Fraud Files: With Madoff, There Were Many Red Flags

If you want to know exactly why it was clear years ago that Bernard Madoff was running a Ponzi scheme, all you have to do is read No One Would Listen: A True Financial Thriller, the new book by whistleblower Harry Markopolos. As fraud investigation goes, Markopolos is a true hero. He took the time to dig deeper into a smelly situation, even when there was no apparent benefit to him personally. He put his reputation and his family's safety on the line to do the right thing. But no one would listen to him.

The magnitude of the investment scheme perpetrated by Bernie Madoff is difficult to pinpoint with any precision. There are likely many investors who will never come forward about their losses for a variety of reasons. We are left to speculate on the total losses, but $65 billion was the total showing on investor statements at the time the fraud was stopped. This number, however, includes the phony "gains" that had accumulated on the money. The $18 billion number is tagged as actual cash put into the Madoff scheme by investors, and ultimately the true total loss.

Markopolos was suspicious about Madoff from the first time he heard about the investment scheme based on the consistently high returns Madoff was supposedly generating. Even the best traders can't beat the market so consistently and by so much as Madoff claimed. He also knew that Madoff was constantly looking for new money from investors. This was even though he gave the appearance that the fund was "closed" to new investors and any opportunity for a new person to put money in was a special privilege offered just to them.

Markopolos couldn't have made investigating Madoff any easier for the Securities and Exchange Commission. Time and again, he identified red flags that made it clear Madoff was lying about his investment strategy and his returns. Obviously, he had no strategy and no returns. Markopolos identified convincing red flags for the SEC time and again.

1. Split-Strike Conversion - Madoff claimed to be purchasing baskets of stocks that were highly correlated to the general market. He supposedly knew which stocks were going up because of the amount of buying and selling that went through his brokerage. Madoff then supposedly hedged his investments with OEX index options.

Markopolos knew this couldn't be true because the number of options he'd have to buy to execute this strategy would be huge and would be easily seen in the market. Further, there were only $9 billion of OEX index put options on the Chicago Board Options Exchange. Yet Madoff would have needed $3 billion to $65 billion of the options to protect his investments. There simply weren't enough options available for Madoff to actually be using this strategy.

2. Market Timing - It was said that Madoff invested in the market only six to eight times a year, with the money staying in the market for a few days to a few weeks. Magically, he apparently knew exactly when the market was going up and only invested then. When Madoff thought the market was going to fall, he would supposedly put everything into cash. And he was always in cash at the year end, when the auditors were going to do their thing.

This explanation is absolutely preposterous to anyone with a grade school education. How finance professionals and the SEC could hear this (and often repeat it) without bursting into laughter is beyond me. Score another one for Markopolos for possessing the common sense that his colleagues and regulators apparently did not have.

3. Giving Up Profits - Madoff's claimed strategy cost him profits. The way he did business with the feeder funds, he only got paid with commissions on trades. This means he was earning less than the feeder funds (who were doing no work), while Madoff did all the work.

Had he run things as a hedge fund, he would have charged a 1% management fee plus 20% of the profit. This would have gotten Madoff about 4% on the assets he supposedly invested each year. Of course, we can now see that the reason Madoff operated this way was to incentivize the funds to keep raising money for him. He needed new cash on a continuous basis to keep the Ponzi afloat.

4. Cheaper to Borrow - It was expensive for Bernie to do business the way he claimed to be doing it. It took tons of time and effort, and the profits he supposedly returned to investors (something around 12% per year) were his cost of doing business. He could have borrowed money for much less and done whatever trading and investing he chose. This red flag is so simple, it's hard to believe everyone but Markopolos missed it!

5. Secrecy - The key to any long-term fraud scheme is secrecy on the part of those who participate. And Madoff demanded secrecy from his clients. He warned them that if they told anyone about investing with him, he'd kick them out of his club and give them their money back. No more consistent huge returns for them!

Anyone with a legitimate and successful business doesn't demand secrecy across the board. Even if they aren't publicity hounds, they certainly aren't going to forbid their clients to talk about how great they are.Secret clubs are for kids and college students. They have no place in legitimate business ventures. When an investor is commanded to remain quiet about the investment, you should know something is wrong.

6. Performance Line Had a 45-Degree Angle - When you plot legitimate investment returns on a graph, the only thing that can be guaranteed is that they will go up and down. But the graph for Madoff's Ponzi sloped upward at a beautiful 45-degree angle. This is simply impossible to do legitimately.Again, this is another red flag that is so in-your-face, it's tough to believe no one but Markopolos figured it out.

I would never discount all the time and effort Markopolos and his team put into investigating Bernie Madoff. But a quick look at these red flags shows that the warning signs were pretty apparent. People were investing millions or billions of dollars with Madoff, yet they didn't even take the time to critically analyze these points before investing?

It makes it harder to feel sorry for them when you see such obvious signs of problem. Even the most basic red flag - - unbelievably consistent and high returns - - should have tipped off everyone who wanted to invest. If it sounds too good to be true, it almost always is.

Next Week: The gross incompetence of the SEC regarding Bernie Madoff, and the Markopolos take on it.