Modeling his strategy was complex. It had a lot of moving parts—at least 35 different securities moving at different rates of change—so it required making some simplifying assumptions. For this exercise I assumed he was front-running, using buy and sell information from his brokerage clients to illegally buy and sell securities based on trades he knew he was going to make. That meant that he knew from his order flow what stocks were going to go up, which obviously would have been extremely beneficial when he was picking stocks for his basket. We found out later that several hedge funds believed he was doing this. I created hypothetical baskets using the best-performing stocks and followed his split-strike strategy, selling the call option to generate income and buying the put option for protection. The following week I’d pick another basket. I expected the correlation coefficient—the relationship between Bernie’s returns and the movement of the entire S&P 100—legitimately to be around 50 percent, but it could have been anywhere between 30 percent and 80 percent and I would have accepted it naively. Instead Madoff was coming in at about 6 percent. Six percent! That was impossible. That number was much too low. It meant there was almost no relationship between those stocks and the entire index. I was so startled that the legendary Bernie Madoff was running a hedge fund that supposedly produced these crazy numbers that I didn’t trust my math. Maybe I’m wrong, I figured. Maybe I’m missing something.
I asked Neil to check my numbers. If I’d made an obvious mistake, I was confident he would find it. Neil went through my math with the precision of a forensic accountant. If I’d made any mistakes, he decided, he couldn’t find them.
By this time I had been working in the financial industry for 13 years and had built up a reasonably large network of people I knew and respected. In this situation I turned to a man named Dan DiBartolomeo, who had been my advanced quant teacher. Dan is the founder of Northfield Information Services, a collection of math whizzes who provide sophisticated analytical and statistical risk management tools to portfolio managers. He’s a super-brilliant mathematician who has probably taught half the quants in Boston and is a lot smarter than Neil or I will ever be.
Neil and I went across the street to see him. Dan is an eccentric, a bow-tie-wearing East Coast surfer with a photographic memory who revels in math. I told him that I thought we’d discovered a fraud, that Bernie Madoff was either front-running or running a Ponzi scheme. I could almost see his brain cells perk up when I said that. Every mathematician loves the hunt for the sour numbers in an equation. After going through my work, Dan told us that whatever Madoof, as he referred to him, was doing, he was not getting his results from the market. Pointing to the 6 percent correlation and the 45-degree return line, he said, “That doesn’t look like it came from a finance distribution. We don’t have those kinds of charts in finance.” I was right, he agreed. Madoof’s strategy description claimed his returns were market-driven, yet his correlation coefficient was only 6 percent to the market and his performance line certainly wasn’t coming from the stock market. Volatility is a natural part of the market. It moves up and down—and does it every day. Any graphic representation of the market has to reflect that. Yet Madoff’s 45-degree rise represented a market without that volatility. It wasn’t possible.
Bernie Madoff was a fraud. And whatever he was actually doing, it was enough to put him in prison.
I knew that was true, but it was just so hard to believe. Several months later I showed another manager’s marketing explanation to Leon Gross, at that time the head of equity derivatives research at Citigroup. I don’t think I identified Manager B as Madoff to him; I just asked his opinion about the strategy. Leon is way up there on the smart chart, and 30 seconds after looking at the material he said, “No way. This is a loser. If this is what this guy is really doing, he can’t beat zero. The way this is designed it’s impossible to make money.” He shook his head in dismay. “I can’t believe people are actually investing in this shit. This guy should be in jail.”
That might have been the end of it for me. I might have filed a complaint with the Boston office of the Securities and Exchange Commission (SEC), and it would have made great pub conversation: “I’ll bet you didn’t know Bernie Madoff—you know, Madoff Securities—is running some kind of scam,” and it wouldn’t have gone any further. But this was the financial industry, and there was money to be made following Bernie—potentially hundreds of millions of dollars.
Frank Casey and Dave Fraley began pushing me hard to reverse engineer Madoff’s strategy so Rampart could market a product that would deliver similar returns. Frank didn’t believe what Madoff was doing was real; he knew that Madoff was using that split-strike jargon to cover for whatever he actually was doing, but he also didn’t believe that it was a Ponzi scheme. “Ponzi’s a strong word,” he said. “Okay, we know he’s a fraud, but maybe he’s doing something else and just claiming this to keep it simple.” What he did believe was that I could design a financial product that could compete with Madoff. “Just look at the return stream this guy is putting out,” he said. “This is what the market wants to buy. Can’t you develop something that we could run at Rampart that would compete against Madoff? Believe me, Harry, Thierry de la Villehuchet is looking for something that would net ten, twelve percent to the client. If we can offer him anything even close to that . . .” He didn’t need to finish that
