The Death of Wall Street's Most Notorious Swindler

The death of Wall Street's most notorious swindler... How it all came crashing down... 'If you ever see a chart like this, run away fast'... Five failed tries to alert regulators... No one wanted to believe it... From the Fed to fat bank jobs... You can't legislate human nature out of existence... Clearer focus through a cynical lens...

Before this week ends, we must talk about the final footnote in one of Wall Street's biggest controversies...

I (Dan Ferris) am talking about the death of Bernie Madoff, the author of the largest Ponzi scheme in history. He died of natural causes on Wednesday, just 15 days shy of his 83rd birthday.

When Madoff died, he was serving a 150-year sentence in federal prison for his crimes.

As you'll see in today's Digest, the tale of Madoff's misdeeds could've ended much sooner than it actually did – if rounds of alerts weren't blindly ignored. Instead, thousands of folks ultimately suffered. And if nothing else, this whole affair can serve as a warning for us all...

Let's begin with how Madoff's house of cards came crumbling down more than a dozen years ago...

Madoff made headlines on December 11, 2008, when he was arrested after admitting to his two sons that his more than $60 billion hedge fund had never actually invested a penny in anything... Instead, it had been an elaborate Ponzi scheme since opening in 1990.

If you're reading this essay, you likely know what a Ponzi scheme is. But if not, it's just a fraudulent scheme that continuously lures investors, paying profits to the earliest ones with funds from the more recent victims. To be successful, the vicious cycle must continue.

Mathematically, no Ponzi scheme can go on forever. But due to the nature of long-term investing, this particular one went on for longer than you would ever imagine it could...

Over nearly two decades, Madoff appears to have taken in about $19 billion from investors... His fraud ultimately victimized almost 38,000 people, all of whom were eventually included in the U.S. Department of Justice's Madoff Victim Fund.

Some of the victims were rich celebrities – like director Steven Spielberg and actor Kevin Bacon.

But sadly, many of the victims didn't have nearly as much wealth as the A-listers. As Diana Henriques, author of The Wizard of Lies: Bernie Madoff and the Death of Trust, detailed in a 2011 presentation at the University of Pennsylvania's Wharton School of Business...

They were laborers, iron workers, carpenters and pension beneficiaries whose pensions were wiped out because they were invested with Bernie Madoff.

There were many, many, many middle-class families. More than 1,000 of the 5,000 direct accounts with Bernie Madoff's firm were half a million dollars or less.

These were the savings of middle-income families who had sold a business or sold a home and entrusted all their liquid assets to Bernie Madoff and lost it in one day, virtually overnight.

And the toll wasn't merely financial...

At least four of Madoff's victims committed suicide in the aftermath. Madoff's oldest son, Mark, hanged himself in his Manhattan apartment on the second anniversary of his father's arrest. His other son, Andrew, died of cancer in 2014, which he said had returned due to the stress caused by his father's fraud revelation.

It's only natural to wonder how Madoff got away with the ruse for as long as he did...

And beyond that... how it got so big without crashing down earlier.

The answer starts with the returns that Madoff claimed he was producing for investors...

Madoff claimed his hedge fund earned returns of about 15% annually, year after year, with no down years – and few down months. He boasted about growing each $1 invested to $6.75 from 1990 to 2008.

About a week after Madoff's arrest, research firm Bespoke Investment Group published a graph of Madoff's reported return history, which it got from one of his feeder funds. As it said in an accompanying blog post, "If you ever see a chart like this, run away fast"...

Now, it's worth noting that some folks were skeptical about Madoff's track record along the way...

The perfect consistency of Madoff's returns – with near zero volatility – looked suspicious to a few people in the finance industry as early as 1999.

That year, a salesman at Boston-based options-trading firm Rampart Investment Management brought Madoff's eerily consistent returns to the attention of a colleague who sat across from him at work...

The colleague, forensic accountant and derivatives portfolio manager Harry Markopolos, looked at Madoff's return claims and almost immediately suspected wrongdoing. In his 2010 book, No One Would Listen: A True Financial Thriller, Markopolos wrote...

His returns were always good, but rarely spectacular. So it wasn't his returns that bothered me so much – his returns each month were possible – it was that he always returned a profit. There was no existing mathematical model that could explain the consistency.

Madoff claimed he had a secret that led to his consistent returns – the "split-strike conversion" strategy.

In that strategy, you buy an asset – Madoff claimed it was a basket of 35 stocks in the S&P 100 Index ("OEX") – then sell an out-of-the-money call option and use those proceeds to buy an out-of-the-money put option to protect the downside.

Eventually, Markopolos figured out that Madoff couldn't have been doing what he claimed...

If Madoff had been telling the truth, his firm would be the biggest buyer and seller of OEX index options by far. It was impossible to trade that many options without leaving a massive footprint in the market, and yet... Madoff left none. As Markopolos continued in his book...

I knew there was in existence a total of $9 billion of OEX index put options on the Chicago Board Options Exchange. Madoff claimed to be hedging his investment with short-term (meaning 30 days or less) options. You can realistically purchase only $1 billion of these, and at various times Madoff needed $3 billion to $65 billion of these options to protect his investments... There were simply not enough options in the universe for him to be doing what he claimed he was doing.

Early on, Markopolos took his work to Dan DiBartolomeo. The brilliant Boston mathematician and financial analyst said that he didn't know what Madoff was doing, but he agreed that the results he reported couldn't have come from the financial markets.

That would become a disturbing pattern... Many who looked into Madoff's reported results and his claims of using the split-strike conversion strategy would conclude that it was a fraud and that its author should be in prison.

However, those whose responsibility was to put such people in prison couldn't be convinced.

Markopolos first submitted evidence of Madoff's fraud to the U.S. Securities and Exchange Commission ("SEC") in May 2000. He would do so four more times after that... for a total of five submissions of evidence over a nine-year period.

And yet, the SEC balked each time...

The No. 1 watchdog on Wall Street... the government agency created during the Great Depression in the wake of the 1929 crash to regulate securities and exchanges... had the biggest Ponzi scheme in history delivered to its doorstep five times in nine years. Not only that, but the fraud was also backed up with meticulous forensic accounting each time.

And the SEC never even tried to stop it.

Why did the SEC balk five times? Why didn't it come down on Madoff like a ton of bricks as soon as it could?

It's simple... Because Madoff was one of them.

Madoff had a long and (initially) legitimately successful career in finance. As the New York Times reported in his obituary earlier this week...

[In 1970, Madoff's brokerage firm] began to build a reputation for harnessing cutting-edge computer technology to the traditional business of trading securities. It was one of the early participants in the fledgling electronic market that ultimately became the modern Nasdaq, and was involved as an investor in several other platforms for computerized trading.

Mr. Madoff's market leadership and his firm's willingness to challenge Wall Street traditions made him a trusted adviser as federal regulators struggled to modernize the nation's marketplace without jeopardizing its international stature. By age 70, he had become an influential spokesman for the traders who were the hidden gears of the marketplace.

(Madoff turned 70 in April 2008, eight months before he turned himself in.) At one time, Madoff's firm was the largest market maker on the Nasdaq... and the sixth-largest market maker of any kind. He became nonexecutive chairman of the Nasdaq in 1990.

It's clear that Madoff was a Wall Street legend with a reputation for persuasiveness and charm. Henriques described it this way in her 2011 presentation at Wharton...

Madoff had a gift for seduction unlike any I have ever seen in a Ponzi scheme, and at my age, I have seen a lot of Ponzi schemers.

Unlike the classic con artists that I have met who always portray themselves as the smartest, most charming people in the room, Madoff made you feel like you were the smartest and most charming person in the room...

As he held up this mirror to you so you could see this very sophisticated, very intelligent person, why would you ever second-guess your own decision to trust him? If I am so smart, I must be right about investing with Bernie Madoff.

Combine Madoff's prestigious career with his mastery of the art of seduction, and maybe it's easier to see how nobody wanted to believe he was a total fraud.

The sense of disbelief was so pervasive that Madoff had to tell the arresting FBI agents that he wasn't innocent...

When the FBI showed up at Madoff's New York penthouse to arrest him after his sons turned him in, one of the agents said they were just there to find out if there was an "innocent explanation."

The only reason the agents would say something like that would be to prime themselves to believe whatever Madoff told them... so they could walk away without having to arrest him. It's as if the FBI sent a pair of teenage boys to arrest Miss America...

Gee, we're really sorry about this, but we just gotta follow up on your son's call. And if you'll just feed us some of your dreamy B.S., we'll be on our way and won't bother you anymore. Hey, by the way, can you sign my stomach with this Sharpie?

Madoff had to come clean and tell the agents bluntly, "There is no innocent explanation."

I doubt you could've sent any other two FBI agents up to the penthouse to arrest the legendary gazillionaire and gotten a different outcome. No one wanted to believe it.

Madoff's brokerage clients were sort of like that, too – though of course, they weren't working for the SEC...

In his book, Markopolos wrote about hedge funds that knew the returns from Madoff's business couldn't be real... But they liked the service and pricing they got from his market-making firm.

So they didn't want to accuse Madoff of fraud in fear of losing him as a service provider.

The salesman who first brought Madoff to Markopolos' attention, Frank Casey, didn't even want to believe Madoff was a fraud... He and others at Rampart wanted Markopolos to help craft a product that mimicked Madoff's results so they could earn a commission selling it.

Nobody wanted to listen to Markopolos, even – or perhaps, especially – if they agreed with him. He was accusing an industry legend of fraud. Nobody saw the upside in that...

Regulators could see plum career opportunities vanish... Hedge-fund clients of the market-making operation could lose a valued service provider, potentially losing their edge... And clients didn't want to hear that all the money they were making wasn't actually there.

You would think someone at the SEC – the supposed Robin Hood for the little-guy investors of the world – would have enough honesty and integrity to know that failing to pursue Markopolos' accusations could result in great harm to investors. You would think they might fear getting fired for letting investors be put in harm's way with Madoff's fraud.

When you buy a car, you assume the brakes will continue to work as long as they're properly maintained and replaced on schedule. If the car dealer knows the brakes will fail within a day or two, hasn't he knowingly endangered your life by letting you buy that car and drive away in it?

The SEC set investors up for bigger losses than if it had done its job properly...

One of the main benefits that investors sought with Madoff was low volatility... And of course, most people believe low volatility indicates lower risk.

But by allowing investors to put their money to work with Madoff, the SEC exposed these poor souls to guaranteed losses... knowing they had signed up for lower risk returns.

The people charged with helping them stay safe exposed them to greater danger. It's like if you were to lean in to kiss Grandma goodnight... and she hit you with a Taser instead.

I don't believe for one minute that nobody at the SEC thought Markopolos was right. Their failure to prosecute him was a sign of something gone horribly wrong in the investment industry's top watchdog.

In Chapter 1 of his book, Markopolos lets us know exactly what he thinks of the state of U.S. financial regulation (my emphasis added)...

... all of the nation's financial regulators – The Federal Reserve Bank, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision – are at best incompetent and at worst captive to the companies they are supposed to regulate.

You don't have to look very far to see evidence of so-called regulatory capture...

The Federal Reserve is perhaps the single most important regulator of U.S. banks...

That should mean it's tougher on banks than any agency in the government. But in practice, it simply means that working for the Fed is a perfect entrée to a fat bank job.

Here's a short list of former Fed officials – including three former chairs of the central bank – who later went to work on Wall Street. And I promise you that many others have done the same...

Is it so hard to imagine that being tough on bankers during your tenure at the Fed might put your plum Wall Street gig in jeopardy? Some of these Fed officials worked on Wall Street first... then at the Fed... and then went back to Wall Street again.

It's as if they needed to underscore that they're all on the same side... Not yours.

Maybe this is why, during the years when Markopolos was trying to get the SEC's attention, the turnover among the agency's employees was so high that the U.S. Government Accountability Office ("GAO") reported on it three times... One GAO report explicitly said that turnover was so high it was affecting the agency's mandate to protect investors.

You can't legislate human nature out of existence...

That's true no matter what rules you make.

If you put a bunch of college grads in government jobs across the street from peers making 50 times more than they do, what do you think will be the outcome every time?

Short-seller Jim Chanos describes financial regulators and law enforcement personnel as "financial archaeologists." That's because, as he explains, "They will tell you after the company has collapsed what the problem was."

Of course, for crimes that happen in an instant – like robbery and assault – nobody expects the police to be on hand to prevent them. They can only try to catch the perpetrators after the crime has already occurred. But financial crimes like Madoff's Ponzi scheme take years to play out... Investigators had more than enough time to stop him and limit the damage.

Government-worshipping keyboard cowboys can yell all they want about the need for rules and regulations...

But they can't claim the rules and regulations have worked anything remotely as promised.

And they can't tell us that the regulatory apparatus doesn't at least occasionally generate disastrous unintended consequences... virtually the opposite of what is sold to the public.

Madoff is to financial regulation what Chicago is to gun control – an irrefutable example of how rules alleged to make us safer... made the world more dangerous for the innocent... while also making it safer and more lucrative for criminals.

Now, I hate to do this, but...

I also can't let Madoff's supposedly innocent investors off the hook here either...

More from Henriques' 2011 Wharton presentation...

He was running a secret, jury-rigged investment advisory business out of the back door of his wholesale stock trading company. It offered no prospectus, no third-party custodian, [and] no independent clearing firm.

Once again, I realize that it's human nature to jump in impulsively when someone promises to deliver exactly what you seek and have found so difficult to get elsewhere. In Madoff's case, it was double-digit returns, year after year, with virtually no volatility.

But human nature doesn't take anyone off the hook for trusting strangers to do the impossible... If people were more honest with themselves about what they know and don't know, they might be more demanding of other folks who want their money.

I just don't see how the investment landscape improves without investors stepping up and spending more time vetting investments than they do picking out carpet or buying a car. (And I believe the work we do here at Stansberry Research goes a substantial way toward filling in that knowledge gap regarding investments in public companies.)

Overall, it might sound like I'm blaming the regulators for not doing their jobs... or the regulatory system for setting up incentives to look the other way. Or maybe I'm suggesting the need for more stringent rules and enforcement – a "get tough on financial crimes" approach... or even blaming investors for not knowing better.

But the thing is... It's none of the above.

Here's what I believe we should all take away from the Madoff affair...

First, as I said earlier, you can't legislate human nature out of existence... People will always commit fraud. No rules can prevent it without shutting down human innovation and the necessary risk-taking that moves us forward and improves our standard of living.

I have to wonder if the net result of pretending to protect investors via regulation isn't worse than not pretending and leaving them to their own devices... but maybe we should just require a lot of warning labels, like we do with cigarettes and poisonous chemicals. If a lot of folks disagree with that sentiment, I'll know I'm onto something.

If it's possible to paint a situation involving one crook, dozens of financial regulators, and 38,000 victims with a broad brush, maybe it's like this...

Everybody thought they were getting away with something.

Madoff was getting away with theft and fraud... Regulators were getting away with being lazy, as they waited for Wall Street to come calling... And investors were getting away with defying market reality and getting returns that were way too good to be true.

But in the end... reality caught up with all of them, with a vengeance. It was too good to be true for everyone involved...

Madoff went to prison, where he died Wednesday... Regulators were caught being negligent and incompetent... And the victims were caught believing impossible results were real.

Every now and then, we all need to ask ourselves... "What do I think I'm getting away with?" And also, "What do I think other folks around me are getting away with (if anything)?"

As you ask yourself those two questions... make sure you're prepared for the reckoning.

When I talk about my "truly diversified portfolio to prepare for a wide range of outcomes" frequently here in the Digest, preparing for a reckoning is definitely part of the deal.

I don't like that these questions are such a cynical lens through which to view the world... But I do like that they bring certain parts of our world into clearer focus – parts that can hurt us the same way that Madoff hurt those nearly 38,000 people when his charade blew up in his face.

I'll try to leave you on the lightest note I can muster...

The good news is... Madoff's investors are getting back most of what they put in.

At first, the folks tasked with liquidating the Madoff fund's assets and distributing the proceeds to victims thought the best they would do is pennies on the dollar. But eventually, they found billions at various banks and financial institutions.

To date, of $19.4 billion of claims allowed against Madoff's firm, investors have gotten $14.4 billion back. A 26% drawdown is a lot better than losing everything...

After all, it gives you something to work with. It's a second chance after a potentially devastating mistake. And the process is ongoing, so maybe the total loss will shrink more.

If you need me to boil everything in today's Digest about Madoff down to a single point that directly relates to your own investing in the present-day environment, I'll try...

Don't count on regulators or money managers to be properly incentivized to serve you. If an investment looks too good to be true, treat it like it is. Take the time to look deeper...

You might miss an opportunity here and there for not acting quickly enough, but you'll become wiser over the long run. And I promise you... that's worth your time, every time.

By making sure you won't fall victim to the next Madoff, you'll be much better off.

New 52-week highs (as of 4/15/21): ABB (ABB), American Homes 4 Rent (AMH), AutoZone (AZO), Berkshire Hathaway (BRK-B), Brown & Brown (BRO), Blackstone Mortgage Trust (BXMT), CBRE Group (CBRE), Crown Castle International (CCI), Richemont (CFRUY), Eagle Materials (EXP), Expeditors International of Washington (EXPD), SPDR Euro STOXX 50 Fund (FEZ), Comfort Systems USA (FIX), Alphabet (GOOGL), Home Depot (HD), Invitation Homes (INVH), IQVIA (IQV), Nuveen Preferred Securities Income Fund (JPS), LGI Homes (LGIH), Markel (MKL), Microsoft (MSFT), Invesco High Yield Equity Dividend Achievers Fund (PEY), ProShares Ultra Technology Fund (ROM), Rayonier (RYN), Starbucks (SBUX), ProShares Ultra S&P 500 Fund (SSO), Seagate Technology (STX), Visa (V), Vanguard S&P 500 Fund (VOO), Vanguard Short-Term Inflation-Protected Securities Index Fund (VTIP), Consumer Staples Select Sector SPDR Fund (XLP), Health Care Select Sector SPDR Fund (XLV), Alleghany (Y), and Zimmer Biomet (ZBH).

In today's mailbag, feedback on yesterday's Digest about China's plans for a digital currency. What's on your mind? Send your notes to feedback@stansberryreseasrch.com. We love sharing your thoughts and comments to keep the conversation going.

"Thank you for your essay today about digital currency.

"With the programming, it would be helpful if our 'digital wallets' were organized to notify us whenever they were accessed by a third party, including governments, banks, courts, credit bureaus, etc.

"I have considerable sanctions at work if I look at records for which I do not have permission, and if enabling legislation protected our privacy by journaling and tracking our account access, we might be less resistant to surrendering our cash and pieces of eight." – Paid-up subscriber Robert T.

"What happens when SHTF and all computers no longer work for months, if not years? Everyone will have to barter for goods and services. I hope everyone has plenty of unopened bottles of booze and cartons of cigarettes to trade. Or better yet, metal coins of dollar and quarter denominations." – Paid-up subscriber John B.

"You all are incredibly naive if you think that the Chinese government sees much beyond digital currency giving them absolute control of the citizens of China. No one will have any funds that the government doesn't want them to have. They won't be able to oppose the government in any fashion without being rendered bankrupt. They won't be able to escape China unless they are willing to escape with nothing but what they can carry. This is not something to celebrate, this is something to fear." – Paid-up subscriber Bruce H.

Corey McLaughlin comment: Just so we're clear... in yesterday's Digest, we did say that China's digital currency plans – including details like setting expiration dates on direct payments – felt "like some dystopian 1984 type stuff."

Good investing,

Dan Ferris
Medford, Oregon
April 16, 2021