This Paper runs like a movie script on how Ed Thorp was able to detect in 1991 itself that Bernie Madoff Scheme was a fraud whereas Bernie accepted this was a fraud at the end of 2008. The Paper ends with mention of other Frauds where the pattern seems common.
"It began on a balmy Monday morning in New York in the spring of 1991, when I arrived at the office of a well-known international company. The investment committee, reviewing their hedge fund investments, decided at this time to add due diligence by hiring me as a consultant."
"One of the fund managers was so paranoid when I interviewed him at his office that he wouldn’t tell me what kind of personal computers they used. When I went to the restroom he escorted me for fear that I might acquire some valuable crumb of information"
"With one exception, I approved the investments. The story from Bernard Madoff Investments didn’t add up. My client had been getting steady monthly profits ranging from 1% to more than 2% for more than two years. Moreover, they knew other Madoff investors who had been winning every month for more than ten years."
"Madoff claimed to use a “split strike price” strategy which worked like this: buy a stock, sell a call option at a higher price and use the proceeds to pay for a put option at a lower price. Table 1 details how this works. "
" The returns Madoff reported were much too large to be believed. Moreover, in months when stocks are down, we expect Scenario 2 of the table to dominate, producing a loss. But Madoff wasn’t reporting any losses. After checking the client’s account statements for such months I found that losing months for the strategy were magically converted to winners by short sales of S&P Index futures. In the same way, months that would have produced very large wins were “smoothed out.”
"Suspecting fraud, I asked my client to arrange for me to visit the Madoff “investing” operation. His brother Peter Madoff, head of compliance and of computer operations, said that I would not be allowed through the front door"
"I asked my client who it was that did the accounting and annual audits for the Madoff fund. I was told it was handled by a one man shop run by a man who had been a friend and neighbor of Bernie’s since the 1960s"
", I asked when the client received confirmations of trades. The answer was that they came by mail in batches every week or two, well after the dates of the alleged trades"
"After analyzing about 160 individual options trades, we found that for half of them no trades occurred on the exchange where Madoff said that they supposedly took place. For many of the remaining options transactions, we found that the volume of trades reported for the client’s two accounts alone exceeded the total volume reported by the exchange"
"To check some of the remaining trades, those which did not contradict the prices and volumes reported by the exchanges, I asked an institutional broker friend at Bear Stearns to find out in confidence for me who all the buyers and sellers were. We could not connect any of them to Madoff’s firm"
"My client had a dilemma. If they closed their accounts with Madoff, and I were right, they would save their principal, their reputation, and avoid a possible legal mess.1 If I were wrong, they would needlessly sacrifice their best investment. On the other hand, if they stayed with Madoff and I were wrong, they expected to prosper. If I were right, their jobs could be at risk. They withdrew."
"In my attempt, via “networking,” to find out how much other money was invested with Madoff I repeatedly heard that all his investors were told not to disclose their relationship, even to each other, on threat of being dropped"
"At this time Madoff was a major figure in the securities industry, serving as chairman of NASDAQ, running one of the largest “third market” (off the exchanges) stock trading firms in the country, consulted by government, and routinely checked out by the S.E.C."
"Better yet, he didn’t charge the typical hedge fund fees of 1% of assets per year plus 20% of any new net gains. How could this be?"
" Supposedly he made his money from small fees on the huge trading volume that was flowing through his brokerage firm from the orders he placed on behalf of his investment clients"
"How did the fraud end? Bernie Madoff (pronounced “made off,” as in “with your money”) turned himself in on December 11, 2008, with the improbable story that he was the sole conspirator in the scheme. This man who was virtually ignorant about computer systems claimed to have single-handedly directed the whole secure 17th floor computerized operation, along with some twenty or so employees generating – supposedly unknowingly – a daily torrent of billions of dollars of fake trades for thousands of accounts."
"Hoaxes, frauds, manias and other large scale financial irrationalities have been with us from the beginnings of the markets in the seventeenth century, long before the Internet. Two readable and entertaining accounts are the famous Extraordinary Popular Delusions and the Madness of Crowds, by Charles MacKay, and its more current sequel, Ponzi Schemes, Invaders from Mars and Other Extraordinary Popular Delusions, by Joseph Bulgatz."
"In a remarkable 477 page document, “Investigation of Failure of the SEC to Uncover Barnard Madoff’s Ponzi Scheme – Public Version,” August 31, 2009, Report No. OIG-509, the SEC investigates and documents its own repeated failures, beginning in 1992 and continuing until Madoff confessed in 2008, to follow up on obvious clues, pointed complaints, and clear violations of securities laws."