No One Would Listen: A True Financial Thriller by Harry Markopolos (rainbow fish read aloud .txt) 📗

believe that BM has perfect knowledge of the market’s direction due to his access to customer order flow into his broker-dealer.

Red Flag # 12:Yes, BM has access to his customer’s order flow thru his broker-dealer but he is only one broker out of many, so it is impossible for him to know the market’s direction to such a degree as to only post monthly losses once every couple of years. All of Wall Street’s big wire houses experience trading losses on a more regular frequency that BM. Ask yourself how BM’s trading experience could be so much better than all of the other firms on Wall Street. Either he’s the best trading firm on the street and rarely ever has large losing months unlike other firms or he’s a fraud.

10. Red Flag # 13:I believe that BM’s returns can be real ONLY if they are generated from front-running his customer’s order flow. In other words, yes, if he’s buying at a penny above his customer’s buy orders, he can only lose one penny if the stock drops but can make several pennies if the stock goes up. For example, if a customer has an order to buy 100,000 shares of IBM at $100, BM can put in his own order to buy 100,000 shares of IBM at $100.01. This is what’s known as a right-tail distribution and is very similar to the payoff distribution of a call option. Doing this could easily generate returns of 30%-60% or more per anum. He could be doing the same thing by front-running customer sell orders. However, if BM’s returns are real but he’s generating them from front-running there are two problems with this:

a. Problem # 1: front-running is one form of insider-trading and is illegal.

b. Problem # 2: generating real returns from front-running but telling hedge fund investors that you are generating the returns via a complex (but unworkable) stock and options strategy is securities fraud.

Some time ago, during different market conditions, I ran a study using the Black-Scholes Option Pricing Model to analyze the value of front-running with the goal of putting a monetary value on front-running where the insider knew the customer’s order and traded ahead of it. When I ran the study the model inputs were valued at: OEX component stocks annualized volatility on a cap-weighted basis was 50% (during a bear market period), the T-bill rate was 5.80%, and the average stock price was $46. I then calculated the value of an at-the-money call options over time intervals of 1 minute, 5 minutes, 10 minutes, and 15 minutes. I used a 253 trading day year. The SEC should be able to duplicate these results:

1 minute option = 3 cents worth of trade information value

5 minute option = 7 cents worth of trade information value

10 minute option = 10 cents worth of trade information value

15 minute option = 12 cents worth of trade information value

Conclusion: Bernie Madoff used to advertise in industry trade publications that he would pay 1 cent per share for other broker’s order flow. If he was paying 1 cent per share for order flow and front-running these broker’s customers, then he could easily be earning returns in the 30%-60% or higher annually. In all time intervals ranging from 1 minute to 15 minutes, having access to order flow is the monetary equivalent of owning a valuable call option on that order. The value of these implicit call options ranges between 3 - 12 times the one penny per share paid for access to order flow. If this is what he’s doing, then the returns are real but the stated investment strategy is illegal and based solely on insider-trading.

NOTE: I am pretty confident that BM is a Ponzi Scheme, but in the off chance he is front-running customer orders and his returns are real, then this case qualifies as insider-trading under the SEC’s bounty program as outlined in Section 21A(e) of the 1934 Act. However, if BM was front-running, a highly profitable activity, then he wouldn’t need to borrow funds from investors at 16% implied interest. Therefore it is far more likely that BM is a Ponzi Scheme. Front-running is a very simple fraud to commit and requires only access to inside information. The elaborateness of BM’s fund-raising, his need for secrecy, his high 16% average cost of funds, and reliance on a derivatives investment scheme that few investors (or regulators) would be capable of comprehending lead to a weight of the evidence conclusion that this is a Ponzi Scheme.

11. Red Flag # 14:Madoff subsidizes down months! Hard to believe (and I don’t believe this) but I’ve heard two FOF’s tell me that they don’t believe Madoff can make money in big down months either. They tell me that Madoff “subsidizes” their investors in down months, so that they will be able to show a low volatility of returns. These types of stories are commonly found around Ponzi Schemes. These investors tell me that Madoff only books winning tickets in their accounts and “eats the losses” during months when the market sells off hard. The problem with this is that it’s securities fraud to misstate either returns or the volatility of those returns. These FOF professionals who heard BM tell them that he subsidizes losses were professionally negligent in not turning BM into the SEC, FSA and other regulators for securities fraud.

Red Flag # 15:Why would a fund of funds investor believe any broker-dealer that commits fraud in a few important areas—such as misstating returns and misstating volatility of returns - yet believe him in other areas? I’d really like to believe in the tooth fairy, but I don’t after catching my mother putting a quarter underneath my pillow one night.

12. Red Flag # 16:Madoff has perfect market-timing ability. One investor told me, with a straight face, that Madoff went to 100% cash in July 1998 and December 1999, ahead of market declines. He said he knows this because Madofffaxes his trade tickets