Innocence Lost

In the spring of 2001, a Barron's reporter was among the first to publicly question Bernie Madoff's record. She tells Portfolio.com how she did it.
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In the spring of 2001, I was working at Barron's covering the asset management business, and even though the dotcom bubble had burst and short-circuited the stock market, it was still a time of innocence.

It was before the 9/11 attacks on the World Trade Center, and sometimes I ate lunch sitting on the edge of its silver plaza fountain, in the sunshine between the two skyscrapers.

The Barron's offices occupied half of one floor in the southern-most World Financial Center building in lower Manhattan, where Dow Jones published the magazine and the Wall Street Journal. One of Barron's long-serving copy editors still smoked in her office (or at least, she and I got away with it until the cleaning lady sniffed us out). Staffers took turns supplying the weekly bottles of dry wine to those closing Friday evenings.

My first year at Barron's I covered options-a beat not unlike covering horse racing. Buy a call option on a stock, and you are betting your "horse" will be a winner and cross the finish line at a certain price sometime in the future. I liked visiting the dimly lit American Stock Exchange on Church Street, behind Trinity Church, because the traders there still ducked in and out of little booths to scream orders into a crowd.

Electronic trading still felt new, even in 2001. Big broker-dealers like Susquehanna and Madoff were using computer programs, not people, to match buy-and-sell orders, but the dinosaurs on the trading floor scoffed, lit another cigarette, and puffed, "It'll never work."

During my second year at Barron's, during which I began covering asset managers and hedge funds, that options background paid off. Hedge funds and options share certain lottery ticket-like appeal: Both offer plenty of upside, and staggering downside potential.

The hedge funds industry blossomed in earnest. In 1996, the top 50 hedge funds accounted for just $55 billion in assets; within seven years that number had grown to $150 billion. (The industry as a whole would top nearly $2 trillion by 2007).

Over cocktails at downtown bars such as the Blarney Stone, P.J. Clarke's, and the 14 Wall Street rooftop bar, I started asking options guys-typically quirky mathematical types with a nose for nonsense-about hedge funds.

It was one of these option traders who brought up Madoff. A strategist at a major investment bank and trading firm, he insisted we talk in person. On an April morning in his company's cafeteria, he told me he'd been asked to run some figures on behalf of a client who was thinking of investing with Madoff.

"The numbers don't make sense," he said. "I've been replicating this strategy six ways to Sunday and I can't make the returns come out right."

This was Madoff's hedge fund strategy, dubbed a "split-strike conversion." I took the train back home and resolved to find someone who could explain it to me.

I got a hold of offering documents for Fairfield Sentry, one of the feeder funds funneling money into Madoff. I then took the offering documents to several individuals whom I respected for their ability to formulate and implement complex option trades.

Not one of them could replicate it; nor could they come up with the source of Madoff's returns. Options were just not making that much money in 2001, especially with electronic trading pressing profit margins down to just pennies.

Other oddities: Our Barron's photographer couldn't locate a picture of Bernard Madoff any later than one taken in 1999. It was as if the guy didn't exist in the 21st century. But Madoff had rabid, religious fans. Individual investors who admitted they were "lucky" enough to get into Madoff's funds revered him. One man put his kids through college from the money earned in Madoff's funds.

A source at Merrill Lynch said he couldn't make sense of the returns and withdrew client funds that his predecessor had invested with Madoff.

Every reporter encounters a big story that feels risky-that carries the risk of offending someone important, someone big, someone savvy, someone smarter than you, or just someone who makes claims that can't be proved or disproved. But feelings aren't facts.

So I went with the facts: Nobody, but nobody, on Wall Street traded options the way Madoff did and made the money that he made. Years later, a hedge fund manager whom I had known since the late 1990s said simply: "Nobody traded options that successfully. That should have been a big red flag."

I worked for months compiling details about Madoff. I easily questioned more than 100 people as to whether they knew Madoff or knew anyone who had ever invested with him. Most either had heard of Madoff or knew of his firm. I could count on one hand the number of people who had actually met the man.

I was beginning to think I'd never be one of the lucky few, even after finishing my profile of him.

Suddenly, though, Madoff was made available to me just as the story was about to be printed. Over a scratchy international telephone line, Madoff told me he was traveling on a boat in Switzerland. "I can't really go into the details," he said of his strategy. He wasn't angry or upset. He sounded more than friendly. He just didn't tell me anything of note.

My article ran, with the headline "Don't Ask, Don't Tell," questioning why Madoff gave up hundreds of millions of dollars in fees (his firm didn't charge the typical two-and-20 hedge fund fees-2 percent of all money invested and 20 percent of any profit earned), as well as why he pressured investors to never reveal they had money with him, and why no one could understand how he made money.

Then there was nothing, silence. Over the ensuing years, fund-of-funds managers I spoke to repeated the rumors about Madoff. He remained a hot commodity in the hedge fund world, but no one had successfully been able to disprove his claims.

By the next bull market, Madoff ranked with Julian Robertson and George Soros-the godfathers of asset management, the founding fathers of Wall Street hedge funds. Madoff was running $17 billion in client funds and had houses in Manhattan; Montauk, New York; and Palm Beach, Florida. The facts were on his side.

Today, the innocence is gone. That Madoff mythology has evaporated, and in its wake even the most smug hedge fund investors are worried.

"There will be a lot more Madoffs discovered," says Edward Seidle, founder of Benchmark Financial Services, which specializes in investigations of pension fraud and money management abuses. "It will no longer be impolite to ask for the documents, sit down, and figure out whether the manager is for real."

Erin Arvedlund is a business reporter. She has worked as a columnist for Barron's, a foreign correspondent with the New York Times, and a staff writer for TheStreet.com. She can be reached at: erinarvedlund@yahoo.com.

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