The Wizard of Lies: Bernie Madoff...

Diana B. Henriques, “The Wizard of Lies: Bernie Madoff and the Death of Trust”, Times Books (2011) 348 pp.

This is a must-read-book for anyone depending on investments for their security or a significant portion of their security.  The basic lesson is, as always, “if it appears too good to be…”  Another important lesson, because you may not even know your investment advisor has placed you in a Ponzi scheme, is diversify.  Neither lesson seems all that profound, but three million scammed people may think otherwise.  I really sympathize with those who invested in a supposedly honest fund and ended up a victim of Bernie’s.

Author Diana Henriques is a senior financial writer for The New York Times since 1989.  She is a Polk Award winner and Pulitzer Prize finalist, and has won several awards for her work on the Times’s coverage of the Madoff scandal; she was part of the team recognized as a Pulitzer finalist for its coverage of the financial crisis of 2008.

After Madoff's arrest, the SEC was criticized for its lack of financial expertise and lack of due diligence, despite having received complaints from Harry Markopolos and others for almost a decade. The SEC's Inspector General, Kotz, found that since 1992, there were six botched investigations of Madoff by the SEC, either through incompetent staff work or neglecting allegations of financial experts and whistle-blowers.  (In fact, Madoff cited the many investigations as evidence that all was just fine at his firm).  It was later established that $64.8 billion in paper wealth vanished by the time Madoff was arrested, including cash losses of about $20 billion (P. 211).  The affected geographical areas included Swiss private bankers, Singapore insurance companies, a Korean teachers pension fund, an Italian bank holding company, major Japanese banks, trust funds in Hong Kong, Dutch money managers, a sovereign wealth fund in Abu Dhabi, hedge funds in Luxembourg, and wealthy families in Mexico, Brazil, Argentina, and Dubai.  As many as three million people were touched by the scandal.

My Notes:

Pg. xxiii:  Madoff claims the after the 1987 market crash he was swamped by withdrawals.  It was then that he began covering those unwelcome withdrawals with cash that had just started to pour in from new hedge fund clients.  Thus began the “robbing of Peter to pay Paul”, at least this is when he claims it began—in reality, it could have even been earlier.

Pg. 150:  A key player in the Ponzi scheme was DiPascali (an employee Madoff hired straight out of high school).  DiPascali was the master mind behind the necessary computer programs that created the documents to fool regulators when they came looking (as they did, six times).  There were programs that generated random numbers of share purchases, and many others.  However, all the computer charades in the world wouldn’t save him if his fraud ran out of real, hard cash.  By November 2nd of 2008 his slush fund account at JPMorgan Chase was down to just $13 million—nowhere near enough to cover the $105 million in redemption checks that had to be mailed in the next three days.

Pg. 152:  The cash crisis of November 2005 pushed Madoff’s fraud right to the brink.  Only some timely cash transfers from his legitimate business accounts and an eleventh-hour bank loan to his firm forestalled immediate disaster.  But the price of that bailout was that the border between Madoff’s fraud and his legitimate Wall Street business was blurred beyond repair.

Pg. 247:  Later research searching all available records going back to 1995 and some records dating to 1993 yield no evidence that Madoff had ever purchased any securities for his clients.

Pg. 256:  Where did all the $20 billion go?  Aside from the hundreds of millions that Madoff diverted for his own use over the years, the cash handed over by investors had been paid out to other investors as bogus investment earnings.  Researchers had the bank records showing when the cash was withdrawn and by whom.  More than $6 billion was withdrawn from the Ponzi scheme between the collapse of Lehman Brothers in September 2008 and Madoff’s arrest in December.  In the scheme’s final year, withdrawals totaled nearly $13 billion, most of which had flowed in since early 2006.  Clawback suits followed and are still being pursued.  First in line to get money back are those termed “net losers”; that is, they had less money in their account than they invested.  Claims have been filed to retrieve $90 billion and it will take years to retrieve even a fraction of that.

Pg. 257:  In bankruptcy jargon, lawsuits to get the money back are known as “clawbacks.”  Clawbacks apply to the six year window preceding the uncovering of the scheme.

Pg. 328:  Madoff suspected that one of his investors, Picower, had been on to him for some time.  Picower died in his swimming pool with a massive heart attack during the investigation but his estate agreed to a $7.2 billion settlement with the SEC, the largest single forfeiture in Amercan Judicial history.  This amount represented the difference between the cash Picower had withdrawn from his Madoff accounts and the amount he had put in—which was estimated at just under $620 million.

Addenda:  Madoff always stated that his successful investing strategy revolved around a “Split strike  conversion strategy.”  Following is a definition of this strategy:

Split strike conversion strategy to hedge/stabilize an existing portfolio

The strategy is known as a collar: It’s a combination of a protective put and a covered call. The strategist is placing a floor on the potential losses of a stock by purchasing a put. The sale of the call helps offset the cost. However, the sale of the call will also limit the potential gains, because if the price of the underlying stock moves higher, the call may be assigned. The chance of assignment will increase as the stock moves higher above the strike price of the option and the expiration date approaches.

So the collar is a limited-risk, limited-reward strategy. Some traders consider it a type of “vacation trade,” because you can establish the position and not worry about what happens until options expiration approaches. The collar can also be used to stabilize or hedge a portfolio. In that case, the choice of expiration month will depend on how long you want protection. You can even use long-term equity anticipation securities (LEAPS) if you want to hold the position for several months or years. So the time frame is up to you, but if you choose shorter-term rather than longer-term options, you may pay more in commissions over time.