Harry Markopolos really did have the goods on Bernie Madoff

I, like lots of other people, have been reading through the pile of documents about Bernard Madoff's Ponzi scheme that Harry Markopolos submitted to the SEC in November 2005. The WSJ describes them as "ranging from in-depth mathematical calculations that purported to show the Madoff investment strategy couldn't work, to little more than rumor or innuendo." That makes Markopolos sound like a little bit of a crank, but reading through his actual allegations doesn't leave that impression at all. Obviously hindsight plays a role here, but I can't imagine anyone reading them in 2005 and not concluding that there was something deeply suspect going on.

Markopolos goes to great lengths to demonstrate that the investment returns claimed by Madoff were impossible to replicate by any known strategy. But to me that wasn't the biggest of his 29 red flags. The biggest red flag was Why on earth would a prominent brokerage firm chief run a giant, mostly secret money management business on the side and not charge any fees for his services if he wasn't up to something dodgy?

The distinction between the brokerage and the money management business is one that most everybody I've been hearing from about the now-famous video of me and Madoff and his employee Josh Stampfli misses. All that talk in the video about how Madoff makes money and what his dealings with the SEC are like relates to his brokerage business, which was a pillar of the Nasdaq system and was, as far as anybody knows at this point, on the up and up. I didn't have the faintest idea that the man also ran a $50 billion sort-of hedge fund in his spare time. If I had known that, I like to think I would have been suspicious. You don't see Lloyd Blankfein or John Mack or Chuck Schwab running $50 billion hedge funds out of their hip pockets, do you?

Very few people knew how big Madoff's money management operation was. Madoff was secretive about it. He gathered investors by word of mouth. The funds of funds that put their money with him generally didn't disclose this fact. His sons, who ran the brokerage business day to day, knew he was managing money but probably didn't know how much. Wrote Markopolos:

If I was the world's largest hedge fund and had great returns, I'd want all the publicity I could garner and would want to appear as the world's largest hedge fund in all of the industry rankings. Name one mutual fund company, Venture Capital firm, or LBO firm which doesn't brag about the size of their largest funds' assets under management. Then ask yourself, why would the world's largest hedge fund manager be so secretive that he didn't even want his investors to know that he was managing their money? Or is it that BM doesn't want the SEC and FSA to know that he exists?

Markopolos made the SEC aware that Madoff's fund existed, and was immense. The SEC's reaction was ... to get Madoff to register as an investment adviser. Harsh!

The argument for not doing anything more seems to be that regulation of such investment funds "communicates confidence in a product that is riskier than normal investors should get involved in," as then Treasury undersecretary Robert Steel put it at a conference on hedge fund regulation last year. There's probably something to that. And except for the whole Bubbie and Zadie aspect, the Madoff collapse may well turn out to be a healthy development if it makes people more dubious of the fee-sucking value-destruction machines that most hedge fund funds-of-funds are.

But the fact that a heavily regulated brokerage business and an unregulated investment business were being run by the same man does strike me as problematic. For some investors and fund-of-funds managers, the regulatory imprimatur that the SEC gave Madoff's brokerage may have communicated confidence in the investment products he sold on the side.

I'll let Markopolos have the final word (from back in 2005):

Bernie Madoff is running the world's largest unregistered hedge fund. He's organized this business as [a] "hedge fund of funds privately labeling their own hedge funds which Bernie Madoff secretly runs for them using a split-strike conversion strategy getting paid only trading commissions which are not disclosed." If this isn't a regulatory dodge, I don't know what is.