Who licked the Madoff envelopes?


One of the most intriguing questions surrounding the Madoff scheme is how he managed to pull it off. Did he do it alone? How many accomplices did he have? Was his family involved?

The assumption is that, given the large sum of money involved, you needed to have a whole lot of hands on deck to steer the ship. But, if you consider a minimalist approach to the mechanics required to construct and manage this kind of Ponzi scam, it just might turn out that he pulled it off with only one or two accomplices.

You have to begin with the man’s resume. He had a reputation for embracing technology early on in his career. He wasn’t really an economist or an investment banker – he ran a state-of-the-art automated brokerage firm. His forte was perfecting the nuts and bolts of a trading operation – perfecting executions, managing transactions and sending out timely and accurate monthly and year-end statements.

Madoff was early pioneer of deploying bleeding edge software and applying it to the brokerage business. In terms of his natural talents, He was more like Bill Gates than Warren Buffet.

Once you have his resume and analyze his skill set – you realize how he deployed his unique talents to pull off this scam. Madoff was a con man and a technological wizard.

In fact, Madoff could have pulled off his scam with a powerful notebook computer.

All he had to do was set up a data base with the names, addresses and social security numbers – that sort of thing. When a new client came through the door, he would set him up on the data base and enter the initial balance.

Then he went about developing model portfolios that generated a targeted rate of return. That’s easy enough to do in hindsight. All he really needed to do was look back at how the markets performed in the previous month pick and choose trading strategies that would have generated the exact return he was looking for. His genius was in putting together models that generated a rate of return that was consistent but plausible rate of return – around 11 percent a year on average.

Take a real simple model. If Madoff wanted to conjure up a one percent return for the month of January – he would wait till the end of the month, take a look at the Wall Street Journal, search for a stock that had appreciated exactly one percent over the course of the previous 30 days and claim that he purchased it on January 5th and sold it on January 29th at a price that generated exactly 1%. If a client went back and checked their statements against the charts, everything would look Kosher and the buy and sell transactions on the statement would match the actual charts

Of course, Madoff’s models were more complex and involved what appeared to be sophisticated hedging strategies that employed index options and other complex derivatives. That was just done for effect – you had to razzle dazzle the sheep to get them to salivate over their fictional statements and hand over more of their money.

One of the red lights that tipped Markopolos off was that – given the size of the Madoff portfolio – there were simply not enough of these complex derivatives being traded to back up Madoff’s claims. Even if Madoff’s buy and sell prices matched the charts – the sheer volume of the fictional transactions in these exotic securities should have set off a red flag. Markopolos handed the smoking gun to the SEC on a silver platter and we all know the rest of the story.

Once Madoff developed a model portfolio – he would execute programs that would generate the fictional transactions. These programs would plug in the model to the starting balance and kick out transactions that would show up in the client’s history file. He would then run another program to generate an impressive looking statement – with starting balance, transactions and ending balances. The actual printing and mailing of the statements could easily have been outsourced. Banks do it all the time because it’s cheap and efficient.

In fact, the first thing I would look for is for the guy who licked the statement envelopes. From there, I would retrace the steps back to the notebook. The fact that he had a whole floor in the Lipstick Building to run this operation doesn’t necessarily mean he used all the square footage for what was an elegantly simple operation. In fact, as a seasoned MIS professional, Madoff definitely tried to apply the KISS factor – Keep It Simple Stupid.

Whatever was up there on the seventh floor in terms of reception suites, offices and impressive looking computer hardware was probably for show. We’ve recently learned that it was the scene of group sex and cocaine snorting. But was that the location where the statements were produced? Did the man who licked the envelopes punch his clock on the seventh floor of the Lipstick Building – I highly doubt it.

Madoff only managed 14,000 accounts. The only thing he had to do was to be meticulously accurate in his record keeping. The actual maintenance to the system only involved adding new clients to the data base, entering starting balances, registering new deposits, registering withdrawals, name and address changes – that kind of thing. Other than that, he only had to print out monthly statements and year-end tax statements. He might also have had to keep a history of transactions going back six years.

What Madoff put together was a scam that could be operated with limited manpower. To execute his business model, it was essential to have a low transaction volume, a relatively small number of accounts and a clientele that didn’t engage in too many transactions. That’s why he targeted a client list of trusts, endowments, pensions, mutual funds and feeder hedge funds. These institutional investors came through the door with large pools of money and generated very few deposit and withdrawal orders. Many of them would go years without making a single transaction – except maybe for an additional deposit. Because of the consistent returns, the account holders thought of them as long term bonds. In fact, because he preyed on his own community – they were known on the Street as the "Jewish Bond."

That’s probably why Madoff used feeder funds that bundled up money and passed it on to his operation. Because then he would only have to set up a single account in his database for the entire fund. The retail traffic would have resulted in a high transaction volume which would have required more hands on deck and a higher risk of exposure.

But what happened to the real money? All Madoff needed was one account to accept new deposits and send out withdrawals. He didn’t even have to monitor the balance and was free to siphon off whatever he pleased.

Even though Madoff made his mark on Wall Street as a pioneering technical wizard, he didn’t allow his clients to have online access to their accounts. He claimed that it would give away his trading strategies and expose his positions to other institutional players. That should definitely have set off some alarm bells. These days you can get online access to your dog’s medical records.

What was Madoff’s end-game? Well, for that you have to evaluate his actuarial skills which were decidedly off the mark. He probably thought that the scam would out-live him. Absent the market turmoil, it probably would have. With the free fall in the market, panic selling led to an increase in redemptions. As Warren Buffet has remarked, when the tide goes down you see who’s swimming naked. And that’s what ruined Madoff’s plans. Otherwise, he could have gone on for another ten years – maybe twenty. Madoff was like Caligula with a Masters Degree in Management Information Systems. If there is one thing about psychos – they get too engaged in their momentary pleasures to think about the future consequences of their actions.

When the news came out that Madoff had done no trading – it was no surprise to me. The other bit of information that intrigued me was that I read where he always went into cash at the end of the month or quarter. That would make sense too. The model portfolios were set up to not over-spill from month to month – that would have been very complex, hard to reconcile and create too much exposure to error. You had to start clean every month with a cash balance – wait till the end of the month – develop a model portfolio that generated a reasonable rate of return – plug in the model – and let it rip – produce the fictional history – send out a fictional statement – and start with a new cash balance. Rinse and repeat.

Madoff was a master swindler and an extremely competent systems analyst. They say the man was meticulous with details and a control freak. That’s what makes for a very good MIS director – no room for technical errors – meet your windows – send out unimpeachable easily reconcilable statements. Madoff just ran out of money. But he had the mechanics down to a science.

Could the regulators have caught him? Of course they could if they had the remotest connection to the regulatory business. But that’s not the line of work they’re in. The SEC is the SEC – an organization that has long since been taken captive by the Wall Street and Madoff was very well connected after having served for a period as the Chairman of FINRA, a regulatory agency that is more corrupt than Tammany Hall.

Forget for a moment about the evidence of foul play that Markopolos tried to stuff down the throats of the SEC. Madoff registered as a hedge fund in 2006 claiming he had 26 clients. If everybody who was somebody had money with Madoff – how could anybody believe he had only 26 clients?

Once the technical nuts and bolts were worked out, all it took was some slick marketing and branding to make Madoff’s operation the most successful Ponzi scheme in history. His genius was to break down the tasks – as only an MIS director can – so that his little helpers only understood the part they were assigned. If he had data entry people maintaining the accounts – that couldn’t have known any better. So even if we eventually track down the guy who licked the envelopes – chances are he’s an innocent man.


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