Another glaring shortfall is in the sad state of HFOF due diligence. For the most part, these fund of funds are nothing more than marketing machines that pretend to conduct exhaustive due diligence. If you don’t believe me, ask what their budget for due diligence is this year in both dollar terms and as a percent of revenue. If they can’t give you an immediate answer, then they aren’t even taking the time to measure what is supposed to be their most important function—preserving your capital! My observation is that most fund of funds spend a lot more effort on their marketing than on their due diligence which, of course, doesn’t help their investors very much.
A well run HFOF can provide a diversified portfolio and generate attractive returns for their investors. While too many HFOFs got caught up in the Madoff Ponzi scheme, I applaud those organizations that did their homework and helped their investors avoid this disaster. In the United States, almost 11 percent of the HFOFs had Madoff—so 89 percent avoided him. But in Europe, particularly Switzerland, the HFOFs got hit hard. Switzerland had Madoff exposure in almost 29 percent of its HFOFs. On the plus side, most of those HFOFs are no longer operating. The key for investors is to conduct their own due diligence of their HFOF to determine that the people behind it really do know what they’re doing and actually do what they say they’re doing.
But as usual where Madoff was concerned, the numbers didn’t work. If he returned 1 percent net a month to his investors and in addition effectively paid the funds 4 percent, he had to gross 16 percent annually. He claimed that six to eight times a year, when his magical black box told him that the moon was in the seventh sun or the bones had fallen in a promising way, or whatever way he supposedly was getting the word, he would sell his T-bills and buy 35 stocks from the S&P 100 and protect them with options. Weeks later when the genie awakened again to tell him the market was going to tank, he would get out with large profits. So he wasn’t continually in the market. And when he wasn’t in the market, his money was in T-bills. That was where his math made no sense: How is he earning those returns when he isn’t in the market? He needed to be buying 16 percent T-bills in a world in which Treasury bills haven’t yielded 16 percent since the early 1980s.
Sometimes it seemed like there were more red flags in Madoff’s claims than in the former Soviet Union.
But Neil had opened a potentially very valuable link. Neil had given no reasons for this adviser to suspect his interest in Madoff was anything but responsible due diligence. This adviser still believed Neil was seriously interested in investing millions of dollars in Fairfield Greenwich Group (FGG), so he was willing to do whatever was necessary to nail it down. He even offered to set up a conversation for Neil with Amit Vijayvergiya, FGG’s chief risk officer. Neil couldn’t believe it. He immediately sent me an e-mail, wondering what questions he should ask. Even though I was busy with a dozen active cases, I dropped everything and started writing just a few thoughts. And then a few more. Eventually I had three pages of questions, more than 80 of them, although, as I wrote, “Gee, I could write questions all night. Somehow I think they’re not going to answer many of these questions in great detail in order to protect their proprietary trading methodology.”
The questions covered all of the red flags we’d been waving for so long: If two stocks with a total portfolio weight of 4 percent drop 50 percent due to company-specific risk (say subprime exposure), how are you protected against a 2 percent portfolio loss? What are your total assets under management? I’m hearing numbers in the $30 billion to $50 billion range.
Who are your leading brokers for stocks? How do you guard against front-running? How do you explain your lack of a down month?
Who are your traders? Where did they learn how to trade your strategy? Can I sit on your trading desk for a day to get a feel of how you run your operation?
What scenario keeps you up at night? What are your strategies’ worst-case scenarios?
I was having fun writing them, and I continued writing them even though I knew there was absolutely no hope he would be able to answer many of them. If he was to be honest, his answers would all have to be nothing, zero, we don’t, I don’t know, and (most often) never. How large is your compliance staff? We don’t have one. Who does your trades? We don’t make trades. How do you explain your lack of a down month? We just make up the numbers. What scenarios keep you up at night? Getting exposed. What is the maximum size that your strategy can handle without watering down returns? As much money as you’re willing to hand over to a Ponzi scheme.
I was actually very excited about this conversation. In all the years we’d been investigating, other than Mike’s 2001 interview and the few questions we’d asked the former employee of his broker-dealer operation, we’d had very few opportunities to get a really good look inside Madoff. As we later verified, the Fairfield Sentry Fund was his single largest feeder fund. When we’d started our investigation, it had about $3 billion in assets; by this time that had increased to more than $7 billion—and every penny of it had been channeled to him. The fund charged its clients 20 percent of profits and a 1 percent management fee, so on a 16 percent gross return, which is roughly what Madoff supplied, it earned close to $40 million for every billion invested. Considering that Fairfield Sentry had $7 billion with Madoff they were earning approximately $280 million per year in fees to look the other way and not ask the tough questions.
So Fairfield Sentry had several million reasons to protect Bernie.
As Neil told me later, Vijayvergiya was pleasant but officious. He certainly wasn’t prepared for the barrage of questions Neil asked, and wasn’t able to answer many of them. He began by explaining the relationship between Madoff and Fairfield Sentry. Madoff was registered with the SEC—he didn’t mention he had been forced to register after the 2005 SEC so-called investigation—and his broker-dealer had $640 million in capital. FGG had been investing in Madoff since 1990 and at that point, according to Vijayvergiya, had slightly more than $7 billion with him. “So about how much is he managing overall?” Neil asked.
Vijayvergiya admitted he didn’t know, but estimated Madoff had a total of $14 billion under management with a dozen people. The head of risk management didn’t know how much money the man who was handling $7 billion for them was managing? Neil took a deep breath—that was astonishing. Within five minutes, he told me, “I was thinking this whole thing was a joke, an absolute joke. He couldn’t have been serious.”
It wasn’t a joke; it was a tragedy. When Neil started asking specific questions, it got worse. Neil asked who took the other side of all the trades Bernie was making. Amit replied that for large trades Bernie got quotes from three or four big brokers and took the best one, then instantly got filled on the option side.
Neil was sitting at his desk in Tacoma shaking his head in disbelief. One of the first things I’d taught him was to be very careful about approaching multiple buyers for a quote on the same trade, because there was nothing to prevent a buyer who didn’t get the trade from front-running—buying or selling before I could make my deal, knowing that my deal was going to move the market. It’s illegal, but it’s absurd to believe that someone with this information isn’t going to take advantage of it. It’s part of the reality of the marketplace.
Neil pushed Amit on this, asking repeatedly who was taking the other side of these deals, because these large deals Madoff supposedly was making didn’t seem to be showing up anywhere. “If they’re off-loading it,” Neil said, “the easiest way of doing it would be to go into the S&P or the OEX pit, and how come no one’s ever been able to find a trace of any of these trades in the market?”
Amit told Neil that it was an interesting question, then claimed he’d never really thought about it. In other words, he just plain didn’t know.
Neil eventually focused on Madoff’s split-strike conversion strategy. It had become obvious to him that Vijayvergiya didn’t understand that this strategy couldn’t produce the rates of return Madoff claimed. “What am I missing here?” Nei
l asked. “You basically need to have some directional bias, whether the market’s up or down or flat. Is there some kind of arbitrage I don’t know about? I have to tell you, Amit, I don’t understand how he does it.”
This was a question Amit had been prepared to answer. He told Neil that Madoff was market-timing the entry and exit of all his trades. “Bernie’s got a proprietary model that helps him decide when to put trades on and when to take them off,” he said. “It’s got three core factors—momentum, volatility, and liquidity. That allows him to be long when the markets go up and out of the market when it is not favorable.”
“Let me be clear,” Neil pressed. “When you put a trade on, you have to put it on with some kind of bias, right? What I want to know is how is he doing that?”
“Well, he’s got a market-timing model.”
Neil asked him why, if this strategy had been so incredibly successful, other people had not been able to duplicate it. Amit attempted to answer that question, pointing out that no one else had Madoff’s proprietary model, which told him when to enter and exit split-strike trades.
The conversation grew increasingly more absurd. Given that Madoff had this perfect knowledge of the market, Neil asked, why does he need all these other funds? According to the model, Madoff was actually earning considerably less than those funds. So why didn’t he just eliminate the middlemen, set up his own hedge fund, and charge 1 percent or 2 percent fees and 20 percent of the profit? Neil told me that when Vijayvergiya said seriously that “Madoff doesn’t have the operational capability to set up a hedge fund structure,” he had to consciously stop himself from laughing out loud.
This guy actually expected Neil to believe that Bernie Madoff, who had helped found NASDAQ and who had built his own market-making operation, couldn’t set up his own hedge fund. It probably takes about $50,000, a computer, and some office furniture to open a hedge fund. There are no barriers to entry into the hedge fund world. All you have to do is copy someone else’s documents and file a few papers, and you’re in business.
Neil finally replied, “Well, I can’t believe Bernie couldn’t just open a hedge fund and hire all the people he needs around the world for less than $20 million a year and keep all the rest for himself. He wouldn’t have to deal with all the headaches that come with these other funds and he would keep most of the money himself. It makes sense. Why wouldn’t he do that?”
Vijayvergiya literally did not answer. Instead, he continued pitching the same nonsense we’d been reading about for almost eight years. Neil had to wonder how many people had listened to it and accepted it without questioning it, instead being seduced by the returns. Well, at least $7 billion worth. Obviously, there had been many other people who had heard it and walked away from the table; for example, none of the major New York investment houses had bought it. But this time Vijayvergiya was talking to someone who intended to call him on it. “Would you explain that to me? I’ve got to tell you, I’ve never heard anything like that before. Are you telling me that Madoff literally knows when the market’s going to go up and when it’s going to go down?” And basically, Vijayvergiya claimed that was true. Neil wondered, do you actually believe that? It’s been proven over and over and over by academic studies that no one can time the market, let alone time the market consistently for 17 consecutive years. It made no sense, so Neil asked, “Are you telling me Bernie basically has had perfect market timing every month for the last 17 years?”
Vijayvergiya didn’t respond directly to that.
“I just don’t get it,” Neil continued. “If you had perfect market timing like Madoff says he does, a split-strike conversion is the last strategy you’d use. I mean, if you really knew which way the market was going, you’d be buying leveraged futures or options. You could make a killing with a lot of other strategies, but this one actually limits you.”
Vijayvergiya basically had no answer for that.
Neil then asked him why Madoff traded over the counter (OTC) rather than doing listed trades. Again, he didn’t have an answer.
Neil asked him the cost of trading OTC against listed stocks. He had no answer.
Later, when Neil was telling me about this, he just kept repeating, “It was comical. This guy didn’t know anything. I kept asking him about how the trades actually get executed, and I was drilling him every which way. Are they instantaneous, does he do the options all at once, does he package trade, does he toss in a third market?—every possible question you could ask about how a trade is implemented. I was firing away at him and eventually he says, ‘There might be a three-or four-hour time lag from the time he actually does the stock trade verses the options.’ He estimated that about 20 percent of Madoff’s trades were done that way.”
Neil told me, “Immediately I was like, ‘Well, when you leg into a trade, when you only do one side and not the other side instantaneously, there’s always the risk of it going against you before you get the other side of the trade off. I’ve done that, and I know you can get burnt really hard, really fast. So how does he protect himself?”’
Vijayvergiya basically had no answer for that question, either.
Neil spent about 45 minutes on the phone with him. In hindsight, he was sorry he hadn’t stayed on the phone for hours and run through all our questions. But 45 minutes was all Neil could take. When he hung up, he was frustrated and angry. After all these years, Neil still thought there was a small possibility it was front running rather than a Ponzi, but this call settled that for him once and for all. He e-mailed me, “I can’t believe they have kept this Ponzi scheme going on for this long.”
Probably the only thing about this conversation that surprised us was the reality that Fairfield had so little respect for the people with whom it was dealing that they hadn’t even bothered to make up some sort of plausible answers to these questions. The attitude was, you want these returns? Then you accept what I’m telling you—or rather what I’m not telling you.
All you have to do to get rich is believe in Bernie.
Even after that disastrous phone conversation, the third party marketer called Neil and asked if he was still interested in giving several million dollars to FGG to handle. Neil made him an offer. “Tell you what,” he said. “I’ll give him fifty million dollars right now. I’ll cut you a check for fifty million bucks. I can get it done next week—but it’s gotta be done in my separate account with my prime broker and only with listed OEX options. He can charge me his two and twenty, whatever he wants to charge me, but my fifty million has to go in my separate account in Goldman Sachs.” Neil said this knowing it was an offer they had to refuse.
Maintaining a separate account meant that Neil would be able to see the execution of all the stock trades with the prime broker. And since no trades were being made and there would be nothing for him to see, there was no way Madoff could allow this. The marketer said, “Honestly, I don’t know if he’s done that before. I have to check.”
He called back the next day and as expected told Neil it wasn’t possible. Neil responded, “No shit. He can’t do it because his whole operation is a fraud.” Neil didn’t mention my name or tell him that he had been investigating Madoff for years. Instead he pointed out that no legitimate manager would refuse a $50 million separate account. The fees would more than offset the hassle. But this marketer refused to believe him. Like so many other people, he just had too much at stake to accept it.
When Neil e-mailed me with this response, I wrote back, “My belief is that the HFOFs [hedge funds of funds] like Fairfield are either in on the scheme or willfully blind. Willful blindness is not a defense.”
And when Neil offered, “Feel free to pass my notes on to SEC. Just remove my name,” I pointed out it would do no good. “I’m not sure sending the SEC anything would help those morons solve the case. They’re so lame, I’ll bet they don’t even catch colds in winter.”
I’d finally given up on the SEC. A month earlier I’d sent it my final submission—and as usual I’d got
ten no response. I’d sent a prospectus from Prospect Capital’s Wickford Fund, another fund that channeled money to Madoff through Fairfield Sentry. But what made this one different was the fact that Madoff had started accepting leveraged money, a strong sign that he was running out of cash.
Frank Casey had found it in early June. He had been searching an Internet database for stable managers, trying to keep up to date with what Benchmark’s competitors were doing. As he remembers, “Eventually the Wickford Fund popped up as a fund of funds. I got on their web site and discovered that it was offering a three-to-one swap written with a counterparty bank that was willing to lend two dollars for every dollar invested in a manager strategy.”
Frank called me right away and said, “Madoff’s got to be running short of cash. He’s doing a three-to-one triple leveraged product with [and he named the bank].”
“My God,” I said. “He’s in trouble. He’s gotta be getting close because he’s willing to take in leveraged money. That means he’s running out of money. He’s getting desperate.” Equally interesting was the fact that one of the two Wickford Funds was offshore, registered in the Cayman Islands, which made it attractive to American citizens who wanted to hide money from the IRS.
No One Would Listen: A True Financial Thriller Page 24
