I first heard of Bernie Madoff at some point in approximately the early 1990s. I think it must have been sometime around 1992 or 1993 because one of the points that made a big impression when I heard of him was that the SEC had investigated and had publicly said it found nothing wrong with what Madoff was doing.
The way that had happened was that two Florida accountants, Bienes and Avellino, had for three decades collected hundreds of millions of dollars from clients and others and invested it with Madoff. The returns on the money were of the medium but steady type for which Madoff has become publicly infamous since December 11th of 2008. The SEC had heard of the arrangement and investigated to see if the deal was a fraud of some type.
At the conclusion of the investigation, the SEC said that Bienes and Avellino, who had been collecting the money on the promise of a return of about 15 percent or so, had thereby been selling unregistered securities. But the SEC found that the invested money was still there — it had not been dissipated or blown — and it publicly and explicitly said that it found nothing wrong with Madoff. This was of enormous importance to many who invested after 1992, as I did, and who knew that the SEC had said it found nothing wrong with Madoff. How could there be anything more important than to know the relevant government agency had investigated a deal and found no wrong on the part of the money manager?
The exact words of the SEC official quoted by the Wall Street Journal on December 1, 1992 were, “Right now, there’s nothing to indicate fraud.” In the next 16 years, although it received many complaints about Madoff and apparently investigated him eight times, the SEC never warned us of possible fraud, never retracted its initial statement, never warned us that things conceivably could have changed since it said that “Right now, there’s nothing to indicate fraud,” and consequently never gave people a chance to “defend themselves” by withdrawing investments or not making new ones.
The money invested with Bienes and Avellino was given back to the investors. But, the way I heard it, a number of them were intensely (and understandably) disappointed because they had been making consistent decent returns, and they understandably asked Madoff if he would continue to invest for them. Madoff, as I heard it, agreed to continue investing for family and friends as an accommodation to them, doing so, it was said, because he was a good guy — which sounds absurd to say after December 11, 2008, but was in full accord with his decades-long reputation at the time and for sixteen years afterward — until December 11, 2008.
What is more, from the day I first heard of Madoff until December 11th, I never heard even a whisper that Madoff was not investing only for a small number of people — in accord with a claimed initial decision to keep the number small and merely accommodate family and friends — but rather was seeking investors widely, was investing for huge numbers of people, was getting billions from hedge funds, banks and other institutions. In hindsight call me stupid, but the press wasn’t following what Madoff was doing, I only knew a few people who invested with Madoff and years later heard of one other, I have never lived in circles where lots of people invested with him, and I thought Madoff’s investing was a small operation in an otherwise large broker-dealer.
The period of the 1990s was one in which massive returns were often being sought and obtained by investors and mutual fund managers. Mutual funds were sometimes reaping annual returns of 25, 30, 40 percent and more on their money. To invest with Madoff was, as odd as it may sound today, a conservative type of investment in which one deliberately forsook efforts to make the huge gains often being obtained by lots of mutual funds, and instead accepted smaller but steady gains. Additionally, one accepted that the gains, whether left invested with Madoff or taken out, would be taxed at a much higher rate than was generally true of much of the gains from mutual funds, stocks and other investments. For the gains with Madoff were ordinary income or short term capital gains rather than long term capital gains, and were therefore taxed at the rate on ordinary income, not the farlower rate applicable to long term capital gains. So investors with Madoff were both taking a lower rate of return and paying much higher income taxes than the capital gains taxes whose attainment was all the vogue then. This is deeply inconsistent with a greedy grab for every nickel one could get, as the media has often portrayed it.
Thus it is that I said then and say now that investments in Madoff were thought a conservative investment, not the greed which has so readily been bruited in the media by reporters who do not know, or at least do not write about, the facts. That they were conservative investments, and did not make as much as hedge funds have held out in their marketing materials, is precisely the point recently made by the first rate financial writer James Stewart. And they were, as said, investments in a system and with a guy in whom the SEC expressly had found no fault — who was, to boot, a leading and highly respected figure on Wall Street. He had been, among other things the Chairman of NASDAQ for three years and a member of the Board of Governors of the NASD. (For those who know financial history, he might in retrospect be thought the Richard Whitney of today.)
In 1995, this writer, who had been hearing about Madoff for a few years, sought to find out whether Madoff would accept an investment from me. At that time — and until December 11th struck — I continued to think that Madoff was running only a relatively small overall total amount of money for family and friends. Because I was, defacto, a virtual family member of one of his investors, Madoff accepted my investment. That, at least, is what I thought then. I never knew, until after the scandal broke, that at some point — whether it was before or after 1995 I do not know — Madoff began seeking huge amounts of money, began using feeder funds, including feeder hedge funds, was running billions upon billions of dollars, etc. Nor did I know, until December 11th, that there were three parts to Madoff’s business, i.e., that there was a third, investment adviser segment. I had signed a broker/dealer agreement, and thought he was investing my money in that capacity.
So an awful lot was news to me when the scandal broke. But things that were news to me were things that one would have been likely to learn before making investments if the SEC had done its job in 1992: if it had made Madoff explain and prove how he was making money when it investigated the deal in 1992, or if it had made him register as an investment adviser in 1992, or if it had put a stop to the whole business if it already was a Ponzi scheme at that time.
Before I made the final decision to invest, I did the due diligence of which I felt capable and which occurred to me. In particular, I met at Madoff’s offices on April 3, 1995 with the fellow I have always been told and always believed was his number two man, Frank DiPascali, to have him explain precisely what was the investing strategy that was being followed. DiPascali explained that Madoff was engaging in what I now know to be called the “split-strike conversion” strategy. Under this strategy, Madoff bought for one’s account a “basket” of stocks that were in the S&P 100. To guard against losses, he simultaneously bought options, called “puts,” that allowed him to sell the stocks — to “put” them to someone, if they went down instead of up. To pay the cost of the puts that he purchased, Madoff sold other options, named “calls,” that allowed the buyer of the option to “call” the shares from Madoff after small gains.
By guarding against losses via “puts” while offsetting the price of the “puts” by selling “calls” that limited the gains from each set of transactions, and by highly active trading that repeated the process time and again during the course of a year, Madoff could make small profits on each of numerous trades when the shares rose in value rather than dropped (Madoff was swinging for singles, not homers, said DiPascali), while he guarded against big losses from downturns.
Over the course of a year, the small profits (the singles) on numerous trades of stocks that rose in value, would mount up. This was not a strategy for big hits, but for a small profit here, a small profit there; if shares rose, say, ten percent, the strategy might garner one or one and a half percent (because the calls would require the stocks to be sold). Over the course of a year, the small profits would add up (and would exceed any small losses when stocks went down and would be “put” to buyers).
That the foregoing description of the investment strategy was what was told me is evidenced by contemporaneous notes — which I still have — of the meeting with DiPascali on April 3, 1995 — the meeting with the number two man to a highly respected Wall Street figure. The notes of the meeting say:
The program will work as follows: I will be long 30 to 40 S&P 100 securities. The portfolio is configured so there is a perfect correlation with the S&P 100 index. It is hedged using index options. So if market goes up and you are in a short position on options, it causes the long assets you own to go up.
So you are long a basket of securities — our core assets — you have hedges. In a volatile market, you’ll do very well. In an even market or a down market, you’ll do okay.
Your long position is protected against going down by being long on puts on the index. Flip side is you have short calls so there will not be unending appreciation.
They are looking to hit lots of singles. It’s a leveraging type of game. If net goes up 10% you make 1 or 1.5%, while you are protected against losses on downside.
Results vary from month to month — some months you make zero, some 2%. The goal is to do twice the long term Treasury bill rate. So the goal now is about 15%. Last year just made it. Other years exceeded it. Doesn’t feel will exceed it now because more people (competitors) are doing it and this limits what you can squeeze out.
So the split-strike conversion strategy was what was described to me as the Madoff investment strategy, was a system that made a lot of sense to me, was what I invested in, and was all I intended to invest in.
Click here to read Part Two of Investing with Madoff.
Lawrence Velvel, dean of the Massachusetts School of Law, is the author of Thine Alabaster Cities Gleam and An Enemy of the People. He can be reached at: Velvel@VelvelOnNationalAffairs.com