How Bernie “Madoff” With $50 Billion!!!

The neighborhood of Far Rockaway in Queens, NY epitomizes the essence of middle income urban life. To say that the kids from this neighborhood develop “street smarts” at a very early age is a huge understatement. 

Hustlers of every strain, predominantly positive in nature, grow up early in Rockaway. The movie, “Flamingo Kid”, starring Matt Dillon is set in Rockaway Beach. From the beaches  in Rockaway one could see the Twin Towers off in the distance. Dreams of fortunes and fame earned on Wall St. drove many with real ambition. Bernie Madoff was one of those boys filled with ambition. However, while ambition can be an amazingly powerful force if left unchecked it can be fatal. 

When the tide is high and the surf is pounding in Rockaway, the kids frolic and never want to come out of the water. However, when the tide goes out, the ocean can leave a few gems. Often times, though, the waves leave a mix of driftwood and waste and a very unpleasant if not putrid odor.

In similar fashion, in 2008 the tide on Wall St. has gone out. While there will be some gems amidst the rubble, it is also mostly a mix of driftwood and waste left upon the shore. Just as at times large fish are trapped and die as the tide recedes, this past Thursday,the unchecked ambition from one of Rockaway’s boys finally caught up with him and in so doing left the biggest “carcass” in the person of Bernard Madoff on the shore for all to observe.

How is it that this “fish” which appeared to be the marvel that created wonderment in the form of outsized financial returns for so many for so long was actually a shark that enveloped and ultimately devoured his followers? Let’s enter the world of this “shark”.

While Matt Dillon played a cabana boy, Bernie was a lifeguard in his youth and set his sights on Wall St.. Bernie did not take the normal route onto Wall St. by working for one of the large warehouses but in 1960 at the tender age of 22, he founded his own firm Bernard Madoff Investment Services. While most stocks at that time were “traded” on the floor of one of the exchanges (NYSE, AMEX et al) Bernie had visions to create competition for the exchanges. As one of the founders of the NASDAQ, he and the other founders of that “over the counter” market listed companies that did not trade on “the floor” but on “trading desks” across Wall St.. This “over the counter” market is also utilized for virtually all bond trading as well.

Bernie Madoff was a visionary. When did he become a con artist and a thief? Well, the authorities are reviewing his firm’s records as I write this to determine just that and likely so much more!!

For the benefit of those unfamiliar with stock trading, I would like to provide some insight on the difference of stock trading executed on the floor of an exchange vs stock trading done “over the counter”.  When an order is placed for a stock that is traded on the “floor” the “specialist” who handles the flow of that stock will commit capital and make an orderly two way market. With the advent of increasingly efficient technology many specialist firms consolidated and processed trades electronically at the respective exchanges. Stocks listed on the NASDAQ are traded “over the counter” on a trading desk at JP Morgan, Goldman Sachs, Morgan Stanley or a smaller broker dealer such as Bernard Madoff Investment Services. Orders from clients are directed to traders who “make the market” (a bid vs asked quote…such as 17.5 bid for a stock and a 17.7 asked). Even at these shops order flow can be processed electronically.

One of Wall St.’s dirty secrets is how dealers often ‘”front run” their order flow. This “front running” is when dealers buy or sell for their own account knowing that they have a customer order waiting in the wings. “Front running” is illegal and hard to detect but it happens all the time. I have no personal knowledge of front running at Bernard Madoff Investment Services but it is widely speculated that his shop did engage in it. 

  Bernie grew his firm by developing a money management business alongside his broker-dealer business. Most major Wall St. firms do have these separate lines of business but by regulation they need to have very strict “Chinese Walls” in place to make sure that customer interests are protected and that insider trading does not occur. The fact that these two separate lines of business were one floor apart in the same office building for Bernard Madoff should have been a major warning signal for the regulators at the SEC and FINRA.

From this point on, I am merely offering opinions as to what I believe occurred at Bernard Madoff based on what has been provided publicly. We will all learn in the days and weeks ahead how multiple billions were lost over many years.

To think that Bernie Madoff pulled off a 50bln fraud strictly by himself defies logic. That said, these Wall St. frauds over the years have shown that the perpetrators have worked very tightly with co-conspirators and have ALWAYS directly controlled their back office for trade reconciliations and settlements. In my estimation, there is little chance that Bernie’s closest business partners, those being his brother and two sons, were not aware of this fraud, either in total or in part.

How could the SEC and FINRA not double check and mandate that BMIS not have a custodial bank to hold it’s securities. For a shop the size of Madoff’s not to have a custodial bank is UNHEARD of!! An even BIGGER question is how it is that nobody ever questioned how a business the size of BMIS was audited by one person fronting as a legitimate operation in upstate New York. The sirens should have been going off long and loud on that. Additionally, a competitor indicated consistently to the SEC back in the late ’90s that BMIS was running a Ponzi scheme. How could they have missed it then or how could they have not placed BMIS on a serious watch list in the intervening years for review?

Bernie Madoff developed a uniquely masterful facade of exclusivity, market savvy, consistency, and charity. His Svengali like demeanor duped his investors into truly believing that they were lucky and blessed to be included into his “club”. In the process of reviewing Madoff’s list of clients, it is obvious that he effectively turned on “his own” as his individual and institutional clients were predominantly Jewish, including many Jewish philanthropies. Bernie could have started losing money in his broker-dealer operation and needed to figure out a way to fund that operation. He could have become entranced by front running clients and wanted a mechanism for generating even greater “wealth”. He may have learned how to manipulate client reports. Perhaps all three catalysts developed simultaneously and his scheme developed small and grew. We should learn a lot more in the weeks and months ahead.

Like any Ponzi scheme, though, in which new investor money is used to pay the interest, dividends, and if need be the principal for prior investors, it crashes when the requests for redemption exceed new incoming funds. In the midst of the massive bear market of 2008, Bernie probably has not been getting much sleep.  

A major failing occurred as the trustees for certain investors/funds that brought money to BMIS failed to perform some of the very basic rules of investing, including:

 1. how is the money manager truly making his money…do I understand it?…if not, ask someone who does…if you still do not understand it, then don’t invest…. 

2. what checks and balances are in place to monitor trading activity…who is the custodian/prime broker??…who is the auditor?…are they all credible and qualified? …get names and references if you are investing with a private money manager for these entities….

3. in analyzing investment returns, compare returns vs an index that the manager is using….question how and why a manager is outperforming or underperforming…if it seems too good to be true, maybe it is…a manager that is trading equities is supposed to have returns that are largely correlated with the equity market…a manager that is trading bonds should be correlated with the bond market…a manager that is generating outsized returns with little volatility should raise warning signals.

Perhaps certain of those trustees who were directing money to Bernie were receiving “extra” incentive in the form of outsized payouts(kickbacks, …you think??) to continue to bring funds. We may never know the full story. 

For all investors and those with an interest in finance and the markets, this story highlights the need for fully understanding and appreciating the need for:

1. understanding and measuring risks of all sort…market risk, interest rate risk, credit risk, counter-party risk

2. diversity in a portfolio

3. transparency

4. humility…as Groucho Marx said, “I wouldn’t want to join any club that would have me!!” In a similar vein, this exclusive world of select money managers and hedge funds is not necessarily all that it appears. While the overwhelming majority of money managers are very reputable, there are crooks and cons in this business just as in every business.   

On Bernie’s website, it reads, “Clients know that Bernard Madoff has a personal interest in maintaining the unblemished record of value, fair dealing, and high ethical standards that has always been the firm’s hallmark.” I’ll say he had a personal interest!!! It is now very obvious that he did not have many of those other qualities.

Get all the details on this fascinating story, “Fund Fraud Hits Big Names.”

As the tide continues to go out, rest assured that there will be more refuse left upon the shore. We will definitely be picking through it and highlighting it here at NQ!

Please join us tonight at 8pm on NQ Radio to discuss this situation and anything else on your mind.

“Gin….Bernie….!!”