Saturday, May 15, 2010

Freedom is the freedom to say that two plus two equals four

Harry Markopolos, I am proud to note, is a Boomer, born in 1956. He spends a good deal of his book on his pursuit of Bernie Madoff, No One Would Listen, trying to figure out (as I have myself) exactly what made him so different. To begin with, he credits his parents with instilling in him a strong sense of right and wrong. Secondly, in his adolescence he helped his father manage some chain restaurants, and figured out how to identify employees were stealing. Thirdly, he spent 20 years as an officer in the Army Reserves, which he joined at a pretty unusual time, the late 1970s, because he had an ROTC scholarship But lastly, he always loved math, partly, at least, because figures did not lie. That, I suppose, was the part with which I identified the most, even though I've never been quite as focused on math as he was. Everyone argued about everything in my family when I was growing up, but perhaps because I was the only one who spent a lot of time reading, I had the keenest awareness of a reality out there, beyond the confines of our house, which offered answers to questions. I had only limited success getting other families to acknowledge particular parts of that reality, but trying to rely on the facts became a lifetime habit.

In the late 1990s Markopolous was working for a Boston financial firm which had learned about the mysterious broker and (in effect) hedge fund manager, Bernie Madoff, who claimed to be running a very exclusive investment service that guaranteed a return of 12% a year. His boss wanted him to look into it because, revealingly, he wanted him to emulate his strategy, secure comparable returns, and secure some of the business that was going to Madoff. Markopolos quickly concluded that he couldn't--and that Madoff had to be running some kind of a fraud. To begin with, it was simply impossible for anyone to generate returns that were not only that high, but that consistent, regardless of the ups and downs of the market. Secondly, the split-strike strategy upon which Madoff claimed to be relying--a strategy of buying a basket of representative stocks, selling call options for them that would have to be redeemed if the stock rose and buying put options that would protect Madoff if they fell--was designed to moderate gains and losses, which was not what Madoff was claiming to do at all. The more Markopolos (and three friends and colleagues whom he enlisted in the chase) learned about Madoff's purported operation the more specific he got. He began to realize that if Madoff was managing billions--eventually, tens of billions--of dollars. If he were telling the truth, he would be executing a huge percentage of the options trades carried on in the world's markets--but he couldn't find any evidence of those trades at all. Curioser and curioser, as Lewis Carroll would say.

Now let me digress for a moment and bring up the example from my own life which parallels this one: the career of the baseball player Barry Bonds, who broke into the majors in Pittsburgh, where I was living, in 1986, when he was 22. (I apologize to readers who are not baseball fans.) Bonds established himself as a great player within a few years, but from 1986 through 1999 his performance followed the normal pattern of a baseball player. It took him about four years to reach an MVP-level of performance, including substantial, but not absolutely top-quality power. In his first 7 years he hit 16, 25, 24, 19, 33, 25, and home runs, never leading the league. Then, at the ages of 27, 28 and 29, when most players are (or, up until the last decade, were) at their peak, he hit 34, 46, and 37 home runs. The 37 came in strike-shortened 1994, when he might easily have reached 50 if the season had played out. During this period, his slugging averages--the measure of his overall power--ranged from .416 as a rookie to .624, .627 and .647 in those three peak years. Then, once again reflecting normal patterns, his home runs and slugging began to fall off as he entered his early thirties. From 1995 through 1999 (when he missed more than a third of the year) he hit 33, 42, 40, 37, and 34 home runs, and his slugging fell back slightly to about .600. The figure of 34 for 1999 when he played in only 102 games, is rather interesting, especially since that was the year after Mark McGwire hit 70 home runs. As 2000 began Bonds was 35, an age at which nearly all players are into the decline phase of their careers.

But from 2000 through 2004, Bonds hit 49, 73, 46, 45 and 45 home runs. His slugging averages established new all-time records, previously held by Babe Ruth: .688, .863, .799, .749, and .812. He also broke the all-time single season walk records by tremendous margins, walking 117, 177, 198, 148, and 232 times in those years. As I saw it at the time (and as I argued repeatedly on a baseball researcher email list), this simply could not have been done without performance-enhancing drugs. Not only were these totally unprecedented performances, but Bonds turned them in when other players, without exception, were declining, or at best staying even. (Henry Aaron, as some of my correspondents liked to point out, did increase his home-run production in his late thirties, but that was because he had moved from a pitcher's park in Milwaukee to a hitters' park in Atlanta, and because offense in general rose after 1968, just as it did in the 1990s.) And several players, like Ted Williams in 1957 (when he hit .388 with 38 home runs) had turned in single extraordinary seasons late in their careers--but not all through their late thirties. Yet those who agreed with me on the list (and there were many) generally preferred to keep their mouth shut, while others raised all sorts of absurd suggestions as to how Bonds could have done this without chemical help. Eventually the proof that I was right emerged after Bonds's drug suppliers were raided.

Now Markopolos at the same moment--the late 1990s--decided to try to expose Madoff, partly because he was drawing off so much business, and wrote the first of repeated submissions to the SEC arguing with overwhelming logic that Madoff had to be running some kind of scam. Either he was indulging in a well-known form of insider trading called front-running, taking advantage of the trades he knew his brokerage customers were about to make to get ahead of the market, or, more likely, it was simply a Ponzi scheme. Drawing on his military training, Markopolos planned his campaign carefully and tried to identify both SEC staffers and journalists who might be sympathetic. He did get some suggestive journalistic coverage in the Wall Street Journal, but he got nowhere with the SEC, despite eventually making about half a dozen submissions. The reasons for all this are fascinating. Madoff, surely one of history's most brilliant sociopaths, had created a structure that was largely self-perpetuating.

When the Madoff story finally broke at the end of 2008, attention focused on individual and institutional investors, many of them Jewish, who had entrusted him with their life's savings. Many of those stories were tragic, but they were a relatively minor part of his operation. Madoff's main source of funds were hedge funds. Hedge funds have become a huge, almost totally unregulated financial industry, and it was only from this book that I began to get some idea of what they do. Their real function, as far as I can tell, is not to find clever bets to make on stocks and other assets, but to diversify. And they do a great deal of their diversification with each other. Since they are not regulated and evidently don't have to report much of what they do, it's very hard to tell how much of the money they have generated comes from brilliant decisions and how much simply reflects the expanding market. But everyone seems to want to put money in lots of hedge funds so as not to miss out on some edge that some one may have developed. Madoff, of course, seemed to have developed the best one of all.

That was not all. Madoff also made it enormously profitable for fund managers to associate with him. When a fund brought him money, he paid it 4% of the 12% annually that he claimed to be realizing on that money, and paid 8% to the investors. Fund managers usually take 1-2% of the money invested with them, so this was an irresistible deal. And as soon as fund managers had substantial amounts of money with Madoff, they had a huge financial and emotional incentive to believe that the gains were real. Many of them clearly did not think that they were honest--they thought Madoff was "front-running", as described above, or taking advantage of other kinds of inside information. But as along as they were getting their annual 4%, they didn't care. Madoff also became a favored manager for people with money they wanted to hide, especially from Europe, where his clients included several royal families. (Prince Charles has denied he was an investor; Markopolos doesn't seem to be fully convinced of that.) But interestingly enough, there were others who, although they were not trying to blow the whistle, realized the truth. None of the big banks ever placed any money with Madoff. Neither, as far as I know, did the mangers of the Harvard Endowment.

There were many reasons, including Markopolos's somewhat abrasive personality, why he could not get the SEC to listen to him. The biggest, he came to believe, was that the SEC, which was created in a much simpler time, simply did not understand new financial instruments like options and derivatives. Secondly, he makes clear, the SEC is not in the habit of taking on major market players--it contents itself with levying small fines on smaller players. After Madoff fell, the SEC inspector general did a massive report on what had gone wrong, one that I hope to read at some point myself. Markopolos makes many suggestions for reforming the agency but I didn't have a great feeling of confidence that any of them would work. The new system is too deeply entrenched, and I'm increasingly persuaded that it is rotten to the core. That, however, will have to await another post--this one is already long enough.

Markopolos did not bring Madoff down--the mad optimism of the financial community, of which he was only one part, did. In late 2008, with markets collapsing around the world, his investors had to have their money back, and he didn't have it. Markopolos has speculated that Madoff essentially turned himself in because he had taken money from Russian mobsters and South American drug lords, who might have taken out their frustrations in other ways had Madoff not found security inside the federal prison system. Meanwhile, Markopolos has become a full-time fraud investigator, and claims to have many cases pending. We shall see how many see the light of day.

I could not help thinking as I read this book of parallels between Markopolos's profession and my own. In the last forty years academia in general and history in particular have largely abandoned the values upon which they were originally based, with disastrous results. Like the transactions of hedge fund managers, the writing done by most professional academics is useless to anyone but themselves. It pays off not in money--no one has ever made a dime writing postmodernist history--but in positions and prestige. Like the fund managers who had to buy subprime bonds because everyone else was doing it, younger historians realize they can't afford to write about politics and government because to do so will cost them their jobs. The new academia is also self-sustaining. I felt better because the collapse of academia has certainly been less serious for American than the collapse of our financial system--but I felt worse because academia lacks any self-correcting mechanism. Perhaps, a friend of mine has suggested, the crash in academia will come when young men and women and their families will start to refuse to pay the inflated price of a university education of very dubious value. I wonder.

Markopolos does not seriously address the fascinating question of what made Bernie Madoff tick. I was more interested, clearly, in what made Markopolos tick. Is he a hero? Yes--but not, perhaps, in the way most people might think. Thirty years ago, writing about citizens of totalitarian regimes, the Swiss psychoanalyst Alice Miller argued that those who resist do not really do so out of extraordinary courage--they do so because they simply are not capable of doing anything else. That seemed to fit Markopolos to a T. Mathematical proof, he points out in one moving moment in the book, is much more powerful than legal proof, which depends ultimately on a jury of emotional human beings. He was one of those who simply could not disregard the numbers. There are others like him in other fields, but it seems they will always be exceptions.


Bruce Post said...

I was particularly drawn to this comment:

"Secondly, he makes clear, the SEC is not in the habit of taking on major market players--it contents itself with levying small fines on smaller players."

This reminds me of my late father's experience as a federal civil servant. He worked most of his professional life within the DOD establishment, but when the U.S. Office of Energy was created as a precursor to the Department of Energy, my father switched, wanting to pursue a more idealistic endeavor. He worked in enforcement of federal pricing regulations, but he soon became disillusioned. He expressed his frustration that he and his colleagues were repeatedly directed to the little guys -- gas station owners, etc. -- and prevented from going after the big players. After that bout with "idealism," he returned to DOD, where he ended his career.

So, given my Dad's experience to Markopolos's, I must ask: What is it that the French says? "Plus ça change, plus c'est la même chose!"

Anonymous said...

Neither party is responsible
with the public's money. On
01/01/00, our deficit was $5.7
trillion; on 01/01/09, it was
$10.6 trillion
. Therefore,
deficits under President Bush rose
$4.9 trillion over 8 years. Our
deficit today is $12.9 trillion,
a $2.3 trillion rise in only one
Democrats have controlled the House and the Senate since
2006, and Congress, not the
President, determines spending.
So, it is patently FALSE to blame
only "Republicans" for deficits.
Take comfort in the undeniable
fact that we are broke, and even
the Chinese are starting to sell
our debt. For true fiscal hawks like us, enforced fiscal sanity
is a welcome relief.

So glad to hear that we do have
the freedom to say that two plus
two equals four Dr. Kaiser.

So glad to hear that we can express
that freedom in november, 2010.

KD said...

As usual David, you have provided intiguing insights into a current event and connected it to otherwise hidden political and social phenomena. I knew something of your research into our home run champion*... :) ... and see how your title captures one of the most disturbing aspects of the American scene, namely the abhorrence of fact.

I'm currently working on the critical thinking curriculum of the school I'm teaching at, for a student body with as little grounding in the topic as any in the world. Nonetheless, they find great value in techniques for deeply examining popular arguments that are too often taken at face value. I cannot say why our own educational system has broken down so badly and with so little sign of turning back. As a fringe boomer, born in 1958, it sometimes appears to me that I narrowly escaped the worst of public education, but did not come out unscathed in terms of an incomplete schooling. You made me aware of the deficit some years ago, though I must admit to doing less than possible or necessary to make up the ground. At this point, given the lost terrain, I wonder if we can regain the battlespace before greater disasters befall us than a couple of ill-advised and poorly fought wars.

Kevin of Arabia

Anonymous said...

Dr. Kaiser, I apologize for being off topic. But.. perhaps you know more about this:

A Rhode Island high school that
fired all its teachers in February
has reached a tentative agreement
with the school's teachers union
to rehire them, the union
announced Sunday.

I am totally confused now.
Ok so all the teachers were fired
over low student performance. If
they are rehired now, what is
going to change?

Is this simply the union thing
and screw the children/pupils?

David Kaiser said...

To anonymous:
Check for more news. The teachers agreed to a much tougher schedule and closer monitoring of their performance. How successful this will be is very hard to say. .

Aunt Katie said...

Especially the last 2 paragraphs re academia, were powerful, and poignant I think for, as you say, those in many professions. One had to have practiced in a field for a while, during this decline, to really get a sense for it, and for the details, over time.

Yet, America has never actually been an especially 'ethical' or moral place, in spite of the self concepts, the religious fervor, and the rhetoric.

It was, for a moment, a place where a consensus of sorts seemed to show a moral, if unrealistic, road into the future. A sort of Camelot (yet 'Camelot' as you may recall, was far from perfect).

Certainly the concept of a shared professional ethics, either within or across fields, has been in decline, though great attention has been paid in recent years to unethical and/or illegal practices in many fields.

There are those who will claim that a separation of church and state is partly to blame; somehow I doubt that. Many other causes could be mentioned.

All the best,