The Bernie Madoff Morality Tale by Andy Kessler

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The Bernie Madoff Morality Tale
Andy Kessler, 12.16.08, 03:15 PM EST
From ''schlub'' to ''macher'' to ''goniff.''


Why, Bernie, why?

By all accounts, Bernard Madoff had a successful trading business and was a hitter on Wall Street. Bernard L. Madoff Investment Securities was one of the top three market makers in Nasdaq stocks, had over 600 brokerage clients and claimed to often contribute 10% of New York Stock Exchange trading volume, usually after the 4 p.m. market close.


So why, inquiring minds want to know, did he perpetrate the largest fraud ever on Wall Street, some $50 billion? He had it made, so why risk it?

Well, for starters, if you leave the Tri-State area, very few people know what a market maker is. At the Palm Beach Country Club or the Boca Rio, the preserved specimens at cocktail parties know about cement or paper plants; their brokers at Merrill (or maybe Goldman) are their only ties to Wall Street.

"And what do you do?"

"I'm the third-largest market maker of …"

"Oh, my drink is empty."

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Madoff was just another schlub ("worthless oaf" for you Yiddish-challenged) from New York with money. Get in line. Schlubs are a dime a dozen in the Sunshine State, contributors of hanging chads and everything.


So Madoff got the brilliant idea to start a money management business on the side. He didn't charge any fees, explaining that he would just make money trading stocks on the securities side of the business. Merrill Lynch (nyse: MER - news - people ) and every retail brokerage player perfected this business model years ago--it's called churning.

And the gerries fell for it. Now, all of a sudden, Madoff is a macher (a big shot, a mover). The ability to make someone money moves you to the top of the cocktail-party list. Madoff didn't advertise; he kept it exclusive, adding to its mystery and allure. And he didn't swing for the fences, he "produced" tortoise-like (steady) returns: 13.72% one year, 9.82% another. Goldilocks-esque. Not too hot or cold, just right.

It became known as the "Jewish T bill." Never mind that his option split strike conversion strategy was completely bogus. As everyone on Wall Street should know, you can limit the downside or enhance the upside, but not both--and certainly not for free. There are too many market makers--hey, like Madoff Securities--who will clip you for trading fees and risk premiums for a strategy like this to ever work. It's like putting $10 on red and on black at a roulette table. You win every time, except when 0 or 00 come up, which they do once every 19 spins.

But still, that doesn't explain the fraud.

OK, Madoff has left us some hints as to why. The first clue is that there isn't $50 billion sitting in some numbered Swiss bank account. In fact, it probably isn't a $50 billion fraud. There seem to be lots of problems with Madoff and numbers. The only facts we know are the claims of $17 billion in assets in his money management business, according to his filings with the Securities and Exchange Commission.

The market is down 40%, so perhaps there should be $11 billion left. Some of his customers, mainly hedge fund-of-funds and European banks, would use 3:1 leverage to magnify Madoff's "steady" returns, hence the $50 billion claim. If you're going to go down, you might as well go big and get something named after you. Why should Ponzi keep hogging the limelight?

So as far as we know, he didn't steal the $50 billion/$11 billion--he probably just lost it. He might have built a trading powerhouse, but he was god-awful as an investor. It happens all the time (Bear Stearns, Lehman Brothers (nyse: LEHMQ - news - people ), Citigroup (nyse: C - news - people ), Morgan Stanley (nyse: MS - news - people ), yadda, yadda, yadda …)

My guess is that this is what went down. Even though Madoff Securities was on the leading edge of automated trading, the business itself was becoming less and less lucrative. Everyone had the same computers. Spreads, the difference between the bid price and the ask price that became Wall Street trading profits, began shrinking. And the move to list stocks in penny increments instead of eighths (12.5 cents) whacked trading desks all over Wall Street.

So you make it up in volume. Beyond cocktail parties, Madoff really created the money management business to feed himself trades. But his strategy was garbage. He absolutely bombed as a money manager, but he desperately needed the assets under management to feed his trading operations, so he started to make the numbers up. As is usually the case, most don't set out to be crooks, but Madoff became one when his talents proved lacking. There is your "why."

It's not new. This was the Enron story: They lost tons in water ventures and Indian power plants, so concocted fraudulent entities to cover up their losses. Same for Sam Israel and his Bayou hedge fund. And even (without the fraud) the Citigroup/Wall Street story, too. They tried to be investors to make up the difference of their bread-and-butter business deteriorating and were awful at it, so they levered up in off-balance-sheet vehicles.

Who knows when the fraud started? As early as December of 1990, he was taking money from the Fairfield Sentry fund of funds. The bull market resumed in January of 1991 as Operation Desert Storm commenced. Madoff showed up years, as did most money managers. But 1994 was rough. So were 1996, 1997 and 1998, yet he did have double-digit years.

Since 2001 and 2002 were ugly, and Madoff showed "only" single-digit returns this decade, so my sense is that money kept flowing in and flowing in. The Tremont fund of funds and Nomura and European banks--my partner and I were out raising a hedge fund and couldn't raise a tarnished nickel from these groups. And we tried.

Public begging is humiliating. But funds of funds and banks were steering money into the Madoff machine. (Ah, schadenfreude delayed.) But it went beyond these so-called professionals or even the country club set; lots of great charities fell for his fudged numbers.

As in any classic Ponzi scheme, you pay old investors who redeem with new money. Sounds like not too many wanted out, until 2008. Now, $7 billion in redemption requests since the Credit Crisis began meant Madoff has made a complete circle, from schlub to macher to goniff (a crook, swindler or cheat).

Let that be a lesson. Learn a few jokes to tell at the club. Impressing the highball crowd with your investing prowess is a losing strategy.

Andy Kessler is a former hedge fund manager turned author. Kessler, who writes a daily blog, most recently wrote How We Got Here: A Slightly Irreverent History of Technology and Markets(HarperCollins, 2005) and The End of Medicine: How Silicon Valley (and Naked Mice) Will Reboot Your Doctor(Collins, 2006).