The Confidence Game: Backstage, the Accomplices

Abstract

This is the second in a series of five articles focusing on how Bernard Madoff's confidence game (con game) worked. This paper examines the activities of a handful of employees who were engaged backstage, hidden from government regulators and most investors, to further Madoff's crime. Their work revolved around the pretense that securities were being bought and sold. All these fairly well-paid accomplices pled guilty to being involved in criminal activities, although only one acknowledged that he knew he was part of a Ponzi scheme. Regardless of how they describe or label their activities, Madoff's back office had evolved into an organized gang of criminals.

Appendix

Excerpts from the Testimony of Frank DiPascali, Jr. before a Committee of the Securities and Exchange Committee, January 26, 2006

In 3 ½ hours of testimony before the three-member committee, DiPascali spent much of the time attempting to confuse them with mostly an arcane lexicon, as if he were practicing a black art, or mythicizing Madoff.

• First, dazzling with jargon:

  • A: If you go long in a security, like gold, soy beans, anything, any, you know, asset, if you bought a put, you mitigate the risk of the downside depending on the premium you pay for the put. It’s insurance on the downside loss.

    For a bazillion years, people were buying General Motors, buying a put on General Motors and possibly selling the call on General Motors. Now there are two ways to play that: Guys that were just simply looking to earn a return that was somewhat just a click over the cost of money would buy General Motors at, let’s say whatever price, 50 something, then they would buy the put at X and sell the 55 call at Y.

    If the sum total buy stock, buy put, sell call, when you consider the dividend income in the cycle, would allow for a return that was marginally above, let’s say, 90-day paper.

    So if you are borrowing at 90-day paper, you would borrow money, put the strategy on, take a $10,000 investment and make $10,300. That’s called a forward conversion. That’s a standard stock market strategy as opposed to a reverse conversion, which is the exact flip side of that.

    It’s a short stock, short put, long call scenario. And if you use the same strikes you were at, absolutely no risk, as long as you set that up for a net cost or a net proceed, depending if it’s a reverse conversion or a forward conversion, when considering the dividend.

    For illustrative purposes, let’s say you set it up for 50.5 and the dividend is 50s, and you used a 50 strike put and a 50 strike call, you were at zero economic risk because on expiration date, you are going to put that stock at 50 or it’s going to get called away from you at 50. It cost you 50.5 to set up, you are going to catch a half dollar dividend. You are at zero profitability and zero risk.

    However, when you shorted the stock on a reverse conversion, you had to go out and borrow those shares. So when you borrow reverse conversion shares, to make your delivery, you need to make the delivery, in effect – I don’t know if they do that today because I am not involved in that. But in the old days, which is the period of time we are talking about, when you made your delivery, the broker delivered two pages.

    You took the cash and that’s the cash that you posted collateral to the loan officer that lent you the stock to make the delivery in the first place.

    For the privilege of doing that, that loan – they would rebate back to you, sometimes 60, 70, or 80 percent of the cost of those funds. So you had a strategy on that, had a zero risk, and a zero profitability, but you were cash flow positive, because for the time the strategy was on, you were catching a stock loan rebate from the stock loan officer. The reverse conversions were the way of the world in the 1970s and 1980s.

    It makes index options, something that wasn’t around in the early 1980s. That’s how the conversions started to go with me and Bernie, because although I wasn’t involved at all, I am pretty sure we had reverse conversions and equities on all the time.

    …So his room probably has a pocket of money that was set up in reverse conversions and catching positive cash flow from the stock rebate.

    He probably had positions on forward conversions and other stocks where he was earning a rate of return slightly above, you know, short-term paper, maybe because at the time he had a pool of short-term paper that he, for whatever reason, wanted to hold onto.

    Instead of taking a treasury-bill deal, you take a forward-conversion deal, and you pick up 10 or 12 or 15 basis points. This is the type of … very astute trader he is.

    [The reason some of the conversions…actually occurred was] because that’s when index options became available as a trading tool. Because a lot of the questions dealt with, okay, can you use an index option to do the same thing that we are doing with equity options in forward and reverse conversions.

    That’s a very complicated question, and the answer I learned is “yes,” it can be done as long as the securities that are in place, whether they are long or short, whatever the stock side of the ledger looks like, had better be in the index.

    If it’s not, you’ve got some severe risk, especially if you are doing a bona fide reverse conversion or forward conversion where the profit potential was already determined to be zero and you are looking for only cash flow returns from, let’s say a stock loan rebate or you are looking for a nominal rebate paper, you can’t afford to have the long side or the short side.

    I will use the term basket of securities disjoint from the index, because now you are at serious economic risk.

• Second, working to mythicize Madoff:

  • Q: Do you have any idea when he decides that?

  • A: Probably 50 years of doing this game…. Are you familiar with who my boss is in the business?

  • Ms. Cheung: Yes.

  • A: He owns and has developed the most technological firm on Wall Street. There is no doubt in anybody’s mind. Over the years, he has – I don’t know who built it for him, but there are momentum tools that are obviously working, and there are, you know, he is an astute market trader, if you had to put a label on him.

    The way Warren Buffett can buy a company that’s undervalued and do whatever he does, and all of a sudden it’s a valuable asset.

    As a trader, he is the Warren Buffett of Wall Street, if you want to call him that. He is everybody that you think he might be. Trust me, I am looking at the guy, he is amazing. Peter may come off as a jerk sometimes, I don’t know if you’ve experienced that, but sometimes he is jerky. The guy is a genius, there is no doubt about it. He has the gut sense of what’s good economically, currency, stock market-wise, real estate-wise.

    The guy is a, you know, astute – and he is a trader. He has a good sense, based on a bazillion different tools, that he has developed over the years of when to enter any particular market.

    …So give me what I’m supposed to buy [he tells his employees] and I will tell you when I am buying it, in essence.

    …

  • Q: You mentioned there are some momentum models. What do you mean by that?

  • A: He looks at screens in his office on the trading desk, and so on, that are giving him indications as to the momentum of the market. A lot of it, I am sure, he is doing in his head where he is looking at two indexes’ relationship to each other and maybe a third source of data – gold, currency, two currencies against each other, the Euro, the dollar, the S&P 500, the Dow Jones Industrial Average.

    As any good trader, you stand there and it becomes part of your bloodstream. You stare at it enough times and you understand the relationship, at least in your own head. You could turn around and say: “This is a good time to buy.”

    You and I can’t. He can, and is going to be successful more times than not.

  • Q: Ms. Cheung: More times than not, is what my question is. When does he have a bad year?

  • A: When does he have a bad year?

  • Q: Ms. Cheung: Warren Buffett buys companies that don’t always work. Have there been instances in the last 10 years where Mr. Madoff’s overall returns have been negative?

  • A: I don’t believe so; for the year, no. But for any particular period of time, definitely; just not for over the course of a year. No, I don’t remember one.

  • Q: How does the firm –

  • A: I don’t want to interrupt you, but keep in mind that there have been market corrections that have occurred. We are not in the market all of the time. We are in the markets for short periods of time.

    …

  • Q: Is there anybody else at Madoff, the company, who can make these judgment calls other than Mr. Madoff?

  • A: No

  • Q: Ms. Cheung: What happens when he goes on vacation?

  • A: He is never on vacation. Bernie Madoff is available 24 hours a day, 7 days a week, and 365 days a year, anywhere on the planet.

  • Q: Does he have the models available to him?

  • A: He has the same data as I have in the office. He has an office in France, Montauk, Manhattan his home in Palm Beach, and his boat in Palm Beach..

    …

  • Q: How does he select the dealers to talk to?

  • A: He’s got a London office he developed, I guess probably in the mid-1980s. He has relationships in Europe, extensive relationships for over 20 some-odd years with banks and other large institutions. I mean he’s got quite a network of various sophisticated institutional dealers in Europe; he is on a first-name basis with the people who are running the derivative desks.

  • Q: How does he –

  • A: Most of them are banks.

(pp. 25–29 and 54–64.)