaler for largely institutional clients, was buffered from the worst of the tsunami of panicky retail orders. With computer networks that could handle large volume at state-of-the-art speed, it made it through the storm. Mike Engler, Madoff’s friend and associate in Minneapolis, would tell his son later that the Madoff firm actually made money for itself and its clients in these bleak days by using options to short the markets. And the Madoff firm was praised by regulators for its solid performance during Black Monday, when so many market makers were falling away.

The reality was different. The market crash had profoundly shaken the confidence of some of Madoff’s largest clients. Men he thought he could count on to keep their portfolios intact and leave their wealth in his hands—men such as Carl Shapiro and Jeffry Picower—suddenly began to cash in their paper profits and withdraw their money. “They were worried all the gains they had would disappear in the years just after 1987,” Madoff said in his first prison interview.

Madoff estimated that his investment accounts totaled about $5 billion at the time of the crash. But he claimed that much of this wealth was tied up in his complex hedging strategies—that he could not fully repay his big American clients without cashing out the French counterparties, who were expecting to stay invested in U.S. dollars. If he honored the withdrawal demands, he risked losing his French connections; if he didn’t, he would lose his longtime American investors.

Those longtime investors grew even more nervous after the “mini-crash” that hit almost exactly two years after the 1987 meltdown. Their withdrawal demands increased, and although Madoff acknowledged “there was nothing I could have sued them over,” he was furious.

“Part of the agreement I had with them was that the profits would be reinvested, not withdrawn. And they were the only ones who didn’t abide by that. They changed the deal on me,” he said in the first prison interview. “I was hung out to dry.”

Madoff’s anger strongly suggests that the protracted cash crisis that began after the 1987 crash was real, even if his explanation for it raises more questions than it answers. His strategy involved big blue-chip stocks; even in the rocky post-crash markets he should have been able to liquidate a legitimate blue-chip portfolio, albeit for less than its pre-crash value. The Gateway fund had a losing year after the 1987 crash, too, but it went on to report only seven losing months between October 1988 and the end of 1992—why couldn’t Madoff achieve the same results with the same strategy? Had he lied to his clients about hedging their accounts against losses? Or, as he suggested in a subsequent letter, had he negotiated another investment “deal” with these big clients, one that bore no resemblance to the “split-strike conversion” strategy he was supposedly using?

Madoff acknowledged that he spent much of the 1980s actively arranging a growing volume of complicated “synthetic” trades to help his biggest clients—including Norman Levy and Jeffry Picower—avoid income taxes on their short-term stock profits. He provided few clear details of these transactions, except to say that they were put in place with the expectation that they would be rolled over year after year. These tax-avoidance trades were not prohibited by law until 1997, but they fell close to the line, as Madoff would grudgingly acknowledge later. “I felt they weren’t sham transactions…,” he said, “but they became more elaborate in their strategy. At worst, it was a gray area.”

Were these complex tax-avoidance trades harder to unwind without enormous losses? Or did Madoff simply guarantee that these old stalwarts would not incur losses if they stuck with him, assuming he could eventually come out ahead if they maintained their positions and did not withdraw their profits on demand? Madoff may never give a straight answer to these questions, but he is clear about the consequences of this crisis.

“Before I realized it, I was in the hole for a few billion dollars,” he acknowledged in his first prison interview. This didn’t happen overnight—it started happening at least by 1988, and it must have involved enormous sums to have reached that level by 1992.

Clearly the complex portfolios and cash pressures that would mark his Ponzi scheme were starting to take shape, even though Madoff insisted his Ponzi scheme had not yet begun and there is evidence that at least a few trades took place in the accounts of some favored long-term clients during these years.

Of course, this is the story “according to Madoff,” possibly the least reliable source in history. So it might be true that, years before the 1987 crash, he was already robbing Peter to pay Paul—robbing the Avellino & Bienes accounts, perhaps, to pay Chais and Picower, Levy and Shapiro. He has consistently denied this, and so far there has been no evidence to the contrary in the public record. But he did not deny that the roots of his Ponzi scheme were planted in the cash demands he faced following the 1987 crash—and, after all, even if his Ponzi scheme was already up and running, those unexpected withdrawals after the crash would have pushed him to the wall.

Bernie Madoff may have been squirming behind closed doors, but to the outside world, he emerged from the crash as a star of the OTC world. He was still a member of the NASD Board of Governors, and he now became an influential voice in putting NASDAQ back together over the next three years.

Apart from the damage from the crash, the NASDAQ market was also struggling with the consequences of the NASD’s flabby discipline—shortcomings that the less adventurous SEC under John Shad repeatedly failed to address. Discipline for infractions was limp and late, to the frustration of regulators and irate customers. For all its technological glitter, the young market was still an adolescent, unruly and resistant to increased supervision. Indeed, one must wonder if Madoff’s firsthand awareness of the NASD’s failings as a regulator encouraged him to think he could get away with his Ponzi scheme long enough to work his way out of the losses he was incurring.

Around this time, Madoff was plowing capital into his firm’s equipment and software so that it could handle automated orders faster, pressing his competition to keep up. In 1983, Peter had led the firm’s adoption of new customized software to run an in-house automated order system. When it was completed after the 1987 crash, it would set a new standard for speed in handling customer orders.

After the crash, Madoff continued to invest in the Cincinnati Stock Exchange—again, a surprisingly big expense for the firm—which helped that venerable regional exchange conduct all its business electronically.

When the NASD introduced predawn trading at the end of the decade, the Madoff firm and a handful of others were already there—they had invested in the staff necessary to do after-hours trading in the evenings and through the night.

In 1990, further enhancing his growing reputation with the industry and its regulators, Bernie Madoff became the chairman of the NASDAQ market. His back-office work on the trading committees and his own firm’s initiatives on the technology frontier were more significant in shaping NASDAQ than his three one-year terms as its chairman, but the position was a pretty good soapbox. He would need it in the battle that would define Bernie Madoff for many veterans of Wall Street’s trading community—the battle over his practice, introduced in 1988, of paying retail brokerage firms a few pennies per share to steer their customers’ orders to him.

He called those pennies “payments for order flow” and “rebates.” The exchanges that had traditionally gotten those orders, chiefly the New York Stock Exchange, called the payments “bribery, pure and simple” and “kickbacks.” They fought fiercely to have the practice declared illegal, but they ultimately lost the battle with regulators after the firms taking Bernie’s pennies were found to be getting faster and cheaper execution of their orders than on the Big Board. Indeed, by the early 1990s, more than 5 percent of all the trades in stocks listed on the Big Board would actually occur inside Bernie Madoff’s computers, untouched by human hands. One scholarly market study observed that “although the Madoff firm isn’t technically a stock exchange, it functions as a de facto surrogate for the New York Stock Exchange.”

Madoff’s practice of paying for order flow put him on the wrong side of a lot of powerful people on Wall Street, many of whom had access to back-office sources of information about him and his firm. Apparently, none of his hostile and prominent critics found any trace of a hidden Ponzi scheme—if they had, they certainly would have used it to discredit and destroy him in this bitter battle over his rebate practices.

Their failure to find it, however, may not mean that the scheme had not yet begun; it may simply mean that Madoff had planted the first seeds of his Ponzi scheme in one of the least visible and least regulated fields in the financial landscape: offshore hedge funds.

By the late 1980s, Madoff was playing on a much bigger social stage, one that would enhance his reputation among a host of generous donors and charitable institutions—many of which would later become his clients and, ultimately, his victims.

On paper, all of his big clients seemed to be getting rich—only Madoff knew how precarious his finances were. By one popular measure, the stock market had climbed more than 17 percent a year between the birth of the bull market in August 1982 and the end of 1989. And in the circles he now frequented, rich people were supposed to be generous people. So, inevitably, Madoff became an increasingly active donor, giving to the pet charities of favored or coveted clients, buying tickets to the right benefit dinners, meeting the right people.

In 1980s Manhattan, the “right people” included Howard Squadron, a prominent New York lawyer with a finger in countless political and cultural pies—and a man who would unwittingly be one of the first to steer important Jewish charities into Madoff’s orbit. His relationship with Madoff would become an increasingly familiar pattern within New York legal and accounting circles.

Squadron had once been the boy wonder of the New York legal world. In 1947, barely twenty years old, he collected both a bachelor’s degree in history and a law degree from Columbia University. Besides being a very smart man, he became a very well-connected one. He spent two years as a staff counsel at the American Jewish Congress and would later become the organization’s president. The American Jewish Congress was a melting pot for wealthy donors to Jewish causes and institutions, and it was there that Squadron first met Bernie Madoff.

A tireless recruit on numerous educational and cultural boards, Squadron was instrumental in the rescue of the New York City Center, an important cultural institution. He chaired the City Center board for nearly a quarter century and, along the way, enlisted Madoff’s support. In time, important people at the American Jewish Congress and City Center would become clients of Squadron’s good friend Bernie Madoff, and Madoff himself would join the City Center board—where his fellow board members would include Squadron’s wife and a member of the Wilpon family, which owned the New York Mets.