The Wizard of Lies: Bernie Madoff and the Death of Trust (30 page)

As hedge funds were gaining strength in Europe, Asia, and the Middle East, they were also multiplying in America. One illuminating example of the proliferation of hedge funds after 2006—a trend Madoff milked to the maximum—was a one-man hedge fund in Florida called Anchor Holdings LLC.

Many of Anchor’s clients were small family or individual “hedge funds,” with names such as the “John Doe Hedge Fund” and the “Jane Doe IRA Hedge Fund.” A few were union or professional pension plans. At its peak, when Anchor Holdings supposedly had more than $12 million in assets, its largest individual account was under $750,000, and its smallest was a Roth IRA account worth just $3,224.43. Anchor Holdings invested these modest nest eggs in another hedge fund, which invested all its assets in an apparently diversified portfolio of international hedge funds. That portfolio consisted of the Primeo fund, the Santa Clara fund, and four other hedge funds—every single one of which was invested exclusively with Madoff. Believing they had avoided the risk of putting all their eggs in one basket, these small investors had actually handed their savings over to one man: Bernie Madoff.

It is no wonder that some members of Congress were demanding that the SEC increase its attention to the hedge fund industry’s incursions into the middle class. Anchor Holdings could have been Exhibit A in the argument that hedge funds had “gone retail.” But since hedge funds were not required to register with the SEC—a badly drafted rule requiring registration was struck down by an appellate court in 2006 and never redrafted—the SEC had no way of knowing about Anchor Holdings or the countless other funds just like it.

In December 2006 the SEC tried to stem the stampede of middle-class savers into barely regulated hedge funds by raising the net worth requirements for “accredited investors”—those who were wealthy enough to buy hedge funds legally—to $2.5 million, from $1 million. By doing so, however, it walked into a buzz saw of opposition from people who were already invested in hedge funds but would not qualify under the new standard. As one Congressional Research Service report observed, “These investors did not wish to be protected from risks that the SEC might view as excessive.” The effort was shelved.

Some critics of hedge fund registration noted that when Europe introduced a registration regime, it simply made hedge funds seem safer and therefore more attractive to middle-income investors. And some high-profile academics on both sides of the Atlantic were producing learned and widely touted papers supporting the concept of “hedge funds for everyone.” Why, they asked, should the profits of hedge fund investing be limited only to the wealthy and sophisticated?

More than social cachet was involved, although one wry observer noted that mutual funds had become “so yesterday” on the summer patio circuit. The low interest rates established by the Federal Reserve to sustain the economy in the aftermath of the technology stock collapse in 2000 had sharply reduced the amount of money a generation of aging Baby Boomers could safely earn on their retirement savings. At the same time, the growing housing bubble was increasing the value of their primary asset, their homes. With mortgage rates so low and home values so high, many people could, and did, borrow against their home equity, invest with Madoff, and earn far more income for retirement than they could have earned with a bank CD or low-risk mutual fund.

So, both at home and abroad, directly and through their pension funds, more investors were putting their retirement nest eggs into hedge funds—and enough of that money wound up in Madoff’s basket to more than cure the cash crisis that had looked so deadly for him in November 2005.

Another important factor in Madoff’s remarkable rebound was the boom in derivatives tied to hedge fund performance, a subset of the derivatives mania that was intensifying on Wall Street and in other financial centers around the world.

At this point in the Madoff tale, Harry Markopolos would be drawing circles and arrows on his whiteboard. But it’s helpful to think of derivatives simply as private contracts between a seller and a buyer; each contract is designed to achieve a particular purpose. The purpose of these particular contracts was to allow the buyer, for a fee, to share in the future gains of a specific hedge fund without having to invest in the hedge fund directly.

Why would anyone have wanted to do that? Well, there were a number of reasons. Perhaps an attractive hedge fund was not accepting new investors; a derivative contract designed to track that closed fund would give investors the benefit of being in it even though the door was shut.

More significantly for Madoff, some of these derivative contracts allowed the buyer to invest with borrowed money, which meant that the investor could earn two, three, or even four times the gains produced by a particular hedge fund—leveraged profits that the hedge fund itself could not have provided. Eventually, derivative contracts would be designed to track a number of Madoff feeder funds, but initially the primary “tracking fund” was the giant Fairfield Sentry fund, whose assets totaled nearly $5 billion at the end of 2005.

In August 2006, as the global appetite for all kinds of exotic derivatives grew, a prominent Spanish banking group called Banco Bilbao Vizcaya Argentaria (BBVA) sold $20 million worth of these derivative contracts designed to pay investors five times the future profits of the Fairfield Sentry fund. A month later, it sold another $5 million of the notes. The bank had a substantial presence in Latin America, in addition to its Spanish business, and its gleaming reputation stood behind the unfamiliar new product.

Soon, Nomura Bank International, a worldwide institution with special strength in the Asian markets, would issue $50 million in derivative contracts offering to pay three times the future gains in the Sentry fund. Compared with some of the derivatives being sold on Wall Street at the time, the deal looked conservative.

In December 2006, another $25 million in Sentry-tracking contracts, derivative notes offering five times the fund’s profits, was issued by Madoff’s own bank, JPMorgan Chase, an institution born in 2000 from the merger of two of the most fabled names in American banking history. J.P. Morgan & Co., of course, was founded by the legendary financier who almost single-handedly reversed the financial panic of 1907. The Chase Manhattan Bank, which traced its ancestry to 1799, had been led for more than two decades by David Rockefeller, a grandson of America’s first oil baron, John D. Rockefeller. The JPMorgan Chase notes attracted the attention of an Italian money manager who had been searching for a way to invest in Madoff. The notes produced better returns but were still tied to the conservatively managed Fairfield Sigma funds, the Sentry fund’s euro-based affiliate. “It’s like they were giving you a parachute with a more exciting trip,” he said. “And it was J.P. Morgan!”

Fairfield Greenwich founders Walter Noel and Jeffrey Tucker had come a long, long way from sharing office space with an options trader back in 1989. Now they were sharing their life-size gamble on Bernie Madoff with one of the most historically successful banks in the world.

The development of these derivatives was important for Madoff because the banks selling them had to hedge the risks they were taking on—and they did this by investing directly in the hedge funds whose performance the derivatives were supposed to track. The funds, in turn, invested that money with Madoff. He let it be known that he disapproved of these leveraged derivatives, but they were a new source of cash for him in the summer of 2006, when he needed it desperately.

But these and other Madoff-linked derivatives—which would soon be offered by HSBC, Citibank, Fortis, Merrill Lynch, and several other global institutions—were also a significant milepost in the evolution of Madoff’s Ponzi scheme. Initially, people had invested with Madoff because they trusted him. In time, they invested because they trusted whichever prominent accountant, lawyer, or pension fund adviser opened the door to Madoff. Then they invested with prominent individual investors who knew Madoff, such as J. Ezra Merkin and Sonja Kohn, or in feeder funds such as Fairfield Greenwich and Tremont Partners, whose founders knew him. Now people who had never heard of Bernie Madoff were tying their fate to his because they trusted the giant banks that were selling these complicated contracts, banks whose chief executives probably had never heard of Madoff either.

Looking at the fine print for these derivatives with skeptical hindsight makes the investors’ trust seem quite remarkable. Bank lawyers had worked a long time on these complicated agreements to protect the banks’ interests and insulate them from liability. Investors were warned repeatedly that they should be prepared to lose
all the money
they invested in these contracts.

In the final terms for the contracts sold by JPMorgan Chase in December 2006, some variation of the word
risk
is used 139 times. One of those citations went like this:

In other words, caveat emptor: buyer, beware.

Of course, similar warnings were scattered through the paperwork for almost every hedge fund in the marketplace. Apparently, people who had invested far more than they could afford to lose did not seriously believe they actually could lose everything. Besides, all those smart, well-compensated managers running these funds were doing the due diligence that would detect a fraud, right?

The notion inherent in these warnings—that you paid for the higher profits the hedge funds produced by taking on much higher risks—was apparently dismissed as just so much legalese. Nothing to lose sleep over.

The final maneuver Bernie Madoff used to pull his Ponzi scheme out of the nosedive of November 2005 was to substantially increase the rates of return his feeder funds could offer, making the funds more attractive to investors. For example, the return on the Fairfield Sentry fund in 2006 was nearly a third higher than its 2005 results. It was a gutsy gamble. If Madoff had guessed wrong about where investors were in their perpetual journey between fear and greed, the move could have been disastrous—if withdrawals had continued, a higher rate would instantly have accelerated the evaporation of his cash.

But the financial landscape in early 2007 made the risk look less worrisome. Home values had been climbing for years, and it seemed they always would. The S&P 500 index had almost regained the ground it lost after the tech-stock collapse in 2000. Even the battered NASDAQ composite index was back where it had been in January 1999, before the last puff of air went into the Internet bubble. Financial deregulation still looked like an excellent idea. So did all the creative financial engineering that produced the Fairfield Sentry derivative notes and the countless other complicated derivatives that were being embraced by institutional investors everywhere.

So it appeared that Madoff had guessed correctly when he raised his rates, and his gamble paid off. Investors were still more interested in high profits than in safety. And, of course, his investors—whether hedge fund managers or heartland retirees, leading economists or lagging industrial unions—all privately convinced themselves that, with Bernie Madoff, they were somehow getting both.

Beneath the surface of public attention, things were already crumbling by late summer of 2007—for Madoff and the nation.

In Madoff’s own realm, bankers and hedge fund administrators were quietly growing more leery of his secrecy and consistent results. The proliferation of his hedge fund investors and the construction of all those complex derivatives had increased the amount of attention he was getting in banking circles. A number of bank due-diligence teams were growing increasingly worried by what they were learning—and not learning—on their visits with the managers of various Madoff feeder funds. By 2007, executives at one giant bank serving his hedge fund clients were looking for ways to immunize themselves legally from any responsibility if whatever Madoff was doing ended badly.