The Madoff whistleblower: it’s the math, stupid(s)
Just call him Cassandra.
Who? Harry Markopolos, that’s who, the man who tried to blow the whistle on Bernie Madoff for nine long years. But nobody heard—or, rather, nobody who was actually in a position to do anything heard him clearly enough.
Markopolos, an accountant and former investment manager from Boston, is having his moment in the sun, that long-awaited chance to say “I told you so.” Although it may give him some personal satisfaction to be vindicated, I doubt it does a whole lot to assuage the frustration he feels at having failed to stop Madoff’s Ponzi scheme before more people got taken in and more damage was done.
Markopolos says as much:
Why would people think I feel good about this?” Markopolos asked at one point in a series of recent interviews. “People think I’m a hero, but I didn’t stop him. He stopped himself.”
Over the past nine years, Markopolos sent detailed and multiple reports to the SEC pointing out red flags in Madoff’s fund operation, all to no avail. He could not get the New York office to understand what he was saying, and it was New York that had jurisdiction.
In an even more ironic note, the SEC head in Boston, Mike Garrity, was listening, understood, and told Markopolos that if he’d had oversight of the case “he would have had an inspection team inside Madoff’s operation the very next day.” But although Madoff’s investors were nation- and world-wide, Boston’s opinion didn’t count.
What was the problem in New York? Why did the top brass at the SEC there ignore what Markopolos colorfully describes as “the equivalent of Major League Baseball player batting .966 and no one suspecting a cheat?”
It’s hard to say for sure, since the former head of the New York SEC (she left the job for personal reasons before the Madoff scandal broke), Meaghan Cheung, seems to be forbidden at this point to say precisely what steps she followed in her investigation of the Madoff threat after she received a heads-up from Markopolos in 2005.
Markopolos thinks Cheung’s problem was that she was mathematically challenged:
In my conversations with her, I did not believe that she had the derivatives or mathematical background to understand the violation,” Markopolos wrote…
As for Markopolos’ reference to her supposed lack of mathematical acumen, Cheung said, “Investigations are conducted by lawyers and examiners and investigators. We have experts available to help us.”
Cheung is a lawyer, not an economist or an accountant or a financial expert. I don’t know how SEC investigations usually work. But if her investigation of Madoff did not involve her calling on the help of a very able accountant or accountants who were trained to detect fraud, then IMHO she would be guilty of gross negligence.
Yes, the math is complex. And yet Markopolos was able to do it. What’s more, Markopolos had given her “a map and a flashlight” to the problems, and yet she could not see them.
How did Markopolos come to believe so strongly in Madoff’s guilt? It was the math, stupid.
In 2000, Markopolos was the resident math whiz at Boston’s Rampart Investment Management when he was asked by his boss to figure out a way to match Madoff’s fabulous double-digit returns by figuring out how Madoff did it. But that proved much easier said than done:
“I’d say, ‘Hey Harry, how come you can’t run a program like this?,’ ” said Frank Casey, a former Rampart colleague who now runs a consulting firm for hedge fund investors.
For Markopolos, though, it was no joke. Again and again he could not simulate Madoff’s returns, using information he had gathered about Madoff’s trades in stocks and options. Madoff seemed to make money whether stock markets went up or down, a red flag to Markopolos.
“You can’t dominate all markets,” Markopolos said. “You have to have some losses.” Also, Madoff seemed unusually secretive, even to his own clients—another warning sign.
But although Markopolos saw the warning signs—and warned about them—it is curious that so few people understood what he was saying, or what to do about it. Markopolos seems to be an unusually tenacious sort of person, motivated by a sense of fairness and justice, as well as intellectual curiosity and excellent math chops. Unfortunately for him, the nation, and Madoff’s clients, these seem to be rare qualities.
The entire mess reminds me somewhat of the plight of Roger Boisjoly, the man who tried to warn of the problems with the space shuttle’s O-rings in the 80s, to no avail. The result? The Challenger explosion. Boisjoly has spent some time afterwards as a speaker on workplace ethics. Would that the New York SEC office had been on his engagement list.
Very interesting. But I think the paragraph that begins “In 2000, Madoff was the resident math whiz” should read “In 2000, Markopolos was the resident math whiz.”
Actually, this reminds me of the cases where we see evidence of voter fraud, but the liberals blow it off because few people have been convicted. If a bank is robbed, we don’t wait till some particular person is convicted to say ” The bank was robbed”. The conviction of a person(s) requires ” beyond a reasonable doubt” – but proving the bank was robbed does not.
It might have helped the SEC if they had had a real trader in there to look at how he did it. Someone versed in the actual functioning of a trade would smell a skunk and would have dug around to find the problem. How the SEC can’t understand the market it is supposed to regulate is beyond me, maybe there are too many political appointees and less actually interested auditors and investigators. Think using a hacker to guard programs against hackers. mpw
The failure of the SEC staff is to some extent a failure of the various SEC divisions and the SEC’s NY regional office to communicate and share information. This failure is somewhat analogous to the failure of our pre-9/11 intelligence failure. That was due to the shameful and idiotic Gorelick wall barring such communication. The SEC’s failure is to due petty, bureaucratic rivalry. btw. It is the staff that runs the SEC, not the Commissioners. It is they, who for the most part, decide which matters come before it. As with other bureaucracies, they focus too much on “picking the fly-sh*t out of the pepper.”
MPW280 is right. Who is the best building inspector? The answer is obvious. Someone who worked in the trades for 30 years. He knows the codes, but more importantly, understands completely the mentality of those who are meeting those codes.
I’m a computer programmer. I submit that only someone who programs for a living has a full understanding of all that goes into it. Yes, others understand it . . . but there is understanding and then there is UNDERSTANDING.
Seems this is what’s missing in our financial oversight. And, I would guess, the new financial instruments ran ahead of the regulators. Just as my building inspector might fail if he’s on old school contractor inspecting totally new technologies.
OK, I’ll be the first to say it:
What are the odds that she was an affirmative action appointment?
It’s not the math! It’s worse than that. A simple review of the audited financials would have uncovered this mess – something a green junior auditor could have figured out. Markopolos did an excellent job of showing that the purported investment returns were highly doubtful. That should have provided enough information of probitive value for the SEC to conduct the investigation. Megan “Mr. Magoo” Cheung just wasn’t looking in the right places. I find it hard to believe that someone who went to law school wouldn’t know were to look. She could have had one of the many auditors available to the SEC do some simple tests. A really slow auditor might have taken a couple of weeks to discover the existence of fraud. I have dealt with government auditors from different agencies and I don’t really think that the people at the SEC are really that stupid. I think there was a deliberate coverup. This is not the same as 9/11. It’s a lot easier to find a fraud at an audit target than a terrorist cell.
It’s very obvious to pros that IF Madoff was actually doing a “split strike” strategy, option exchanges don’t have enough size.He would have needed to do OTC options with firms like Goldman Sachs, Morgan Stanley, UBS,Deutsche Bank,JP Morgan,Citi and others.They would have had their credit depts crawling all over his operation and they would have required he use them for custodial holding or used a third party like BNY Mellon or JP Morgan or State St.He could have BS’d his way through it if he said he was only running $750 million, but even that would have stretch the limits of using the listed exchanges.
His investors willingly suspended their disbelief.
I’ve been programming for thirty years, and earning my living at it. I’m very good at it, and yet I can’t claim to rise to the highest understanding. What’s more, even the very best can occasionally be surprised. For a classic example, see the Wikipedia entry for Duff’s Device.
I’m sure the same thing is true in the financial industry which is, after all, less mechanical than the execution of a program.
Perhaps Ms. Cheung was being paid not to notice what Madoff was doing.
Kurt: absolutely. I was in such a hurry today that I didn’t proof things as carefully as usual. I just corrected it—thanks!
As one who knows a bit of mathematics, I would say that people are too easily hypnotized by “math” and too easily impressed by “math whizzes” — the problem here wasn’t difficulty in understanding the underlying mathematics, but rather in appreciating the truth of simple maxim:
If it looks too good to be true, it is.
Jamie Irons
Have you ever worked in a gov’t job? I have. Incompetence is the rule,because that is the default position for most people. In industry one is forced to be competent, else you go out of business-unless you can get the gov’t to support you.
“”Incompetence is the rule,because that is the default position for most people.””
It seems like the default position of politically correct bureaucracies. My girlfriend works at a big city hospital and you just wouldn’t believe the incompetence and laziness that abounds. I can only imagine what it will be like with more govt influence on hospitals.
Bureaucracies seem to be where we warehouse all the idiots in society in hopes of diluting their incompetence.
http://neoneocon.com/2009/01/27/madoff-and-his-sons-walking-the-perp-walk-alone/#comments
I think it is time to repeat The Tale of the Little Bird Who Wouldn’t Fly South, a fable for bureaucrats:
My money is on a combination of incompetence, a payoff, ideology and innumeracy, with innumeracy probably coming out ahead of the pack.
What if all of this is part of a deliberately designed “perfect storm” that is being used as an excuse to make government bigger. ie- The Sheeple will be told we need MORE regulations., Like the housing crisis that was in part brought on by government interference in the marketplace (Fannie and Freddie encouraging bad loans by buying them up from banks) . Much of the Sheeple seem to have no idea how Fannie and Freddie were already part of the government and don’t realize they helped bring this on. But the Sheeple swallow the lie ” We need more government” because that is what the MSM tells them.
To me it is pretty good parallel to the Fannie and Freddie mess. Two years before it toppled there were people (including republican congresspeople and the Bush administration) who were raising red flags about the situation and the coming catastrophe. They were not only dismissed but the party running the committees actually commended idiots who were making millions and driving the market into a crater bigger than the one made by the meteor that signaled the end of the dinosaurs.
Madoff tale and every other Ponzi scheme is an example of “greed” among everyone of us. We all know that if it is too good to be true, that it actually is. And yet time and time again, people fall for more of the same. Because this time it is different – it is us, we are smarter than the previous bunch.
As for SEC, in its entire 70 year history, has it ever “uncovered” anything on its own. Only in our government do people get to keep a job in which they suck. And might even get paid more for it. We might as well abolish it – but then again, I am dreaming. Look who is governing now.
And how do YOU, maneocon know that the SEC, in its entire 70 year history has never uncovered anything on its own?
Who do you think uncovered the accounting fraud at Fannie Mae when Fannie Mae fraudulently misstated earnings by about $10.6 billion from 1998 through 2004.
Why don’t you spend some time doing your homework before your make any more sweeping dismissals. You can start here: http://www.sec.gov/divisions/enforce/friactions.shtml an d begin reading the SEC’s Accounting and Auditing Enforcement Releases
Or you can spend sometime learning about the SEC’s internet related litigation here: http://www.sec.gov/divisions/enforce/internetenforce/litreleases.shtml
and
http://www.sec.gov/divisions/enforce/internetenforce/internetlitrelold.shtml
or bank fraud:
http://www.sec.gov/divisions/enforce/primebank/pbaction.shtml
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BTW: Has anyone yet considered what impact 9/11 had on the SEC New York Regional Office? The New York Office was housed in World Trade Center 7 which burned and collapsed with a catastrophic lost of records, evidence, computer equipment etc.
That’s what offsite backups and backup sites are for.
Nonetheless the loss remains. Perhaps you can tell us what sort of off-site hardcopy records retention practices are used by major law firms and the Big 4 accounting firm for analogous current and recent workingpapers and evidenitary materials. For that matter recall the pre 9/11 and post 9/11 state of the FBI’s information systems. The FBI agents were unable to make use most common e-mail capabilities. Keep in mind that if Congress doesn’t provide the necessary funds for IT and records retention it doesn’t happen. And many Congress critters prefer pork to spending money administrative infrastructure. Moreover, I seem to recall that the SEC was severely under staffed and underfunded by Congress in the 1990s and the early part of this decade.
Neo, a bit off-topic, but it looks like Ruth did know about it and wasn’t on denial…
Here.
newton: It’s certainly possible. But consider that Madoff only had confessed to his sons (supposedly, anyway) on Dec. 10.
The last two withdrawals she made were after that confession. It stands to reason that if he had confessed to the sons at that point, he had probably already confessed to her earlier. Her first withdrawal was on Nov. 25, only about two weeks earlier. My guess is that she may have been told just prior to that date.
Of course, as I’ve said several times, it’s certainly possible she was in on the whole thing from the start. But the timing of these withdrawals doesn’t really answer that question, in my opinion.