Column overall title: Column 25

A Mathematician on Wall Street

My Encounters With Madoffs Scheme and Other Swindles by Edward O. Thorp Copyri ht 2!!"

On the a#ternoon o# Thur$day% &ecember ''% 2!!(% ) ot the new$ ) had been e*pectin #or more than $eventeen year$. Callin #rom +ew ,or-% my $on .e## $aid /ernie Mado## ha$ con#e$$ed to de#raudin inve$tor$ o# 05! billion in the reate$t 1on2i $cheme in hi$tory. 3)t4$ what you predicted in 5 '""'67 he $aid. )t be an on a balmy Monday mornin in +ew ,or- in the $prin o# '""'% when ) arrived at the o##ice o# a well8-nown international company. The inve$tment committee% reviewin their hed e #und inve$tment$% decided at thi$ time to add due dili ence by hirin me a$ a con$ultant. ) $pent a #ew day$ li$tenin to $ummarie$ o# trac- record$% analy$e$ o# the bu$ine$$ $tructure$ o# the hed e #und$% the bac- round$ o# their mana er$% and ma-in on8$ite vi$it$. One o# the #und mana er$ wa$ $o paranoid when ) interviewed him at hi$ o##ice that he wouldn4t tell me what -ind o# per$onal computer$ they u$ed. When ) went to the re$troom he e$corted me #or #ear that ) mi ht ac9uire $ome valuable crumb o# in#ormation. With one e*ception% ) approved the inve$tment$. The $tory #rom /ernard Mado## )nve$tment$ didn4t add up. My client had been ettin $teady monthly pro#it$ ran in #rom ': to more than 2: #or more than two year$. Moreover% they -new other Mado## inve$tor$ who had been winnin every month #or more than ten year$. Mado## claimed to u$e a 3$plit $tri-e price7 $trate y which wor-ed li-e thi$: buy a $toc-% $ell a call option at a hi her price and u$e the proceed$ to pay #or a put option at a lower price. Table ' detail$ how thi$ wor-$.
";'';!"

'

Table 21.1 &ay ' /uy '!! <,= at >2 /uy one put option at 0? per $hare to $ell '!! $hare$ o# <,= at 0>! on day @! Sell one call option at 0? per $hare to buy '!! $hare$ o# <,= at 0>5 on day @! &ay @! Scenario 1. Stoc- i$ 0>5 or hi her. 1ut e*pire$ worthle$$. /uyer o# call pay$ 0>5 and receive$ '!! $hare$ o# <,= Scenario 2. Stoc- i$ 0>! or lower. Call e*pire$ worthle$$. Mado## u$e$ the put to $ell the $toc- at 0>! a $hare Scenario 3. Stoc- clo$e$ between 0>! and 0>5. Sell $toc- #or a ain or lo$$ 1ro#it or lo$$ e9ual$ 0'!! time$ the di##erence between the current $tocprice and the ori inal purcha$e price o# 0>2. 02!! lo$$ Ae$ult 0?!! pro#it Owed 0>%2!! 0?!! ' call% $tri-e 0>5 Owned '!! $hare$ <,= ' put% $tri-e 0>! 0?!!

Scenario 4. Call holder e*erci$e$ early. Thi$ i$ u$ually a mi$ta-e on the part o# the call owner. )# it occur$ the pro#it i$ more than in Scenario ' and the elap$ed time i$ $horter% #urther boo$tin the rate o# return. )n the Mado## world o# #ictitiou$ trade$ thi$ doe$n4t happen.

0?!! pro#it plu$ ain #rom $ellin put.

) e*plained that% accordin to #inancial theory% the lon run impact on port#olio return$ #rom many properly priced option$ with 2ero net proceed$% a$ the e*ample in Table 2'.'% $hould al$o be 2ero. So we e*pect% over time% that the client4$ port#olio
";'';!"

return $hould be rou hly the $ame a$ the return on e9uitie$. The return$ Mado## reported were much too lar e to be believed. Moreover% in month$ when $toc-$ are down% we e*pect Scenario 2 o# the table to dominate% producin a lo$$. /ut Mado## wa$n4t reportin any lo$$e$. A#ter chec-in the client4$ account $tatement$ #or $uch month$ ) #ound that lo$in month$ #or the $trate y were ma ically converted to winner$ by $hort $ale$ o# SB1 )nde* #uture$. )n the $ame way% month$ that would have produced very lar e win$ were 3$moothed out.7 Su$pectin #raud% ) a$-ed my client to arran e #or me to vi$it the Mado## 3inve$tin 7 operation on the $eventeenth #loor o# the #amou$ Cip$tic- /uildin on Third Avenue. /ernie wa$ in Europe that wee-% and a$ we now -now% li-ely rai$in more money. Di$ brother 1eter Mado##% head o# compliance and o# computer operation$% $aid that ) would not be allowed throu h the #ront door. ) a$-ed my client who it wa$ that did the accountin and annual audit$ #or the Mado## #und. ) wa$ told it wa$ handled by a one man $hop run by a man who had been a #riend and nei hbor o# /ernie4$ $ince the '"@!$. +ot rea$$ured% ) a$-ed when the client received con#irmation$ o# trade$. The an$wer wa$ that they came by mail in batche$ every wee- or two% well a#ter the date$ o# the alle ed trade$. At my $u e$tion%

the client then hired my #irm to conduct a detailed analy$i$ o# their individual tran$action$ to prove or di$prove my $u$picion that they were #a-e. A#ter analy2in about '@! individual option$ trade$% we #ound that #or hal# o# them no trade$ occurred on the e*chan e where Mado## $aid that they $uppo$edly too- place. Eor many o# the remainin option$ tran$action$% we #ound that the volume o# trade$ reported #or the client4$ two account$ alone e*ceeded the total volume reported by the e*chan e. To chec- $ome o# the remainin trade$% tho$e which did not contradict the price$ and volume$ reported by the e*chan e$% ) a$-ed an in$titutional bro-er #riend at /ear

";'';!"

Stearn$ to #ind out in con#idence #or me who all the buyer$ and $eller$ were. We could not connect any o# them to Mado##4$ #irm. My client had a dilemma. )# they clo$ed their account$ with Mado##% and ) were ri ht% they would $ave their principal% their reputation% and avoid a po$$ible le al me$$.' )# ) were wron % they would needle$$ly $acri#ice their be$t inve$tment.2 On the other hand% i# they $tayed with Mado## and ) were wron % they e*pected to pro$per. )# ) were ri ht% their Fob$ could be at ri$-. They withdrew. )n my attempt% via 3networ-in %7 to #ind out how much other money wa$ inve$ted with Mado## ) repeatedly heard that all hi$ inve$tor$ were told not to di$clo$e their relation$hip% even to each other% on threat o# bein dropped. ) wa$ able to 3locate7 about hal# a billion and in#erred that the $cheme had to be much lar er. ) wa$ iven one inve$tor4$ trac- record% $howin $teady monthly ain$ in the 2!: annuali2ed ran e bacto '"G"% and wa$ told the record wa$ $imilar bac- into the late '"@!$. )t appeared a$ thou h the $cheme had already been operatin #or more than twenty year$6 Davin $hown that Mado## wa$ po$tin #a-e trade$ to my client4$ account$% and that he wa$ apparently doin $o to $everal other inve$tor$ with whom ) $po-e% ) had the 3$mo-in un7 that proved #raud. ) warned people in my 3networ-%7 #oreca$tin an ever8

e*pandin 1on2i $cheme that would one day end di$a$trou$ly. The lon er it went undetected the wor$e it would be when it ended. At thi$ time Mado## wa$ a maFor #i ure in the $ecuritie$ indu$try% $ervin a$ chairman o# +AS&AH% runnin one o# the lar e$t 3third mar-et7 Io## the e*chan e$J $toc- tradin #irm$ in the country% con$ulted by overnment% and routinely chec-ed out by the S.E.C. Would the e$tabli$hment have believed char e$ o# wron doin K The $tory o# Darry Mar-opoulo$ ive$ the an$wer. Challen ed by hi$ bo$$ in '""" to e*plain why Mado##% with a $uppo$edly $imilar $trate y% could produce much better and $teadier
";'';!"

>

return$% Mar-opoulo$ concluded on the ba$i$ o# 9uantitative #inancial rea$onin % a$ ) had done% that it wa$ impo$$ible and mu$t be a #raud. Thou h he didn4t e$tabli$h that the individual trade$ were #a-ed% even without that 3$mo-in un7 hi$ ar ument$ were

overwhelmin ly per$ua$ive. Eor the ten ne*t year$ Mar-opoulo$ attempted to et the S.E.C. to inve$ti ate. The S.E.C. repeatedly bru$hed him a$ide% cleared Mado## a#ter $uper#icial inve$ti ation$% and in one in$tance 9ua$hed a re9ue$t #rom the /o$ton o##ice% prompted by the Mar-opoulo$ in#ormation% to inve$ti ate Mado## )nve$tment$ a$ a po$$ible 1on2i $cheme. )n a remar-able >GG pa e document% 3)nve$ti ation o# Eailure o# the SEC to Lncover /arnard Mado##4$ 1on2i Scheme M 1ublic Ner$ion%7 Au u$t ?'% 2!!"% Aeport +o. O)O85!"% the SEC inve$ti ate$ and document$ it$ own repeated #ailure$% be innin in '""2 and continuin until Mado## con#e$$ed in 2!!(% to #ollow up on obviou$ clue$% pointed complaint$% and clear violation$ o# $ecuritie$ law$. )n 2!!'% at a hed e #und inve$tin con#erence $pon$ored by Barrons% the headline $tory? wa$ about the inve$tment mana er who wa$n4t there% the mana er with the be$t record o# all% /ernie Mado##. /etter yet% he didn4t char e the typical hed e #und #ee$ o# ': o# a$$et$ per year plu$ 2!: o# any new net ain$. Dow could thi$ beK Suppo$edly he made hi$ money #rom $mall #ee$ on the hu e tradin volume that wa$ #lowin throu h hi$ bro-era e #irm #rom the order$ he placed on behal# o# hi$ inve$tment client$. Even with the well publici2ed doubt$ e*pre$$ed in the Barrons $tory% and the $u$picion$ o# #raud now voiced by many% the re ulator$ $lept on. So did Mado##4$ thou$and$ o# inve$tor$ and the many #iduciarie$ they were payin to protect them. Dow did the #raud endK /ernie Mado## Ipronounced 3made o##%7 a$ in 3with your money7J turned him$el# in on &ecember ''% 2!!(% with the improbable $tory that he wa$ the $ole con$pirator in the $cheme. Thi$ man who wa$ virtually i norant about computer
";'';!"

$y$tem$ claimed to have $in le8handedly directed the whole $ecure 'Gth #loor computeri2ed operation% alon with $ome twenty or $o employee$ eneratin M $uppo$edly un-nowin ly M a daily torrent o# billion$ o# dollar$ o# #a-e trade$ #or thou$and$ o# account$. On Au u$t ''% 2!!"% e*actly nine month$ a#ter Mado## turned him$el# in% Eran&i1a$cali% .r.% the man who $upervi$ed hi$ operation$ #rom day8to8day% wa$ char ed by the SEC in the L.S. &i$trict Court% Southern &i$trict o# +ew ,or-. At thi$ point the SEC -new that /ernard Mado## )nve$tment Securitie$ 3I/M)SJ mana ed inve$tor account$ a$ #ar bac- a$ the '"@!$57. Dowever% the SEC complaint $ay$ the $plit $tri-e price $trate y dated #rom '""2% wherea$ it wa$ in place year$ earlier. Mado## claimed hi$ #amily% brother 1eter% $on$ Mar- and Andrew% all principal$ in the #irm% and the detail oriented hand$8on wi#e Auth% were totally innocent and unaware o# any complicity in the on oin ma$$ive #orty8year #raud. )n addition to $in le8handedly runnin hi$ $windle% Super /ernie wa$ vacationin at hi$ variou$ re$idence$% travellin abroad to rai$e ever more money% $hu##lin ma$$ive #und$ internationally amon ban-$% payin lar e #ee$ to 3#iduciarie$7 who brou ht him inve$tment$% while the comple* $cheme $omehow ran li-e cloc-wor- in hi$ ab$ence. When pleadin uilty% he told the Fud e that he be an $tealin

money in the early '""!$.> A$ we4ve $een% it wa$ already bi then and had $tarted at lea$t twenty year$ earlier. Mado## ave the $i2e o# the $cam at 05! billion% with later e$timate$ o# $i*ty8#ive billion%5 #or the amount o# #a-e e9uity inve$tor$ believed they had in their account$ at the end. More meanin #ul i$ how much money wa$ put in% how much paid out% and to whom. Several 3handler$%7 who each collected hundred$ o# million$ or billion$ #rom inve$tor$% claimed to have thorou hly veri#ied the le itimacy o# Mado##4$ $trate y% $-immed o## hundred$ o# million$ in #ee$% and moved up the ran-$ o# the politically and $ocially connected $uper rich. One individual reportedly@ withdrew over #ive billion
";'';!"

dollar$ more than he put in6 The #act that Mado## wa$ lettin other$ collect the hundred$ o# million$% and eventually billion$% in mana ement #ee$% all the while $ettlin #or much le$$ in tradin commi$$ion$% $hould have been enou h to alert inve$tor$% advi$or$% and re ulator$. The overnment relea$ed a $earchable li$t o# more than '?%!!! pa$t and pre$ent Mado## account holder$% ran in #rom hundred$ o# not very rich Elorida retiree$% to celebritie$% billionaire$% and non8pro#it$ li-e charitie$ and univer$itie$. )# the$e le ion$ o# inve$tor$ were ea$ily ulled% o#ten #or decade$% what doe$ thi$ and other $windle$ tell you about the e##icient mar-et hypothe$i$K /y the time you read thi$% $everal boo-$ detailin the #raud will have been publi$hed% mo$t li-ely with #ar more detail than ) can ive here. /ut even #rom my $ynop$i$% you can $ee that Mado##4$ inve$tor$ enerally #ailed to do their own independent thin-in and analy$i$% tru$tin that other$ had veri#ied the le itimacy o# hi$ $trate y and hi$ operation. )# you are oin to $ee- $uperior inve$tment$ you had better do the wor-. When ) $hi#ted my #ocu$ #rom beatin amblin ame$ to analy2in the $toc-

mar-et% ) naively thou ht that ) wa$ leavin a world where cheatin at card$ wa$ then problematic and enterin an arena where re ulation and the rule o# law ave inve$tor$ a #air playin #ield. )n$tead% ) learned that bi er $ta-e$ attracted bi er thieve$. Mado##4$

1on2i $cheme wa$ only the lar e$t o# the many that were e*po$ed in 2!!( and 2!!"% with other$ ran in #rom ei ht billion Ia 3ban-7J throu h hundred$ o# million$ Iincludin $everal hed e #und$J% to multimillion dollar real e$tate% mort a e and annuity $cam$. ) $peculate that the $i2e o# $windle$ li-ely #ollow$ a $imple mathematical 3power law%7 li-e the di$tribution o# hi h income$ and top wealth di$cu$$ed in previou$ column$% with their number increa$in a$ their economic $i2e decrea$e$. More Frauds
";'';!"

Mado##4$ $cheme wa$ the bi the late '"G!$% while Fo

e$t ) encountered but it wa$ not the only one. )n

in near my home in +ewport /each% Cali#ornia% ) wa$

a$toni$hed to $ee a new $ecuritie$ #irm which had $prun up almo$t overni ht. 1a$$in the bi $i na e o# 3<,= Corporation%7 ) entered the hubbub o# boomin phone ban-$ and $core$ o# $ale$men;trader$. Adopted at once by my own per$onal uide% ) wa$ 3introduced7 to their 9uic- buc- world where ) would ma-e a #ortune #rom the put and call option$ on old% $ilver and other metal$ which they $tood ready to $ell me. /ac- in my o##ice% ) compared their price$ to the 3correct7 model price$ we u$ed at 1rinceton8+ewport 1artner$ to whole$ale lar e amount$ o# $uch option$ to Mocatta Metal$. With in#lation approachin double di it$ and a $pi-e in commodity price$% preciou$ metal$ and option$ to buy or $ell them were a boomin bu$ine$$. To my a$toni$hment% ) #ound that <,= Corp. wa$ o##erin to $ell me option$ at le$$ than hal# my e*pected payo##6 A#ter ) collected #inancial $tatement$ #rom my #riendly $ale$man and e*amined them% ) di$covered that when <,= Corp. $old an option it counted the proceed$ a$ income% but it did not $et a$ide any re$erve to pay o## the option$ i# and when they were ca$hed in by the buyer. Since the correct re$erve$ on each option they $old $hould have been more than twice what they were bein paid% proper accountin would $how their net worth becomin more ne ative every time they $old another option. )t wa$ clear that they had to $ell more and more option$% u$in the ever8 increa$in ca$h #low to pay o## any early 3inve$tor$7 who mi ht ca$h in. Cla$$ic 1on2i and it would end badly. What to doK ) decided on a little educational e*periment #or my$el#. A#ter con$iderin the $canty in#ormation available on $ale$% option$ out$tandin % early redemption rate$ and $o #orth% ) e$timated they would $urvive #or at lea$t ei ht more month$. )t turned out to be ten. /uyin 0>%!!! worth o# $i*8month option$% ) doubled my money in #our month$
";'';!"

and ca$hed out. A #ew month$ later the o##ice$ were $huttered% the operator$ one% and another #raud inve$ti ation had be un. Ca tain Money and the !olden !irl )n the early (!$% a decade be#ore comin acro$$ Mado##% ) learned o# a remar-able inve$tment mana er in nearby San &ie o. A eniu$ #orei n e*chan e trader wa$ rac-in up return$ o# one percent% two percent% three percent and even #our percent a month. De didn4t lo$e. ) a$-ed mathematician Oeor e Show$% an a$$ociate in my +ewport /each o##ice o# 1rinceton8+ewport 1artner$% to ma-e an on$ite vi$it to the o##ice$ o# .. &avid &ominelli in Ca .olla. Oeor e came bac- with the ama2in tracrecord and 3adverti$in 7 literature but could #ind no evidence o# any actual tradin activity. Our re9ue$t #or audited #inancial $tatement$% proo# o# a$$et$% and proo# o# trade$% were $moothly de#lected. ) $u$pected 31on2i7 and we didn4t inve$t. The whole $cheme collap$ed in '"(>% wipin out over 02!! million Iworth twice a$ much in 2!!"J% de#raudin over one thou$and inve$tor$% includin much o# the $ocial% political and #inancial elite o# the San &ie o area. &onald C. /auder tell$ the incredible $tory in hi$ boo-.G Character is "estiny +ot much later% in '"(>% ) came acro$$ an innovative company with a new hi h tech computeri2ed product #or the #inancial community. They were $ee-in more capital to #ini$h re$earch and development and to mar-et their product. The $tory wa$ per$ua$ive to me% and the bu$ine$$ plan made $en$e% and my computer e*pert a$$ociate% Steve Mi2u$awa% ave a thumb$8up to the re$earch and development plan. ) and $everal #riend$ inve$ted alon $ide the principal$% payin them the typical hed e #und annual per#ormance #ee o# 2!: o# any new net pro#it$. When we received the #ir$t year4$ #inancial $tatement$ we #ound that% althou h much money had been $pent on re$earch and development% the principal$ declared a pro#it% o# which they paid
";'';!"

"

them$elve$ 2!: be#ore allocation to the inve$tor$. /ut there wa$ no pro#it. There wa$ a lo$$. What happenedK The principal$ declared that the money $pent on re$earch and development produced value% a value reater than the amount $pent% and they treated thi$ a$ thou h it were money earned6 A#ter another year% we inve$tor$ mana ed to e*tricate our$elve$ without lo$$. Mi$mana ed% the company then di$$ipated their clear technolo ical ed e% the competition pa$$ed them with a $imilar product that became ubi9uitou$% and it$ #ounder i$ a multi8billionaire. A #ew year$ later% two o# the principal$ #ounded a hed e #und% and -nowin their character$% ) warned a ain$t inve$tin in it. )n 2!!( they were char ed with mi$appropriatin $everal hundred million dollar$ o# their inve$tor$4 capital in yet another 1on2i $cheme. Whats in a #ame$ )n the mid "!$% ) made an on$ite vi$it to chec- out a $tart8up hed e #und mana er who pre$ented an impre$$ive trac- record and a pillar8o#8the8e$tabli$hment name% /enFamin Eran-lin /u$h ))). What ) #ound wa$ a #i#tyi$h $in le #ather who $hared a one bedroom rental bun alow with hi$ rammar $chool a ed child. On a de$-% loo-in li-e an a#ter8thou ht% wa$ an idle per$onal computer #rom which /en /u$h alle edly traded. )t wa$ obviou$. We didn4t inve$t. /ut% un-nown to me% a #riend o# mine% a well8 -nown local #inancial advi$or and hed e #und mana er% did hi$ own due dili ence% inve$ted% and then #aced the pain when the Los Angeles Times8 reported that /u$h pleaded uilty to ta-in client #und$ #or hi$ per$onal and bu$ine$$ u$e. The #lood o# almo$t daily #raud$% $windle$ and hoa*e$ reported in the #inancial pre$$ ha$ continued durin my entire inve$tment career and ) e*pect that when you read thi$ month$% year$ or decade$ later% you4ll #ind your own pro#u$ion o# e*ample$. Doa*e$% #raud$% mania$ and other lar e $cale #inancial irrationalitie$ have been with u$ #rom the be innin $ o# the mar-et$ in the $eventeenth century% lon be#ore the
";'';!"

'!

)nternet. Two readable and entertainin account$ are the #amou$ Extraordinary Pop lar !el sions and t"e #adness o$ %ro&ds% by Charle$ MacPay% and it$ more current $e9uel% Pon'i Sc"emes( )n*aders $rom #ars and +t"er Extraordinary Pop lar !el sions% by .o$eph /ul at2. ,et account$ li-e the$e are not proce$$ed by the EMD true believer. E ilo% A#ter writin thi$ and di$cu$$in the Mado## Scheme with my wi#e% ) mentioned two item$ that didn4t ma-e $en$e. /ernie Mado##% in hi$ elocution to the Fud e% $aid% contrary to #act% that he thou ht hi$ $cheme be an about '""'. The SEC4$ complaint a ain$t Eran- &i1a$cali $aid% pre$umably u$in in#ormation #rom Mr. &i1a$cali% that the #raud wa$ computeri2ed and the $plit $tri-e price $trate y had be un in '""2% al$o contrary to client report$ ) had reviewed earlier. Then my wi#e a$-ed a -ey 9ue$tion% 3What would they have to ain7 #rom $uch claim$K An an$wer occurred to me that not only neatly an$wered her 9ue$tion% with a uni#ied e*planation o# both pu22le piece$% but ave me an in$i ht into what may yet be revealed.

";'';!"

''

";'';!"

'2

'

Eor the cla$$ic $tory o# a le al me$$% $ee .arndyce ver$u$ .arndyce in Blea, -o se by Charle$

&ic-en$.
2

)# Mado## i$ really ainin 2!: a year and their be$t alternative$ would ive% $ay% '@: a year% then

they4re only out >: a year.

?

Arvedlund% Erin E.% 3&on4t A$-% &on4t Tell%7 Barrons #aga'ine% May G% 2!!'. 3/ernard Mado## Oet$ '5! ,ear$ in .ail #or Epic Eraud ILpdate GJ%7 /loomber .com% .une 2"% 2!!". +ew$ Aelea$e% 3/ernard C. Mado## Char ed in Eleven8Count Criminal )n#ormation%7 L.S. Attorney #or

>

the Southern &i$trict o# +ew ,or-% March '!% 2!!".

@

One .e##ry M. 1icower% accordin to the .e& /or, Times( Sunday% .uly >% 2!!"% pa e /2. /auder% &onald C.% %aptain #oney and t"e 0olden 0irl( Darcourt /race .ovanovich% +ew ,or-%

'"(5.
(

Los Angeles Times% April (% '""(.