Book Review: No One Would Listen by Harry Markopolos

by: Philip Mause

Unlike the party atmosphere which pervaded the iconic movie, "Weekend at Bernie's", the end of the month atmosphere in Bernie Madoff's office was probably hectic and grim as a small group of dedicated insiders labored to generate bogus trading records justifying that month's predetermined positive return. The story of how all of this came to be is fascinating, revealing and ultimately disillusioning.

Harry Markopolos deserves credit for repeatedly blowing the whistle on the World's greatest Ponzi scheme. His book No One Would Listen (Wiley, 2010) is a must-read for investors and financial professionals because it reveals defects in the regulatory regime which oversees financial markets. Markopolos displayed courage and tenacity in calling the SEC's attention to numerous (actually 30!) "red flags" which revealed the fraud Madoff was performing in the plain view of the financial community and its hapless regulators.

The more interesting issue is what Bernie Madoff really reveals about the financial community, its regulators and the investing public. Of course, this is not the first Ponzi scheme to unravel; there have been many, many others and there will be many, many more. But unlike other Ponzis which took place in San Diego, South Carolina, Minnesota or other "provincial" centers of what Wall Street professionals might derisively describe as "financial illiteracy," Madoff worked his mischief right at the heart of the financially "sophisticated" New York community. Well paid hedge fund managers, SEC lawyers, financial journalists, and all sorts of "smart" investors had numerous opportunities to exercise due diligence and frequently had the evidence of fraud delivered to them on a silver platter.

Even more mysterious is Madoff's own motivation. Very successful in his legitimate businesses, Madoff apparently set in motion a financial Doomsday Machine which ultimately led to the suicide of one of his sons(as a parent, I can say that no amount of money would ever lead me to take such a risk), rather than admit in the early 1990s that he had a couple of bad months. When things unraveled, he quickly pled guilty, rather than taking his chance with a jury and at least spending a year or two in court rather than in prison.

Reading Markopolos gives one a good feeling for the context in which this tragedy unfolded. We read about Rene-Thierry de Villehuchet (boy oh boy, do I wish my Alsacian ancestors had changed our name from "Mause" to "de Villehuchet" - on the other hand, "Rene-Thierry" might have been a little bit over the top growing up on Long Island in the 1950s) who channeled billions of dollars of "smart" European money to Madoff and then committed suicide when things blew up. We read about taciturn SEC lawyers who passively listened to Harry Markopolos as if he were describing an alien invasion and sat on their hands. And Harry is a bit scary. I have seen him on You Tube and he talks a little too fast. When he rattled off his 30 RED FLAGS (for me, one good red flag is usually enough), he may have sounded a little like a hyperkinetic version of Mel Gibson in the movie, "Conspiracy Theory". But it would have been so easy to check things out. By his own description, Madoff was selling a naked call option large enough to stabilize returns on a $60 billion portfolio. Why not call up the counterparty and ask them about their due diligence?

My conclusion is that the problem is Pride and its horrible deflator, Shame. Horror at the Shame of having to report a down month is apparently what got Bernie started - when everyone thinks you are a "Wizard of Wall Street", it's hard to send out statements revealing that you are a mere mortal. Horror at the Shame of a trial is what led to the early guilty plea.

Pride kept the SEC off the case. SEC lawyers think of themselves as the elite of the Bar. One of my first cases out of law school involved a White Shoe New York firm and its securities lawyers. They dressed a lot better than we lowly litigators; most of them wore suspenders. They were proud of being Securities Lawyers and probably rightfully so. But it's easy to imagine SEC lawyers looking down on Harry Markopolos from Boston and being afraid to ask questions which might reveal to him that they didn't really have a clue about what a "split-strike conversion strategy" was. No one wants to appear to be stupid and asking questions can be very revealing.

This failure to ask questions and understand complex investments seems to have become pervasive. I doubt that the pension funds investing in mortgage backed securities had a good handle on what they were buying. The geniuses at AIG seem to have been really surprised to learn that the credit default swap contracts they entered into required the posting of collateral.

Bernie was also brilliant at playing upon his investors' Pride. The hedge fund managers who channeled money to Bernie were seduced by the perception of having "exlsusive access" and being part of a special club. Maybe Gordon Gekko had it right, "Greed is good" but "Pride goeth before a fall". After all, Greed would lead one to exercise due diligence before investing. And a greedy, but humble, Bernie Madoff would never have risked his already considerable fortune by embarking on a dangerous Ponzi adventure.

As always the Greeks (not the ones about to default, but their ancestors who founded Democracy 2500 years ago) had a word for it, "Hubris". In Greek mythology and drama, Hubris almost always called forth the wrath of the gods and led to tragedy. In the Judeo-Christian tradition, one God can be wrathful enough and His (or Her) attitude toward Pride is frequently not pleasant. While the punishments meted down upon the arrogant in my lifetime have not been accompanied by voices from Heaven, the dire consequences of excess Pride have been unambiguous - especially in the unforgiving(except for TARP) financial markets.

And don't expect things to change for the better. Many of the young people entering the financial services industry have been raised on the euphoria of "self-esteem"(something I have never perceived as being in short supply in our country). They will find it especially hard to record a down month or to admit that they don't understand a complex financial instrument or strategy.

Markopolos argues that the solution to the problems reflected in the Madoff case is more government regulation. I am not so sure. Investors must be responsible for their own decisions and must exercise due diligence. If you don't understand something, don't assume you are stupid. If you don't understand it, don't be afraid to ask questions, and, if after hearing the answers, you still don't understand it, don't invest. Period.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.