The Wizard of Lies: Bernie Madoff and the Death of Trust (7 page)

In the late spring of 1962, a twenty-four-year-old Wall Street trader named Bernard Lawrence Madoff was facing almost total ruin.

Madoff started his own brokerage business while he was still a senior at Hofstra University, in the winter of 1959/60, just as the stock market was about to embark on a wild decade that would be immortalized later as the “go-go years.” The era was overheated, volatile, and peopled with characters who belonged in a Marx Brothers movie. And no corner of Wall Street was wilder or riskier in those days than the one where young Bernie Madoff had put out his shingle: the over-the-counter (OTC) stock market.

The enormous, decentralized, and weakly regulated OTC market of the 1960s may be hard for modern investors to imagine. The New York Stock Exchange, known as the Big Board, had long been dominated by Main Street—or, more accurately, by the people who owned and ran Main Street. Few pension funds or endowments owned common stocks, so a large majority of the Big Board’s daily orders were from individual investors, people wealthy enough to feel comfortable in the market despite its turbulent history. They were cosseted by their family stockbrokers. Taking the long view for their children’s trust funds, they bought shares in railroads, utilities, automakers, steel companies, the blue chips they knew and understood—and, in some cases, managed or had founded. Each day, they could check the prices of their shares in the evening newspapers.

In the years after World War II, however, new companies pursuing new technologies were cropping up everywhere, almost overnight. At the same time, family-dominated companies with few public shareholders needed to raise capital to grow. The shares of these unseasoned or thinly traded companies—some of them destined to become household names, such as Anheuser-Busch, Barnes-Hind, Cannon Mills, Tampax, Kaiser Steel, and H.B. Fuller—did not meet the requirements for listing on the prestigious New York Stock Exchange or its smaller sister exchanges around the country. But that didn’t mean their shares didn’t trade. They were the mainstays of the over-the-counter market, where Bernie Madoff planted his flag in the early 1960s—and where he first started to get rich.

Without doubt, there were plenty of people getting rich in those hyperventilating days. The year the Madoff firm opened its doors, 1960, was the next-to-last lap in the longest bull market the country had seen to that point—a spectacular climb that began in the summer of 1949 and would continue until New Year’s Eve 1961. Over that time, the prices of blue chips in the Dow Jones Industrial Average would more than quadruple, with an average gain of nearly 13 percent a year. After the brief bear market in the first half of 1962—the long-forgotten lurch that would nearly destroy Bernie Madoff—the party rolled on into the late 1960s at roughly the same pace.

And those were the returns on conservative blue chips that traded on the Big Board. The gains in riskier OTC stocks during the bull markets of the 1960s were poorly documented, but one study put them perhaps as much as five times higher than the Dow Jones Industrial Average. These are stock price gains reminiscent of the technology stock bubble of the late twentieth century—or the Ponzi schemes of all ages. So Madoff investors who recall early annual returns of 20 percent may not be inflating their memories; such returns would not immediately have raised red flags in an era when the hottest mutual funds were sometimes doubling their value in a single year.

The possibilities of the young OTC market in the 1960s were recalled by Michael Steinhardt, who made a fortune on the Street and later invested a portion of his charitable foundation with a fund that passed it along to Bernie Madoff. “I thought, when we started up our company, I could compete effectively with older people in the business,” Steinhardt said in one published interview. “Youth believed in such things, because we had grown up in the ’40s, ’50s and ’60s and saw extraordinary technological innovation.” He recalled buying stock in a company whose price increased ninefold in less than a year; he sold it, and within a year, it was bankrupt. “There were plenty of them like that,” he said.

The first home of Bernie Madoff’s one-man brokerage firm in 1960 was a spare desk at his father-in-law’s accounting firm on Forty-second Street, near Bryant Park. Within a few months he had found two small rooms downtown at 40 Exchange Place—an anteroom for his wife, Ruth, who worked part-time as his office manager, and an inner office where he could work the telephones and try to make trades with other dealers.

Besides a license, running an OTC trading house in the 1960s required two indispensable tools: a telephone and access to the daily catalogs known as the Pink Sheets, published by the National Quotation Bureau. (The catalog pages devoted to stocks were printed on pink paper, while the pages listing bonds were printed on yellow paper.) A writer visiting the bureau in the late 1950s thought “the manufacture of The Sheets is perhaps the most amazing operation in the financial market.”

Every weekday, in a stunning feat of manpower and logistics, bureau clerks manually collected price lists for nearly eight thousand stocks submitted by about two thousand over-the-counter dealers. The clerks collated the prices by stock name, entered the data on mimeograph stencils, printed the catalogs, and got them out the door to several thousand firms around the country in a matter of hours. Only dealers with full-service subscriptions, priced at about $460 a year, could submit price quotes.

That was a big expense for Madoff in his first few years in business, so he relied on day-old Pink Sheets collected from another brokerage firm’s offices on the same floor at 40 Exchange Place. After all, Madoff realized, the prices were out of date before the sheets were even printed; all you really needed were the names and telephone numbers of the dealers making markets in the stocks you wanted to trade. And there is no question that Bernie Madoff was trading some stocks in these early days. The share certificates were delivered to Ruth’s desk or picked up there by messengers, and the trades were manually entered into big ledgers maintained at the office. On a miniature level, she was his “back office,” maintaining his trading records for at least the first year he was in business.

As hard as it is for wired-in and instantly connected twenty-first-century investors to accept, there was absolutely no way for the public to independently verify the prices of over-the-counter stocks in the 1960s. A retail customer interested in the price of an OTC stock would have to call a broker, who would likely have to make a half-dozen phone calls to people like Madoff to come up with a slightly reliable answer. The newspapers did not print daily prices for OTC stocks, as they did for exchange-listed stocks. It was an utterly opaque market, a black box for customers and barely more visible to regulators. But armed with broker names and price quotes from the Pink Sheets, an aggressive broker could work the phones looking for business. Madoff would have spent his days calling around to trusted counterparts at other firms to buy shares that he could resell at a higher price to another broker or maybe to a retail customer—at a price that the customer or broker took on faith or walked away from. The whole process was a vast tutorial in how to win and keep the trust of other people. Those who couldn’t do that didn’t survive; Bernie Madoff survived.

There is little documentary evidence of how Bernie Madoff made money in the 1960s, but this is so for most tiny firms of that era. His own version is that he made money primarily by trading, regularly buying OTC stocks at one price and selling them at a much higher price, and then using his profits to finance more trading. The only trace his early business left in the available records is an underwriting deal his firm handled in March 1962 for a little outfit called A.L.S. Steel, based in Corona, Queens. According to Madoff, his father was working as a finder for the company and arranged the deal. The underwriter’s markup promised to the firm was handsome, but Madoff said he was not sure the transaction was ever completed.

Years later, the family legend was that he went from success to success in those early days, and this may have been true for the trading desk of his fledgling business. But as an investment manager, he began to bend the rules almost from the beginning, which led him to the brink of failure by mid-1962.

At the time Madoff was managing money for about twenty clients, many of them relatives and most of them small-scale investors who could not afford to take speculative risks. Nevertheless, by his own account, he invested their savings in the famously volatile “new-issues” market of the early 1960s, an early version of the hot stock offerings sold during the “tech stock” bubble of the late 1990s. Like the market for those flimsy Internet stocks, the new-issues market in those go-go years was filled with highly speculative stocks sold by young, unseasoned companies that occasionally flourished but more often failed. Caught up in the frenzied trend, Madoff violated long-standing market rules and common sense by selling such unsuitable investments to his risk-averse clients.

This lapse didn’t fall into a regulatory gray area. Decades before he set up shop, market regulators had imposed and enforced what came to be known as “the suitability rule.” Brokers were forbidden to sell their clients investments that were too risky for their individual financial circumstances, even if the clients were willing to buy them. Selling those hot new issues to his clients was wrong, and Madoff knew it.

If the new-issue market had continued to rack up the giddy gains of 1961, he might have gotten away with it. But after slumping steadily for weeks, the overall stock market fell sharply in the week of May 21, 1962—its worst weekly loss in more than a decade. Then, on May 28, the market stunned legions of young brokers like Bernie Madoff by plummeting to a daily loss second only to the shuddering one-day drop on October 28, 1929, on the eve of the Great Depression. Trading outpaced the stock ticker by several panicky hours. Although the market calmed down a few days later, the boom of the previous year was gone. Worst hit in the “little crash” of 1962, according to one account, were “the hot-issue boys, the penny-stock plungers, the bucket-shop two-week millionaires of 1961.”

Those “hot-issue boys” included Bernie Madoff. When the market for new issues collapsed and the price of those stocks plummeted, his trusting customers faced substantial losses. “I realized I never should have sold them those shares,” he later admitted.

Madoff didn’t just break the cardinal rule of investor protection, the suitability rule, he lied about it, covering it up in ways that preserved his reputation and thus laid the foundation for all that came later in his life of crime. He simply erased those losses from his clients’ accounts by buying the new-issue shares back from them at their original offering price, hiding the fact that his customers’ profits had actually been wiped out by the market’s turmoil. “I felt obligated to buy back my clients’ positions,” he later explained.

Doing so required him to spend all the $30,000 in capital he had built up in his first two years of business, he said. Unless he could raise fresh cash, he was essentially out of business. To recapitalize his firm, he turned to his father-in-law, Saul Alpern. Madoff said he borrowed some municipal bonds from Alpern and used them as collateral for a $30,000 loan—“a large amount to me in those days.” The cash infusion allowed him to resume his firm’s trading activities. It was a bitter taste of failure, “a humiliating experience,” he said.

But if Madoff felt “obligated” to erase the losses his recklessness had created in his client accounts, he did not feel obligated to disclose what he had done to his small collection of customers, who continued to think of him as a brilliant money manager who could safely navigate even the rocky market of 1962. “My clients were unaware of my actions due to their lack of experience in the OTC market,” he later acknowledged in a letter from prison. “If they were aware, they certainly didn’t object.”

Madoff insisted that this early trip across the line between right and wrong—illegally selling unsuitable stocks to his clients and then hiding their losses with phony prices—was not a Ponzi scheme, which is a form of fraud in which the profits promised to early investors are actually paid with cash raised from later investors, not from any legitimate investing activity. Madoff said that he simply used his firm’s money to erase his clients’ losses and burnish his own reputation as a trading star. That reputation would help him attract and hold the wealthy and influential investors who would become the first to testify to his genius.

Madoff initially suggested that he encouraged his father-in-law to think that repurchasing the shares was a legitimate business practice permitted by the original underwriting agreements. But, in a subsequent letter from prison, he said that Alpern “was aware of how this happened and understood why I felt obligated to do what I did. I was able to repay the loan within a year, which made both of us happy.” Perhaps Alpern simply believed the young Madoff had learned a valuable lesson and would not violate the rules again. Or possibly—but far less plausibly, to those who knew Alpern—he knew that Madoff was playing fast and loose with investors’ money and went along for the ride.

In any case, the incident did not visibly shake Alpern’s trust in his ambitious son-in-law, and they remained on good terms for the rest of Alpern’s life.

Beyond the indisputable facts that Madoff was an OTC trader and the market hit a jolting air pocket in the spring of 1962, one cannot know whether Madoff’s version of his early misbehavior is even partially true, of course. As he told the tale to prosecutors in the emotional days after his arrest, he mixed in a garbled chronology of confusing details about doing high-risk “short sales” and other strategies for his biggest customers in later years, trades that he said left no clear paper trail. He created the indelible impression in the minds of the government lawyers that his Ponzi scheme began much earlier than he would later admit, possibly as early as this incident in 1962.

In Madoff’s view, this early blot on his record was soon eclipsed by the increased business—and unbridled admiration—that his legitimate trading success brought him in the years that followed. But one must wonder how willingly new customers would have flocked to Madoff if they had known the truth about his disastrous losses in 1962.