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Madoff $65 billion Trap

Gaetan Guy Lion


May 2010

Introduction
Harry Markopolos wrote a book about his
uncovering the $65 billion Madoff Ponzi
scheme; and, his sharing with the SEC
detailed findings in 1999, 2000, 2001,
2005, and 2007. But, the SEC never
caught Madoff.
This presentation is an analytical review of
Markopolos findings.

Losses to Investors
In a Ponzi scheme, the earlier investors get repaid by the
later ones. So, it is not like the entire $65 billion was lost.

Investors invested $36 billion in Madoff funds.


They got back $18 billion. They lost $18
billion. They also thought they reaped $29
billion in gains that never existed.

A few unlikely Madoff victims


Henry Kaufman: economist, former Managing
Director at Salomon Brothers and economist at
the Federal Reserve.
Eliot Spitzers family.
Madoff Family Foundation to the tune of $19
million.

Lets look at a couple of fraud


detection methods that would not
have worked

Benfords Law used in Fraud Detection Software


The Gateway Fund (GATEX) used a
strategy most similar to Madoff. It is a
benchmark on how Madoffs fund
should have looked if it had been legit.

This test would not have uncovered Madoffs Ponzi scheme.

Detecting Fraud using Serial Correlation

The greater the serial correlation of monthly returns the


more probable such returns are manipulated.
Madoffs low negative correlation does not raise a red flag.

To catch this Ponzi scheme, you


had to understand what Madoff
was claiming to do

Bernie Madoff claimed strategy


His split strike conversion strategy amounted to
reducing stock returns volatility. He (supposedly)
did this in three steps:
1)He bought 35 large cap stocks.
2)He bought S&P 100 Put options to reduce losses.
3)He sold S&P 100 Call options to finance the
premium he paid for the Puts.

So, he has a long position in stocks

He bought stocks at prices where the two lines cross. If


stocks go up on the horizontal line he makes money (on
the blue line) and vice versa.

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He buys Puts to reduce losses

The Put strike price is at the red line inflection point. If stock
prices along the horizontal line decline (moving to the left) of
the strike price, the Put is in the money and will cover
additional losses. Buying a Put establishes a floor on losses.
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He sells Calls to finance the Puts premium

The Call strike price is at the green line inflection point. If stock prices along the
horizontal line increase (moving to the right) of the strike price, the Call is in the
money. This creates a cap on returns because you are forced to sell the stock
at the strike price. This is to earn a premium on the Call to finance the Put
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premium.

Net result is much lower volatility


Selling the Calls sets a low
Ceiling on stock returns
gains.

Buying the Puts sets a


Floor on stock return
losses.

Now the return profile looks very different than simply being
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long the stocks.

Problem: Skewness
Skewness implication:
Premium paid = Premium earned
Losses retained > Gains retained
For the same premium level, you
have to retain greater losses on
the Put (red box top graph) than
the gains you can retain on the
Call (green box below).
Skewness is really bad for a split
strike conversion strategy.

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Skewness on S& P 100 Options


on May 24, 2010

For about $6 you could sell a Call with a strike price of 510 on the S&P 100. This is
16.1 points away from the S&P 100 current level at the time of 493.9. You could use
this $6 to buy a Put with a strike price of 455 or 38.9 points away from the current S&P
100 level. The distance of the Put strike price is more than 2 x the one of the Call 15
strike price (38.9/16.1). Thats bad.

Skewness = Asymmetry

At all option premium prices, the respective Puts strike prices are much
further away than the Calls strike prices. We highlight the difference in
strike price distance for a Call and a Put with a premium close to $6 as
shown on the previous slide.

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Another Problem: mismatch between


the risk basis (specific stocks)
vs the hedge basis (Puts S&P 100 Index)
Madoff was long 35 stocks;
He bought Puts on the S&P 100 index;
It would be inevitable that he would run into
losses on specific stocks;
He was not hedged vs any specific stock losses.
He was only protected against the index
dropping. This should have caused Madoff to
incur monthly losses more frequently than he
did.
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Percent of month with loss?!

Markopolos states that Madoffs record from 1993* to 2008 is unheard of in


the hedge fund industry. 93.5% month gain only 12 months losses out of
186 months. His loss frequency is only a fraction of the Gateway Fund
(GATEX) that followed a similar strategy. And, that was during a wrenching
time for capital markets including the 1997-1998 Asian currency crisis, the
three year dot.com crash (2000-2002), and the onset of the financial crisis
(2007 onward).
*Data for GATEX goes only back to 1993. So, we cut off the time series at
this point to make it comparable between Madoff and GATEX.
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Madoff Expected Returns:


Near Risk Free Rate

To avoid almost all monthly losses, Madoffs Put strike price should
have been very close to the current price. This takes him almost
out of equity returns and leaves him barely with a Risk Free Rate
(even less if you factor skewness and basis risk).

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Returns are way too high to be legit

Madoff split strike conversion strategy should have earned


close to the Risk Free Rate. Instead, it earned nearly three
20
times that.

Thats Consistency!?

Madoff perfectly side steps the Dot.com and housing bubbles.


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No one can duplicate his returns!?

Gateway Investment Fund (GATEX) used a similar but superior


strategy to Madoff, but it did not come close to replicating Madoff riskadjusted returns.

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An Efficient Frontier Map


This shows the
combination of
volatility (x axis)
and return (y axis).
GATEX that was
expecting to do
better than Madoff
is already above
the Efficient
Frontier, reflecting
a strong
performance.
But, Madoffs returns are way above the Efficient Frontier. Can you beat
the Efficient Frontier? Yes, but not by that much!
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Madoff had to earn 15% before fees!

Madoff was giving away the entire Hedge fund fee


structure to Fund of Funds. This includes a 20%
performance fee of returns and a yearly 1% management
fee.
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Markopolos knew this was a Ponzi Scheme


Investors thought Madoffs returns were due to:
1) Market timing based on a proprietary model; and
2) Front-running (placing his orders ahead of his
clients to extract illicit gains).
Markopolos knew it was a Ponzi
scheme for a simple reason. Madoffs
equity positions were much larger
than the entire market for S&P 100
index options that he claimed to use
for hedging.
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How did Madoff succeed for so long?

As an investor wouldn't you like to earn 11% nearly risk


free with the former Chairman of the NASDAQ?.
As a feeder fund wouldnt you like to retain the entire
hedge fund compensation (1%/20%) and market to your
client a world beating manager (11% nearly risk free)?
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Who did not invest with Madoff?


The vast majority of large U.S. investment and
commercial banks did not invest with Madoff.
The head of derivatives at such institutions all
concurred it had to be a Ponzi scheme.
This is not true for European banks. Many of
them got caught with exposures ranging from
$200 million to $2 billion.

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Financial Crisis & Lehman Chapt. 11


take out Madoff
Lehman Chapt. 11
on 9/15/08

$8 billion investors
redemption requests
Lehman files chapter 11 on September 15, 2008. Within
next couple of months, the S&P 500 loses 30% of its value.
Investors flee to Treasuries. Their resulting yield drop by
175 bp. Investors request $8 billion in redemptions from
Madoff. He is arrested on December 11, 2008.

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The Four Red Flags summary


1)
2)

3)
4)

This option strategy should have earned close to the risk


free rate. T-Bills over the period earned less than 4%.
Madoff earned close to 11%. Impossible.
His mismatch between his risk on specific stocks and
hedges using S&P 100 options should have caused
frequent monthly losses. Instead, he incurred losses in
only 6% of the months. Impossible.
The skewness in option prices dictates he could not
simultaneously achieve: i) net zero hedging costs; and ii)
avoiding nearly all losses on the S&P 100. Impossible.
The size of his equity portfolio was a high multiple of the
entire market for S&P 100 options he claimed to use for
hedging. Impossible.
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