“Mr. Madoff’s crimes were extraordinarily evil… The breach of trust here was massive.” --US District Judge Denny Chin on sentencing Bernard Madoff to 150 years in prison.
How did Bernie Madoff do it? How did he perpetuate a God-only-knows how many billion dollar Ponzi scheme for two decades? Most of the media focus has been on how he deluded investors, but he also slipped past three examinations and two investigations conducted by the Securities and Exchange Commission (SEC). This month the SEC’s Inspector General (IG) issued its report on the botched handling of the Madoff affair.
The SEC is a federal agency created in the aftermath of the 1929 stock market crash to enforce America’s first comprehensive regulations of securities. Up through the Roaring Twenties, the financial markets were self-regulated. Companies issued financial statements when and if they felt like it; smart operators were continually plotting to corner one market or another; and insider trading was taken for granted. The SEC’s mandate was to stop all that. To make sure that it did, President Franklin Roosevelt appointed Joseph P. Kennedy as the SEC’s first chairman. Kennedy, the father of John, Bobby, and Ted, had been a none-too-scrupulous Wall Street operator himself. Roosevelt was widely criticized for the appointment, but his reasoning was solid. “It takes a thief to catch a thief.” It’s too bad there were no Joe Kennedy’s at the SEC when it looked at Madoff’s companies. Instead, as the IG report concludes, “The SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme. Had these efforts been made with appropriate follow-up at any time beginning in June of 1992 until December of 2008, the SEC could have uncovered the Ponzi scheme well before Madoff confessed.”
The IG’s report exonerates SEC personnel from “any financial or other inappropriate connection” with Madoff or his interests. It also clears senior SEC officials from interference or direct attempts to influence the staff’s investigations. The IG report details the many errors of commission and omission that allowed Madoff to escape discovery for so long, but it draws no conclusions as to how or why such a systematic pattern of error originated and persisted. The reader is left with the impression that the SEC is simply incompetent; a collection of Inspector Clouseaus whose buffoonery would be a good joke if it hadn’t cost so many people so much money. This is a highly unsatisfying conclusion, calling in to question as it does the entire regulatory apparatus of the US securities markets. The performance of the Madoff investigators and examiners certainly was incompetent, but, I would argue, their failure can be traced to two reasons that are deeply embedded in human nature.
The first reason has to do with Madoff’s purported investment strategy. I am going to explain the strategy in the next few paragraphs. I have simplified it somewhat by using a single stock and options on that stock, while Madoff claimed to use a basket of 30-35 stocks and options on stock indices. The principles are the same, and besides, Madoff never actually executed the trades, so a little license in describing them won’t matter much.
On a given day, Bernie buys 100 shares of Coca Cola stock at $50 a share. Simultaneously Bernie sells a “call” option to another investor, whom we will call Bob. Bob’s option gives him the right but not the obligation to buy (or call away) Bernie’s 100 shares of Coke stock at specified price on some specified future date. Bob pays Bernie a fee, called a “premium” up-front, and Bernie gets to keep it, no matter whether Bob exercises his option to buy the stock or not. Let’s suppose that Bob’s option gives him the right to buy Bernie’s stock in three months at $60 a share, which is called the “strike price.” Bob hopes that Coca Cola stock will be trading above $60 in three months. If it is, Bob will exercise his option. He will buy Coke at $60, sell it at the market price, and pocket the difference. If Coke is trading below $60, Bob will let his option expire and simply be out the premium.
Bernie now has three ways to make money. He has received Bob’s premium; he will get any dividends declared by Coca Cola while he owns the stock; and the price of the stock can rise. But, stock prices can fall as well as rise. Bernie protects himself by buying a “put” option from a different investor, whom we will call Alice. The put option gives Bernie the right but not the obligation to sell (or put to) Alice 100 shares of Coca Cola at $50 a share three months from now. If, at that time, Coke’s stock price is under $50, Bernie will exercise his option and recoup his investment, minus the up-front premium he paid Alice. If Coke is trading above $50, Bernie will let his option expire and simply be out the premium.
The difference between the current price of Coca Cola, $50, and the strike price of Bob’s call option, $60, is large. Such a big price movement in only three months is unlikely, and therefore, the option is “out of the money.” As a result, the premium Bob pays is low, in the same way a life insurance premium for a healthy 21-year old is low. But, the put option Bernie buys from Alice is “at the money.” The probability that Coca Cola stock will be trading near its current price of $50 in three months is high. In consequence, the premium Bernie pays Alice is higher than the premium Bob pays Bernie for the call option. Bernie is underwater the day he initiates his trades. He has to significantly and consistently outperform the market to succeed.
Bernie Madoff did claim that success. Over a period of more than 15 years, he reported an average annual return of 12%, with only seven losing months and no monthly loss greater than 0.55%. The years Madoff claimed to be earning 12% included 2000, 2001, and 2002, when the S&P 500 stock index lost 9.13%, 11.8%, and 22.1% respectively.
I hope the explanation of Madoff’s trading strategy is clear and easy to follow because—and here is the heart of the first reason for Madoff’s successful deception—it can be made extremely complicated and confusing. My version of the price relationship between at-the-money and out-of-the-money options is accurate, but the mathematics behind the specific pricing and, especially, the forecasting of option values is frighteningly difficult. A financial professional named Harry Markopolos made three separate complaints to the SEC, in May 2000, March 2001, and October 2005. In the last one, titled “The World’s Largest Hedge Fund is a Fraud” (and footnoted in the preceding paragraph), he writes, “Very few people in the world have the mathematical background needed to manage these types of products but I am one of them.”
I am making a conjecture, but I believe something very like it must have happened repeatedly. The IG report stresses that most of the people who investigated Madoff were young, inexperienced lawyers. But, they worked for the SEC and so they were supposed to understand how the various securities markets work. When Madoff “explained” his methods, quickly dropping into the jargon of “split-strike conversions” and “Black Scholes models,” I can imagine the SEC lawyers nodding their heads, each one too embarrassed to admit bewilderment, and each one assuming that all the others understood Madoff perfectly. How human, and how comprehensible a weakness, especially when connected to the second reason: Who Madoff was perceived to be.
Bernie Madoff, in his glory days, was a really big deal. He was one of the key developers of the NASDAQ stock market and had been chairman of its board and a Governor of the National Association of Securities Dealers. He was a founding member of the International Securities Clearing Corporation in London. His legitimate broker-dealer, ECN, was highly respected and, in fact, has not been implicated in the scandal. And Madoff knew how to throw his weight around. Here is an excerpt from the IG’s report:
“The other [SEC] examiner noted that ‘all throughout the examination, Bernard Madoff would drop the names of high-up people in the SEC.’ Madoff told them that Christopher Cox was going to be the next Chairman of the SEC a few weeks prior to Cox being officially named. He also told them that Madoff himself ‘was on the shortlist’ to be the next Chairman of the SEC. When the examiners would seek documents Madoff did not wish to provide, Madoff would become very angry, with an examiner recalling that Madoff’s ‘veins were popping out of his neck’ and he was repeatedly saying, ‘What are you looking for?...and his voice level got increasingly loud.’”
Junior examiners were told by higher-ups that Madoff “was a very well-connected, powerful, person.” And, “when the examiners reported they had caught Madoff in lies, the Assistant Director minimized their concerns, stating ‘it could just be a matter of semantics.’”
Bernie Madoff intimidated the SEC through bluster and rants, but most of all by the strength of his reputation as, in the words of an SEC branch chief, “the sort of people who are seen as reputable members of society.” The intimidation factor went beyond posing. Anyone managing tens of billions of dollars has true power. In his 2005 report, Markopolos begged the SEC to keep his identity secret. “I am worried about the personal safety of myself and my family.” Certainly an SEC employee who got on Madoff’s bad side would have reason to fear for his or her career at least.
Embarrassment at perceived ignorance and intimidation by power are strong dampers on human action and initiative. I suspect that they were strong enough to stymie three SEC examinations and two investigations.
The really astonishing part, though, is how easy it would have been to trip Madoff up. If Madoff were really making the trades he claimed, there would have been independent third-party records confirming them. The records would have been readily available to the SEC. Time and again, the examiners failed to ask for them “‘because it can be tremendously voluminous and difficult to deal with’ and ‘takes a ton of time’ to review.” But SEC examiners didn’t need “voluminous” records; they only needed the records of a day or two. That’s all the IG asked for, and the records “immediately revealed” Madoff’s fraud. The records would have “immediately revealed” the fraud to you or me too. Imagine that you were being audited. The auditor asks to see the register where you keep a record of the checks you write, but never request your bank statement. That’s all the SEC had to do, ask for the equivalent of Madoff’s bank statements. They never did.