In October 2005, in his small office in Boston, USA, a young and inexperienced legal clerk was examining a report titled: “The World’s Largest Hedge Fund is a Fraud”… An imaginative title, at least..
I worked at the Securities and Exchange Commission (SEC), where alerts like this are common, but something was strange.
It wasn’t just that the report was so detailed. What he said was disturbing.
There was the litany of scandalous accusations, which were not uncommon. But the desperate plea for help and the mathematical data caught his attention.
If true, this report denounced something impossible.
The employee turned the page and his eyes stopped on a simple graph.
Shooting from left to right across the X and Y axes were two lines: one corresponded to the movements of the S&P 500 stock index over time.
It charted the ups and downs of America’s corporate giants, so it was uneven and unstable, full of surges and rapid declines, just as it should be.
The second line, however, was different.
Far from being irregular, it was beautifully smooth, as if its author had drawn an elegant upward slope from left to right.
It was the recorded growth of a hedge fund.
Would it be possible? Could a hedge fund simply expand for 15 years?
It would have to be completely immune to the noise and disorder of the market.
Perhaps this was evidence, as the author alleged, of seismic fraud.
But he hesitated.
One name appeared over and over again throughout the document, and there was simply no chance that person was a thief.
The employee sighed and tossed the report under his desk.
He was no longer another jealous competitor.
Surely.
A secret manager
To understand all this you have to go back nine years, to the spring of 1996.
At the time, Frank Casey was a risk analyst.
His job was to spot good investments and persuade rich people that he knew what he was doing.
His regular clients were gigantic pension funds, but his ambition was to obtain a more exclusive clientele.
“I started talking to someone who was running an operation from Europe.
“He told me, ‘I’ll be honest with you, I’m royalty. “I know all the royals in Europe.” I asked him, ‘What would you and your customers like to receive from the markets?’”
The answer was predictable: with an initial investment they wanted to make profits using a smart strategy that offered high returns with minimal risk.
“So I said, ‘If I can design a system that’s compliant, would you give me some of your money?’ And he said sure.”
But then this royal told him something else.
“I had hired a guy who was really unique, and I had invested $320 million with him”.
That was a lot of money to invest with one person. Who was the guy?
“He said, ‘I can’t tell you who it is. He asked to remain secret, but uses options and stocks. You enter the market the day before it goes up and exit the day before the market goes down. His rhythm is perfect.”
“I asked him how much he was producing, and he told me: ‘1% a month like clockwork.’”
That was $32 million a year, and that initial injection of cash would be safe even if the stock market crashed.
Frank was bubbling with curiosity.
Whoever it was, it was about a genius or a scoundrel.
“I thought maybe he somehow knew that the big banks were going to deal in x and y stocks, and he went ahead and got them for his clients.”
That’s called advantageous investing.
It involves exploiting advanced knowledge of pending orders to gain a competitive advantage, and is most often illegal.
But even if that’s what they were doing, that 1% return was still notable. How could it be possible?
In October 1999, a clue fell into his lap.
He was talking to a billionaire family from the Carolinas and they showed him a prospectus in which he was able to detect windfall income streams and monthly profits going back years.
The prospectus belonged to the secret manager.
He asked them if he could keep it and they told him yes, but not to show it to anyone.
Frank couldn’t believe his luck.
It was all he needed to create a dream investment product, a rival that could take that guy out of the game.
From dream to reality
“Mathematics is the truth. If you don’t have mathematics, where is the truth going to come from?” declares Harry Markopolos.
He was not dedicated to dreams, but to reality and mathematical proofs.
He was in charge of modeling, testing and building the products that people like Frank devised.
With the prospectus in hand, Frank says they had to reverse engineer what the guy was doing. Harry said, “It’s going to take me about four or five hours.”
Harry ran model after model and tried to replicate a careful balance between market knowledge, risk and reward that would produce 1% profits month after month.
But he ran into a problem.
“I spent a few hours modeling the returns, and I succeeded, but unfortunately, you could lose up to 48% in a month,” he explains.
No matter what he did, there would always be a loss if the stock market changed.
But Harry kept going until he finally made a breakthrough.
There was a way to do it.
When Frank and Harry’s boss asked the mathematician if he had the answer, he said, “Yes, sir. If you want to duplicate it, we can do that. But when they catch us, we’ll probably have to leave the country“.
The team was taken aback. They thought he was joking, but he wasn’t laughing.
Harry told Frank that it was a fraud, probably a Ponzi scheme.
Frank knew that the “secret manager” had at least $320 million in royal dollars and possibly $1 billion from a Carolina family.
If this were a Ponzi scheme where investors were paid with fake profits, funded by new clients, this operation was huge.
They both knew something was very wrong..
“We knew we were right, but we couldn’t prove it. And if we didn’t intervene, who would?” says Frank.
Adding nightmares
Frank and Harry began poking around gala dinners and conference rooms, peppering seemingly innocent questions at unsuspecting colleagues, compiling a list of names and figures.
One by one, they added each name and the total assets invested into a simple spreadsheet.
“The numbers kept getting bigger and bigger and more incredible, and the nightmare kept growing.”.
Before long, the combined figure was staggering.
And in 2002, things were getting even bigger because the secret manager’s clients were appearing everywhere: from France, Switzerland and England to South America and Russia.
“I was very scared because of some of the conduits I was discovering,” Harry confides.
“But it wasn’t until I arrived in Switzerland and while we were having lunch I saw next to us a criminal wanted in the US.
“I realized that a lot of that money came from the Russians and the Latin American drug cartels, some of the most dangerous people on the planet.”
Harry and Frank were seriously worried.
Until then, their investigations had gone unnoticed, but if their names came to light, they could easily end up in serious trouble.
It seemed like things were reaching a turning point, but they couldn’t move away because the information kept flowing.
“Of all the big European banks, Swiss, British, French, German, Spanish… What I was seeing was a horror show,” Frank recalls.
In 2005, the combined total at the bottom of that spreadsheet was truly impressive.
“This guy had grown from $5 billion to over $50 billion dollars.
“The largest hedge fund in the world was a fraud,” Harry summarizes.
But they had discovered a piece of information so they could finally prove it to the world..
“It was probably the simplest mathematical proof in the entire case,” says Frank.
“There were not enough options in the world for him to carry out his strategy of trading as he declared to investors.”
For it to be possible to do what the secret manager claimed to be doing, “between $3 billion and $64.8 billion of some type of option” was needed.
“Unfortunately for him, more than $1.5 billion of those options never existed.”
The financial market in which this secret manager claimed to be operating was not large enough to carry out his operation.
However, it had raised huge sums of money and Harry and Frank realized that this was a ticking time bomb that would not only affect the super-rich.
It would affect ordinary people around the world who had entrusted their income, pensions and life savings to a criminal.
That report
On a cold October day in 2005, Harry sat down to write a dossier of 25 pages that contained a detailed account of 29 red flags and a single graph.
He sent it to the Securities and Exchange Commission, and it landed on the desk of that hapless legal clerk.
Harry desperately wanted someone, anyone, to pay attention, as this wasn’t the first time he had warned them.
Harry had alerted the Securities and Exchange Commission (SEC) about the hedge fund and its secret manager in 2000, in 2001 and this time, in 2005..
But after a series of brief reviews, the SEC took no action.
Harry would make the same complaints once again in 2007 and again in 2008.
“No one believed us. Nobody cared about mathematics,” laments Frank.
It was time to give up, but suddenly something happened.
During the 2008 crisis, investment funds around the world began to fall apart.
Too many people wanted their money back, and There was a man who had guaranteed that the investments would be safe, no matter what happened.
Banks, hedge fund managers and individual investors rushed to him first.
“The markets exploded. And then (Bernard Lawrence) Madoff exploded.”
On December 10, 2008, Wall Street giant Bernie Madoff confessed to his family, his younger brother and his two children that his investment advisory business was a fraud.
Harry was with his children learning karate when he heard the news.
“I came out and I had two messages that said, ‘Congratulations. You were right. Madoff turned himself in. “He is under arrest in New York.”
“It was the worst and the best possible feeling in the world at the same time.”
Overnight, the lives of hundreds of clients, including charities, synagogues, families and even their own childhood friends had been destroyed.
“I still get goosebumps when I think about it,” says Harry.
“People lost their homes, thousands of lives were ruined. There were dozens of suicides”adds Frank.
“I lost a dear friend 11 days later in New York, I met many victims who told me their stories of horror and hardship, with tears in their eyes. “I can’t tell you how many times I cried with them.”
On June 29, 2009, Bernie Madoff was sentenced to more than 150 years in prison and ordered to pay back $170 billion in restitution.
He died in prison on April 14, 2021.
Attempts to recover the funds continue.
The SEC had not done its job.
How was it possible that they didn’t notice?
In 2009, it was brought to Congress, and Harry Markopolos was finally able to lay bare this story and the problem at the heart of it.
“They had too many lawyers and not enough accountants. Mathematics will never lie. “They reveal the truth”.
* If you want to listen to the episode “The Confidence Trick” of the BBC series Uncharted, click here
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