Harry Markopolos has a way with numbers. It's this innate ability that led him to uncover Bernie Madoff's epic Ponzi scheme almost a decade before market forces ultimately leveraged a confession out of the spectacularly crooked investment fund manager.
In 1999, while working as a portfolio manager at Rampart, a Boston based investment management company, Markopolos had been asked to reverse engineer a fund offered by Bernard L. Madoff Investment Securities LLC so his firm could compete by offering a similar product. After studying Madoff's marketing material for a mere 5 minutes, Markopolos realized that the results the fund claimed to achieve were highly improbable, a further 4 hours of mathematical modeling proved the stated returns were categorically impossible by legal means.
Smelling a rat, Markopolos assembled an informal investigative team to probe Madoff's operation further. In May 2000, when Madoff's scheme was only a $3 to $7 billion fraud, they submitted their first whistleblowing report to the Securities and Exchange Commission (SEC). It was summarily ignored. Frustrated but undeterred, Markopolos' tenacious group, dubbed The Foxhounds, submitted numerous subsequent memos (in 2001, 2005, 2007 and 2008) offering even more evidence, to no avail. A 2005 missive had what one might consider to be an attention-grabbing title -"The World's Largest Hedge Fund Is A Fraud" - but even this failed to get an appropriate response from those charged with policing Wall Street.
It was only following the crash of 2008, when Madoff's investors were clamoring to liquidate their assets and he was unable to meet their demands, that the man responsible for the largest act of financial fraud in world history was forced to fess up. By then, Madoff's "fund" had grown on paper to a value of $65 billion. In the following days, the complete and utter failure of the SEC came to light, as press outlets - who had also been alerted by Markopolos, but by and large had declined to report his findings before Madoff's arrest - competed to interview the "Madoff whistleblower." With egg on their faces, the government also sought out Markopolos' knowledge and expertise, and on February 4, 2009 he delivered some riveting televised testimony in front of the House of Representatives' Financial Services Subcommittee.
In March 2010, Markopolos published a book chronicling his investigations into Madoff and the utter incompetence he bore witness to during his dealings with the SEC. Called No One Would Listen: A True Financial Thriller, it became a New York Times bestseller. A new film, Chasing Madoff, based on the book is currently in cinemas. SuicideGirls caught up with Markopolos, who now works as a freelance investigative accountant exposing Fortune 500 wrongdoing, to talk about Madoff and the current state of play in our financial markets. We also asked him to focus his considerable financial acumen our nation's balance sheet and assess the future prospects of our economy. Given Markopolos' track record, his conclusions about America's should-be junk status are indeed cause for concern, if not outright alarm.
NP: How did you first discover the Madoff fraud?
HM: I became aware of Bernie Madoff managing an option split-strike conversion strategy with numbers that I knew were not achievable by that strategy because I had managed money using that strategy. I knew those numbers were too good to be true so I sent a colleague from marketing at my firm, a Boston based asset management firm, down to New York to find out about this Bernie Madoff. He came back with a one-page marketing tear sheet, and in five minutes I knew it was a fraud, most likely a Ponzi scheme...Then I spent four hours mathematically modeling the returns, and then I was convinced beyond any reasonable doubt to a criminal standard of proof that in fact it was a fraud and very likely a Ponzi scheme.
NP: When you realized this what did you do?
HM: I started analyzing it. We formed an informal team with Neil Chelo, who worked for me as an assistant portfolio manager, and Frank Casey to obtain more information. Then a few months later, in May of 2000 I submitted my first red flags memo to the Securities and Exchange Commission in Boston.
NP: And what did they do?
HM: They were supposed to send it to New York, but they put it in a circular file and it made its way quickly to the trash can...
NP: So you continued writing these memos to various branches of the SEC for an 8 1/2 year period I understand.
HM: Multiple submissions.
NP: You listed 29 red flags, which if people had just made a single phone call they could've verified -- is that correct?
HM: Yes, but back then the SEC examiners were not trained to make phone calls to third parties. But it would've been that quick. All you'd have to do is call a third party and you'd know. You call a witness, and you find out the answer, but that's not how they were trained back then. They are now, but back then they were not.
NP: So when they were investigating a company, they'd talk directly to the company in question, but then they wouldn't verify what they were told with any third party.
HM: That's what exactly what I'm saying. Because that would cast aspersions against the firm they were investigating. So they only investigated the firm and relied on internal documents with out cross-checking them with third party, outside sources.
NP: They were more concerned about libeling the company that they were investigating, than actually investigating the company.
HM: That is correct. That's how it was a few years ago. Now it's no longer like that. They've changed all their procedures.
NP: This would've been a fairly easy thing to catch, because there was no actual trades happening, and the trades that they claimed to be doing had no subsequent effect on the market, which given the volume they should've done. And at one point, they even claimed to have bought 7 times the number of options that were actually in existence - right?
HM: Well, that was me. They were always 7 to 65 times larger than the actual number of those types of options in existence. There was only $1 billion in options in existence of the type that Bernie Madoff needed for his portfolio. And of course, he was managing $7 to $65 billion. So he was several times the size of the market. That was such a clear math proof, but the SEC did not consider math proofs because they were trained as lawyers and not familiar with mathematics. In math there's only one correct answer. You may solve a math problem in various different ways, but in the end there's only one answer, and it's the highest form of proof in the world. You can never change the answer to a math problem.
NP: I know that you've repeatedly stated that you don't think that the SEC were being dishonest, they were just being incompetent because it was staffed by lawyers rather then accountants. Do you still think that that was the case?
HM: Yeah. I don't think that the SEC is corrupt in any way, shape or form. I know that the government asked me many questions when they were examining their staff, feeling that they had to be corrupt, that there was no way that they missed this. They read my red flags memo, in retrospect, and they said, "Hey, these things are all true. How come our staff didn't figure it out? This case was handed to them gift-wrapped on a silver platter, everything in here is true, how could our people be that dumb to miss that? There's no way that's possible. They must be corrupt. They obviously were paid off my Madoff or offered jobs or some other incentive to look the other way." They were investigating their staff at all levels, very closely under a microscope, and, of course, they found out what I knew to be true, that there was no corruption there -- that their staff was systemically incompetent. As a result, the agency has engaged in a series of rapid reforms to change the way they investigate fraud.
NP: I found it very telling that at one point you talked about how you gave information to someone at the SEC in Boston, but he didn't understand the math so you had to draw it out for him.
HM: Oh, yeah. I had two people in Boston really helping me a lot with this case. One of them, Ed Manion, is a Chartered Financial Analyst. He understood the math. But the other one, the higher ranking one, was a Branch Chief then, he's been promoted since, Mike Garrity. He was a lawyer, and so he had to have me diagram out the math on a blackboard until he understood it. And you know what? He understood it, and he knew how serious it was. He told me, "This is very serious. I promise you a thorough and fast investigation, and if I find it has merit, I'm going to be putting you in touch with the New York regional office because that's who has jurisdiction." Within a week he called me back and he said, "I've investigated, I can't tell you what I found, but it's very serious. You need to be in contact with the New York regional office. We need to get moving on this." He said, "Harry, if this was in Boston, I would have multiple teams in there tomorrow tearing the place apart. But it's in New York, so I don't have jurisdiction there." He passed me on to the New York regional office, and, of course, the case met with disastrous consequences down there because they did not take this case seriously in the New York regional office, nor did they conduct a competent investigation.
NP: And that was because of inter-branch politics. The New York, Boston, and Washington, DC offices didn't cooperate with each other.
HM: Right. There was turf rivalries between those three offices. Each one thinking they were the best.
NP: It's like a badly scripted TV show, isn't it? It's such a clich.
HM: Well, like a baseball rivalry between the New York Yankees and the Boston Red Sox is the way I put it before Congress. It's like a sport rivalry. It was just like that. You had different offices feel like they were competitors instead of on the same team.
NP: Going up the food chain, do you think that there was maybe a deliberate and convenient culture of incompetence that had been created?
HM: Yes. The industry had captured all the financial regulators back then. In 2008 and before, the banking regulators were asleep at the switch, as was in the Securities and Exchange Commission, as was FINRA. All the regulators were in the pockets of industry. They were weak willed, had untrained staff that were not aggressive investigators whatsoever. They were happy to look the other way. They didn't want to be bothered with big cases, and they sought out the small cases against the small firms because those people couldn't defend themselves. The big ones got a free pass because they were tough targets, they could defend themselves with an army of lawyers, and, as a result, the government did not do large fraud cases against major Wall Street firms like Bernie Madoff's.
NP: And that was also politically expedient, because that meant that the government didn't have to prosecute the people that they were relying on for campaign contributions.
HM: Of course. Those are your biggest campaign donors among the financial services industry. Neither political party in the United States had any incentive to insist upon strict regulation. In fact, they defanged and defunded the regulators over a period of decades. Both parties were guilty of this.
NP: That ultimately not only allowed the Madoff fraud to happen, but also was responsible for a climate which allowed the entire banking industry to fail to the point where we have to bail them out with public funds though TARP.
HM: Yes. If you don't regulate, then that will cost taxpayers trillions of dollars. We've proven that in 2008, and we'll take the nation into bankruptcy, I think we've proved that in 2008 as well. If you starve your regulators, and you defang them, then you're going to end up paying trillions. It's pennywise and a pound foolish. It's going to cost you everything you have as a nation. Capitalism left unregulated, unsupervised will destroy itself because greed kills. Unregulated, unchecked greed will destroy capitalism every time it gets a chance to do so.
NP: Have we learnt anything post-Madoff and post-TARP? Has the climate changed within the SEC?
HM: Yes, it has. The SEC is night and day better than where they were two and a half years ago. They're very aggressive. They sent their staff away for training to become certified fraud examiners, so they know how to conduct a proper investigation. They know the steps to take in a proper investigation and they're aggressively looking for cases against large financial firms, whereas before, those same firms were on a protected species list. They were left untouched and basically unregulated.
Now, the SEC has the whistleblower program under [the] Dodd-Frank [Act] that allows them to pay then to thirty percent rewards to whistleblowers who come in with documents, emails, transaction records, and accounting books proving fraud. The SEC wants to see these cases, and they want to stop them before they become $65 billion Ponzi schemes. They want to stop them before they become too expensive for the American taxpayer, and the best way to do that is to have insiders incentivized to turn evidence over to the SEC and allow them to stop these frauds while they're of manageable size.
NP: I guess part of the problem, whether it's subprime mortgages, bonds from bankrupt countries, or junk stocks and options, is that it didn't matter if the underlying investment was sound, because traders got commissions and bonuses based on volume. So you had a culture that never saw beyond the next trade, because there were no consequences if bankers and traders got investments wrong. There was no incentive to change things for the better.
HM: Well, I would even argue that there was an incentive when looking at wrong doing on Wall Street, because your bad behavior went not only unpunished, it was actually incentivized because we bailed them out. They learned the wrong lessons from the bailout in 2008. They learned that crime does pay, and then if you're a big firm, you will not be prosecuted for those crimes. You will be bailed out and allowed to pay bonuses. That's the wrong lesson. So, actually, the world is far more dangerous today than it was back in 2008 because we rewarded bad behavior. As a result you will get more bad behavior. Now, counteracting that is the SEC's whistleblower program, and hopefully they can find the frauds and stop them when they're still small. So you have two competing sets of influences there. It remains to be seen which influence will win out, the good one or the bad one.
NP: Do you think that in light of Citizens United, and the unlimited amounts of campaign funds that are going to be flowing into Washington in the upcoming year, that the good will win out?
HM: In Washington? No. Both political parties are beyond salvation. Each party represents corporate interest and special interests. Neither party represents the taxpayers or the citizenry of the United States. They're owned lock, stock, and barrel by the corporations, and that's who they represent.
NP: So, even if the SEC has been fixed to some extent, can you see it being declawed over the next year?
HM: Their budget has been reduced from $1.25 billion to $1.1 billion for 3,900 staff members. I want to put that in perspective for you. John Paulson [founder of the New York-based Paulson & Co hedge fund] last year earned, personal income, $5 billion. Now, he earned every penny of that. I'm not taking anything away from Mr. Paulson's hedge fund. However, it shows you the disparity of resources. $5 billion for one man [versus] $1.1 billion for 3,900 men and women. And a travel budget, and an information technology budget, and real estate, to staff the entire Securities and Exchange Commission, 11 regional offices and the headquarters in Washington. So you can see that it's not a level playing field, but hopefully the whistleblower program will put the SEC on an even keel with industry because they can incentivize whistleblowers to come in and save them thousands of man hours and bring them the largest cases and the best prepared cases in their history. Hopefully, that will level the playing field, a bit. But I think the bad guys always have an advantage. They're always going to have more resources than the good guys.
NP: It's interesting to see what's happened over the last month or so with S&P and Moody, because we're kowtowing to these institutions for downgrading us, despite the fact that they made a $2 trillion error, but meanwhile, in Italy they're actually being raided and treated as criminals.
HM: Well, the time to raid and treat the S&P and Moody as criminals was in 2008. They should be held responsible and prosecuted for those failings. I think if you wanted to prosecute them today for downgrading the United States, you'd have to prosecute them for not downgrading us to junk status. If you look at the true books for the United States, off balance sheet, we have $80 trillion in unfunded Medicare liabilities that are not accounted for in our deficit figures. You also have $7 trillion in unfunded Social Security liabilities. So the government is using a cash basis accounting system, which is improper. They should've used the accrual system of accounts, which all corporations are required to use. If they did, you'd see that there's $87 trillion more in unfunded liabilities sitting there. Instead, Congress and the President foolishly focused on the $14.3 trillion fiscal deficit when the true deficit is far higher, several times higher than that. So if you want to see who should be prosecuted, I would say it's our government for crooked accounting. I'm really good at accounting -- certainly much better than the people in government -- I'm telling you the honest numbers, the true numbers.
NP: How would you fix our economy? Because we do have a lawyer in the top job rather than an accountant.
HM: Oh, I think what you need to do is be honest with the American people, let them understand the severity of the situation. We are very close behind Greece. If you want to see the American dollar turn into the American peso overnight through a currency devaluation, if you want to see the nation enter the equivalent of national bankruptcy and be controlled by the International Monetary Fund, well we're very close behind Greece. I'm talking only a measure of a few years before it all comes crashing down.
I think you need to do a holistic approach. You need to certainly get Medicare spending under control. Forty cents of every dollar spent on Medicare is either wasted or stolen. That's unconscionable. That needs to be straightened out immediately. That's the biggest test this nation faces -- waste, fraud and abuse in Medicare. That needs to be clamped down upon quickly. And we have to bring all those off balance sheet liabilities onto our balance sheet, and figure out a plan to pay for them. It's going to require cuts in government services and increases in taxes to pay down the debt.
Some things that we can do to quickly reduce those unfunded liabilities is raise the age before one qualifies for Social Security and Medicare. We also need to raise the Social Security tax slightly and certainly the Medicare tax as well. We need to eliminate all the tax loopholes -- in fact, there should be no tax deductions for anything. It should just be straight rates. We probably need the imposition of a national sales tax, because that makes it fair for everyone. Right now, half the people in the country don't pay any federal tax -- well that's not far. So maybe a national sales tax where everybody is contributing and income taxes for certainly the wealthier portion of the population.
It's going to require cost cutting and tax raising. You can't just do all of one and none of the other. You've got to be fair and balanced, and realize we have huge debts and we're going to have to come up with a plan to pay them. We have to treat the nation's balance sheet like we do our own checkbook; it needs to be in balance. And since we're in debt, we need to weigh it more toward savings and taxes to pay for what we've already spent. We've overspent. We've been like a drunk on a spending binge, and now we need to sober up. It's going to require sacrifice across the country from everybody. Anybody that tells you anything different is a politician lying to you as they run for President or run for Congress.
NP: One of the things S&P did get right in their reasoning behind the downgrade was their expressed concerns about how "the political brinksmanship of recent months" has resulted in "America's governance and policymaking becoming less stable." Referencing the Tea Party in all but name, they basically said the lunatics have taken over the asylum and that there's not the political climate for prudent fiscal responsibility to take place.
HM: You can't have a AAA credit rating with a junk rated Congress, is the way I would put it.
NP: Argentina had a similar runaway economy, which resulted in hyperinflation and a severely devalued currency in the late '70s and early '80s, and it seems to me that we should be in a similar place now. We're not right now because there's some very artificial mechanisms at play propping us up, but how long do we have and what will happen before we get to a disastrous scenario like that seen in Argentina?
HM: It's impossible to predict. There's so many instabilities built up into the system that you don't know how it's going to come crashing down or when. You just know that it's out there in the not too distant future. You don't know what the trigger event is going to be, you just know it's coming and it's going to be very bad.
Our politicians lack the will to get the nation's accounts into proper order. And you know, I think the only solution there is, people need to go to the ballot box in 2012 and vote against every incumbent. Maybe it's time for an independent party to form, because you can't trust the Democrats or the Republicans because they're owned by the corporations. There's unlimited campaign funding coming into this election and if we vote for either major party in 2012 we'll become nothing but corporate slaves and indentured servants.
We need to fight back and take back our country from the career politicians. I would rather see mom and pops run independently and elect them. I would even rather have our congressmen and women picked like we pick our juries. Pick one person in every district and say, 'Sorry you lost the lottery, you have to serve in Congress for two years. You have to go to Washington, it's a big sacrifice, but somebody has to do it.' I'm confident they would do a better job than the people we elect into office today.
NP: You're saying pick public servants like we pick a jury pool. You were a bus driver last week, and you're a congressman this week.
HM: Right now we elect nothing but losers. I would rather send somebody there that at least has a prayer of doing the right thing in not wanting to be there and not running for reelection. Because elections are so expensive they're bought and paid for, and as a result we get the wrong people in those elected offices.
They've proven they are incompetent to handle the task at hand, so they need to be replaced en mass, every single one of them. The Senate and the House needs to be gone quickly. They've failed this nation and they need to pay for that failure by being booted out and replaced. The same people that got us into this mess are not going to be able to solve it. They have too many vested interests to protect and so they need to be removed. We need to take back control of our nation from these folks. These people are vermin.
NP: What people don't realize is this that this is why the price of gold is so high, because people are betting against our economy. I remember in 2005, for the first time I had a little bit of spare cash, and I had friends that were traders so I asked them what should I invest in. They told me not to buy shares, but to buy gold. At the time I thought they were kidding since the general school of thought was that there was actually more gold in the world than people realized, so it wasn't such a valuable resource. But it wasn't really about the gold, it was people taking the money out of the economy because they didn't want to invest in a corrupt system. An investment in gold is really an investment against a corrupt system.
HM: It is. It's a direct bet against currency, the currency being whatever you call it, the Euro, the dollar or the yen.
NP: And against stocks and shares, and what they represent.
HM: Right. And they want something that's going to do well in times of turmoil. Gold is not really an investment, it's a hedge -- it's a bet against currency and it's a bet against government. And it's forecasting the odds of a collapse as being very, very high. Right now, the Greek two-year note is yielding what? Forty-four percent. Well, the last time I saw a two-year note yield forty-four percent was WorldCom, and the investors received that yield for approximately two months before Enron went under.
It's only a matter of time before you're going to see countries failing. It's hard to predict which ones will go down first. The only thing that's kept the United States from going the way of Argentina and defaulting is that we own the world's reserve currency, but it's not to say that we can't default in the future or that we won't default in the future. We're almost going to have to. It's either going to be a hard default, meaning a currency devaluation. Or it's going to be a soft default, which means high inflation. It's the same thing as defaulting though if you have a deflationary environment.
NP: Because you're devaluing the currency by default anyway with inflation.
HM: Yeah, you're just devaluing it a lot slower through inflation instead of doing it by fiat, overnight devaluing the dollar by proclamation, you just do it slower through an inflationary process. Each is a default. One's a hard default, one's a soft default. In the end, anybody that holds US debt is going to find themselves either not being repaid or being paid with far cheaper dollars.
And who's going to suffer? Us. The citizens. Why? Because our politicians have no courage whatsoever. And they don't represent us. They represent the status quo that they're trying to protect, and we know that that can no longer exist. And yet they refuse to come to grips with this problem. So they need to be gone. They need to be removed. But that's just my personal opinion. I'm not a politician. Don't pretend to be. Don't want to be.
NP: In a way, to have a modicum of sympathy for them, they're just victims of circumstance too. They can't afford to do the right thing because then they don't get elected.
HM: Right, they don't get the money. No one is going to give them campaign donations. These guys are beholden to corporate donations. Otherwise they can't run those races. They're very expensive races to run. We need to change our way of doing business politically, and we haven't so far, so maybe it's going to be forced on us from the outside through a financial crisis that we can't get out of.
NP: One question before I leave you...Obviously there's only so much an individual can do in the face of a complete shit storm. How are you shoring up your own finances for what may come?
HM: I have zero debt. I paid off my home mortgage two years ago. I have no debt on the cars. I have pre-funded the kids' college educations as long as they go to public university, not private. I'm 85% in cash even though it has no yield. I have 5% weight in Japan, which I'm probably going to eliminate soon, and a 10% weight in dividend paying oil stock.
I would expect to see deflation and then inflation. I think we're stuck in a deflationary spiral right now, but eventually we'll see inflation. Right now we're following the Japanese experience, and they've had a miserable experience for 21 years. We're making all the same mistakes that the Japanese did. It's almost like they wrote the playbook in Japan and we're following it.
NP: For those that aren't familiar with what happened in Japan, what was their playbook?
HM: The playbook was stimulus programs that failed repeatedly, public debt that piled up such that it can never be repaid, an aging population receiving entitlements at too young of an age. Nothing was financed, everything was kept off the books, so the true debt picture was never revealed to the populous. And it was instability in government, where governments were repeatedly booted from office and removed by an angry electorate, and I think that's where we are now. We have a very angry population here, and none of the politicians are telling us the truth.
NP: Right, that's the big concern here. You have an angry electorate that's on the cusp of voting back in the people that caused the deficit in the first place.
HM: Right. Putting in the same people that caused the problem is not a solution. If you always do what you've always done, you'll always get what you've always gotten. I think that denial is a lot more than just a river in Egypt, and we're in denial.
NP: What would you say to the American electorate over the next 12 months?
HM: Wake up. Vote for an independent candidate that is not a career politician. That's our only hope for salvation and common sense in government.
NP: Well, on that note, I will bid you farewell...And given your summary, I shall expect you to be putting your name into the pool so I can vote for you.
HM: No, no, no. I have three boys at home, I don't want to go to Washington. I like chasing bad guys. Someone's got to chase bad guys. That's what I do for a living. I think I'm going to keep at that. I don't want to run for office, I want to run from it. Maybe in a few years. Maybe 2016, but certainly no time soon. My boys are too young. Boys need a father.
NP: Well, I'm holding you to it at 2016.
HM: Oh no, that's the worst fate. I'd rather just do it like a jury pool -- loser has to go to Washington.
In 1999, while working as a portfolio manager at Rampart, a Boston based investment management company, Markopolos had been asked to reverse engineer a fund offered by Bernard L. Madoff Investment Securities LLC so his firm could compete by offering a similar product. After studying Madoff's marketing material for a mere 5 minutes, Markopolos realized that the results the fund claimed to achieve were highly improbable, a further 4 hours of mathematical modeling proved the stated returns were categorically impossible by legal means.
Smelling a rat, Markopolos assembled an informal investigative team to probe Madoff's operation further. In May 2000, when Madoff's scheme was only a $3 to $7 billion fraud, they submitted their first whistleblowing report to the Securities and Exchange Commission (SEC). It was summarily ignored. Frustrated but undeterred, Markopolos' tenacious group, dubbed The Foxhounds, submitted numerous subsequent memos (in 2001, 2005, 2007 and 2008) offering even more evidence, to no avail. A 2005 missive had what one might consider to be an attention-grabbing title -"The World's Largest Hedge Fund Is A Fraud" - but even this failed to get an appropriate response from those charged with policing Wall Street.
It was only following the crash of 2008, when Madoff's investors were clamoring to liquidate their assets and he was unable to meet their demands, that the man responsible for the largest act of financial fraud in world history was forced to fess up. By then, Madoff's "fund" had grown on paper to a value of $65 billion. In the following days, the complete and utter failure of the SEC came to light, as press outlets - who had also been alerted by Markopolos, but by and large had declined to report his findings before Madoff's arrest - competed to interview the "Madoff whistleblower." With egg on their faces, the government also sought out Markopolos' knowledge and expertise, and on February 4, 2009 he delivered some riveting televised testimony in front of the House of Representatives' Financial Services Subcommittee.
In March 2010, Markopolos published a book chronicling his investigations into Madoff and the utter incompetence he bore witness to during his dealings with the SEC. Called No One Would Listen: A True Financial Thriller, it became a New York Times bestseller. A new film, Chasing Madoff, based on the book is currently in cinemas. SuicideGirls caught up with Markopolos, who now works as a freelance investigative accountant exposing Fortune 500 wrongdoing, to talk about Madoff and the current state of play in our financial markets. We also asked him to focus his considerable financial acumen our nation's balance sheet and assess the future prospects of our economy. Given Markopolos' track record, his conclusions about America's should-be junk status are indeed cause for concern, if not outright alarm.
NP: How did you first discover the Madoff fraud?
HM: I became aware of Bernie Madoff managing an option split-strike conversion strategy with numbers that I knew were not achievable by that strategy because I had managed money using that strategy. I knew those numbers were too good to be true so I sent a colleague from marketing at my firm, a Boston based asset management firm, down to New York to find out about this Bernie Madoff. He came back with a one-page marketing tear sheet, and in five minutes I knew it was a fraud, most likely a Ponzi scheme...Then I spent four hours mathematically modeling the returns, and then I was convinced beyond any reasonable doubt to a criminal standard of proof that in fact it was a fraud and very likely a Ponzi scheme.
NP: When you realized this what did you do?
HM: I started analyzing it. We formed an informal team with Neil Chelo, who worked for me as an assistant portfolio manager, and Frank Casey to obtain more information. Then a few months later, in May of 2000 I submitted my first red flags memo to the Securities and Exchange Commission in Boston.
NP: And what did they do?
HM: They were supposed to send it to New York, but they put it in a circular file and it made its way quickly to the trash can...
NP: So you continued writing these memos to various branches of the SEC for an 8 1/2 year period I understand.
HM: Multiple submissions.
NP: You listed 29 red flags, which if people had just made a single phone call they could've verified -- is that correct?
HM: Yes, but back then the SEC examiners were not trained to make phone calls to third parties. But it would've been that quick. All you'd have to do is call a third party and you'd know. You call a witness, and you find out the answer, but that's not how they were trained back then. They are now, but back then they were not.
NP: So when they were investigating a company, they'd talk directly to the company in question, but then they wouldn't verify what they were told with any third party.
HM: That's what exactly what I'm saying. Because that would cast aspersions against the firm they were investigating. So they only investigated the firm and relied on internal documents with out cross-checking them with third party, outside sources.
NP: They were more concerned about libeling the company that they were investigating, than actually investigating the company.
HM: That is correct. That's how it was a few years ago. Now it's no longer like that. They've changed all their procedures.
NP: This would've been a fairly easy thing to catch, because there was no actual trades happening, and the trades that they claimed to be doing had no subsequent effect on the market, which given the volume they should've done. And at one point, they even claimed to have bought 7 times the number of options that were actually in existence - right?
HM: Well, that was me. They were always 7 to 65 times larger than the actual number of those types of options in existence. There was only $1 billion in options in existence of the type that Bernie Madoff needed for his portfolio. And of course, he was managing $7 to $65 billion. So he was several times the size of the market. That was such a clear math proof, but the SEC did not consider math proofs because they were trained as lawyers and not familiar with mathematics. In math there's only one correct answer. You may solve a math problem in various different ways, but in the end there's only one answer, and it's the highest form of proof in the world. You can never change the answer to a math problem.
NP: I know that you've repeatedly stated that you don't think that the SEC were being dishonest, they were just being incompetent because it was staffed by lawyers rather then accountants. Do you still think that that was the case?
HM: Yeah. I don't think that the SEC is corrupt in any way, shape or form. I know that the government asked me many questions when they were examining their staff, feeling that they had to be corrupt, that there was no way that they missed this. They read my red flags memo, in retrospect, and they said, "Hey, these things are all true. How come our staff didn't figure it out? This case was handed to them gift-wrapped on a silver platter, everything in here is true, how could our people be that dumb to miss that? There's no way that's possible. They must be corrupt. They obviously were paid off my Madoff or offered jobs or some other incentive to look the other way." They were investigating their staff at all levels, very closely under a microscope, and, of course, they found out what I knew to be true, that there was no corruption there -- that their staff was systemically incompetent. As a result, the agency has engaged in a series of rapid reforms to change the way they investigate fraud.
NP: I found it very telling that at one point you talked about how you gave information to someone at the SEC in Boston, but he didn't understand the math so you had to draw it out for him.
HM: Oh, yeah. I had two people in Boston really helping me a lot with this case. One of them, Ed Manion, is a Chartered Financial Analyst. He understood the math. But the other one, the higher ranking one, was a Branch Chief then, he's been promoted since, Mike Garrity. He was a lawyer, and so he had to have me diagram out the math on a blackboard until he understood it. And you know what? He understood it, and he knew how serious it was. He told me, "This is very serious. I promise you a thorough and fast investigation, and if I find it has merit, I'm going to be putting you in touch with the New York regional office because that's who has jurisdiction." Within a week he called me back and he said, "I've investigated, I can't tell you what I found, but it's very serious. You need to be in contact with the New York regional office. We need to get moving on this." He said, "Harry, if this was in Boston, I would have multiple teams in there tomorrow tearing the place apart. But it's in New York, so I don't have jurisdiction there." He passed me on to the New York regional office, and, of course, the case met with disastrous consequences down there because they did not take this case seriously in the New York regional office, nor did they conduct a competent investigation.
NP: And that was because of inter-branch politics. The New York, Boston, and Washington, DC offices didn't cooperate with each other.
HM: Right. There was turf rivalries between those three offices. Each one thinking they were the best.
NP: It's like a badly scripted TV show, isn't it? It's such a clich.
HM: Well, like a baseball rivalry between the New York Yankees and the Boston Red Sox is the way I put it before Congress. It's like a sport rivalry. It was just like that. You had different offices feel like they were competitors instead of on the same team.
NP: Going up the food chain, do you think that there was maybe a deliberate and convenient culture of incompetence that had been created?
HM: Yes. The industry had captured all the financial regulators back then. In 2008 and before, the banking regulators were asleep at the switch, as was in the Securities and Exchange Commission, as was FINRA. All the regulators were in the pockets of industry. They were weak willed, had untrained staff that were not aggressive investigators whatsoever. They were happy to look the other way. They didn't want to be bothered with big cases, and they sought out the small cases against the small firms because those people couldn't defend themselves. The big ones got a free pass because they were tough targets, they could defend themselves with an army of lawyers, and, as a result, the government did not do large fraud cases against major Wall Street firms like Bernie Madoff's.
NP: And that was also politically expedient, because that meant that the government didn't have to prosecute the people that they were relying on for campaign contributions.
HM: Of course. Those are your biggest campaign donors among the financial services industry. Neither political party in the United States had any incentive to insist upon strict regulation. In fact, they defanged and defunded the regulators over a period of decades. Both parties were guilty of this.
NP: That ultimately not only allowed the Madoff fraud to happen, but also was responsible for a climate which allowed the entire banking industry to fail to the point where we have to bail them out with public funds though TARP.
HM: Yes. If you don't regulate, then that will cost taxpayers trillions of dollars. We've proven that in 2008, and we'll take the nation into bankruptcy, I think we've proved that in 2008 as well. If you starve your regulators, and you defang them, then you're going to end up paying trillions. It's pennywise and a pound foolish. It's going to cost you everything you have as a nation. Capitalism left unregulated, unsupervised will destroy itself because greed kills. Unregulated, unchecked greed will destroy capitalism every time it gets a chance to do so.
NP: Have we learnt anything post-Madoff and post-TARP? Has the climate changed within the SEC?
HM: Yes, it has. The SEC is night and day better than where they were two and a half years ago. They're very aggressive. They sent their staff away for training to become certified fraud examiners, so they know how to conduct a proper investigation. They know the steps to take in a proper investigation and they're aggressively looking for cases against large financial firms, whereas before, those same firms were on a protected species list. They were left untouched and basically unregulated.
Now, the SEC has the whistleblower program under [the] Dodd-Frank [Act] that allows them to pay then to thirty percent rewards to whistleblowers who come in with documents, emails, transaction records, and accounting books proving fraud. The SEC wants to see these cases, and they want to stop them before they become $65 billion Ponzi schemes. They want to stop them before they become too expensive for the American taxpayer, and the best way to do that is to have insiders incentivized to turn evidence over to the SEC and allow them to stop these frauds while they're of manageable size.
NP: I guess part of the problem, whether it's subprime mortgages, bonds from bankrupt countries, or junk stocks and options, is that it didn't matter if the underlying investment was sound, because traders got commissions and bonuses based on volume. So you had a culture that never saw beyond the next trade, because there were no consequences if bankers and traders got investments wrong. There was no incentive to change things for the better.
HM: Well, I would even argue that there was an incentive when looking at wrong doing on Wall Street, because your bad behavior went not only unpunished, it was actually incentivized because we bailed them out. They learned the wrong lessons from the bailout in 2008. They learned that crime does pay, and then if you're a big firm, you will not be prosecuted for those crimes. You will be bailed out and allowed to pay bonuses. That's the wrong lesson. So, actually, the world is far more dangerous today than it was back in 2008 because we rewarded bad behavior. As a result you will get more bad behavior. Now, counteracting that is the SEC's whistleblower program, and hopefully they can find the frauds and stop them when they're still small. So you have two competing sets of influences there. It remains to be seen which influence will win out, the good one or the bad one.
NP: Do you think that in light of Citizens United, and the unlimited amounts of campaign funds that are going to be flowing into Washington in the upcoming year, that the good will win out?
HM: In Washington? No. Both political parties are beyond salvation. Each party represents corporate interest and special interests. Neither party represents the taxpayers or the citizenry of the United States. They're owned lock, stock, and barrel by the corporations, and that's who they represent.
NP: So, even if the SEC has been fixed to some extent, can you see it being declawed over the next year?
HM: Their budget has been reduced from $1.25 billion to $1.1 billion for 3,900 staff members. I want to put that in perspective for you. John Paulson [founder of the New York-based Paulson & Co hedge fund] last year earned, personal income, $5 billion. Now, he earned every penny of that. I'm not taking anything away from Mr. Paulson's hedge fund. However, it shows you the disparity of resources. $5 billion for one man [versus] $1.1 billion for 3,900 men and women. And a travel budget, and an information technology budget, and real estate, to staff the entire Securities and Exchange Commission, 11 regional offices and the headquarters in Washington. So you can see that it's not a level playing field, but hopefully the whistleblower program will put the SEC on an even keel with industry because they can incentivize whistleblowers to come in and save them thousands of man hours and bring them the largest cases and the best prepared cases in their history. Hopefully, that will level the playing field, a bit. But I think the bad guys always have an advantage. They're always going to have more resources than the good guys.
NP: It's interesting to see what's happened over the last month or so with S&P and Moody, because we're kowtowing to these institutions for downgrading us, despite the fact that they made a $2 trillion error, but meanwhile, in Italy they're actually being raided and treated as criminals.
HM: Well, the time to raid and treat the S&P and Moody as criminals was in 2008. They should be held responsible and prosecuted for those failings. I think if you wanted to prosecute them today for downgrading the United States, you'd have to prosecute them for not downgrading us to junk status. If you look at the true books for the United States, off balance sheet, we have $80 trillion in unfunded Medicare liabilities that are not accounted for in our deficit figures. You also have $7 trillion in unfunded Social Security liabilities. So the government is using a cash basis accounting system, which is improper. They should've used the accrual system of accounts, which all corporations are required to use. If they did, you'd see that there's $87 trillion more in unfunded liabilities sitting there. Instead, Congress and the President foolishly focused on the $14.3 trillion fiscal deficit when the true deficit is far higher, several times higher than that. So if you want to see who should be prosecuted, I would say it's our government for crooked accounting. I'm really good at accounting -- certainly much better than the people in government -- I'm telling you the honest numbers, the true numbers.
NP: How would you fix our economy? Because we do have a lawyer in the top job rather than an accountant.
HM: Oh, I think what you need to do is be honest with the American people, let them understand the severity of the situation. We are very close behind Greece. If you want to see the American dollar turn into the American peso overnight through a currency devaluation, if you want to see the nation enter the equivalent of national bankruptcy and be controlled by the International Monetary Fund, well we're very close behind Greece. I'm talking only a measure of a few years before it all comes crashing down.
I think you need to do a holistic approach. You need to certainly get Medicare spending under control. Forty cents of every dollar spent on Medicare is either wasted or stolen. That's unconscionable. That needs to be straightened out immediately. That's the biggest test this nation faces -- waste, fraud and abuse in Medicare. That needs to be clamped down upon quickly. And we have to bring all those off balance sheet liabilities onto our balance sheet, and figure out a plan to pay for them. It's going to require cuts in government services and increases in taxes to pay down the debt.
Some things that we can do to quickly reduce those unfunded liabilities is raise the age before one qualifies for Social Security and Medicare. We also need to raise the Social Security tax slightly and certainly the Medicare tax as well. We need to eliminate all the tax loopholes -- in fact, there should be no tax deductions for anything. It should just be straight rates. We probably need the imposition of a national sales tax, because that makes it fair for everyone. Right now, half the people in the country don't pay any federal tax -- well that's not far. So maybe a national sales tax where everybody is contributing and income taxes for certainly the wealthier portion of the population.
It's going to require cost cutting and tax raising. You can't just do all of one and none of the other. You've got to be fair and balanced, and realize we have huge debts and we're going to have to come up with a plan to pay them. We have to treat the nation's balance sheet like we do our own checkbook; it needs to be in balance. And since we're in debt, we need to weigh it more toward savings and taxes to pay for what we've already spent. We've overspent. We've been like a drunk on a spending binge, and now we need to sober up. It's going to require sacrifice across the country from everybody. Anybody that tells you anything different is a politician lying to you as they run for President or run for Congress.
NP: One of the things S&P did get right in their reasoning behind the downgrade was their expressed concerns about how "the political brinksmanship of recent months" has resulted in "America's governance and policymaking becoming less stable." Referencing the Tea Party in all but name, they basically said the lunatics have taken over the asylum and that there's not the political climate for prudent fiscal responsibility to take place.
HM: You can't have a AAA credit rating with a junk rated Congress, is the way I would put it.
NP: Argentina had a similar runaway economy, which resulted in hyperinflation and a severely devalued currency in the late '70s and early '80s, and it seems to me that we should be in a similar place now. We're not right now because there's some very artificial mechanisms at play propping us up, but how long do we have and what will happen before we get to a disastrous scenario like that seen in Argentina?
HM: It's impossible to predict. There's so many instabilities built up into the system that you don't know how it's going to come crashing down or when. You just know that it's out there in the not too distant future. You don't know what the trigger event is going to be, you just know it's coming and it's going to be very bad.
Our politicians lack the will to get the nation's accounts into proper order. And you know, I think the only solution there is, people need to go to the ballot box in 2012 and vote against every incumbent. Maybe it's time for an independent party to form, because you can't trust the Democrats or the Republicans because they're owned by the corporations. There's unlimited campaign funding coming into this election and if we vote for either major party in 2012 we'll become nothing but corporate slaves and indentured servants.
We need to fight back and take back our country from the career politicians. I would rather see mom and pops run independently and elect them. I would even rather have our congressmen and women picked like we pick our juries. Pick one person in every district and say, 'Sorry you lost the lottery, you have to serve in Congress for two years. You have to go to Washington, it's a big sacrifice, but somebody has to do it.' I'm confident they would do a better job than the people we elect into office today.
NP: You're saying pick public servants like we pick a jury pool. You were a bus driver last week, and you're a congressman this week.
HM: Right now we elect nothing but losers. I would rather send somebody there that at least has a prayer of doing the right thing in not wanting to be there and not running for reelection. Because elections are so expensive they're bought and paid for, and as a result we get the wrong people in those elected offices.
They've proven they are incompetent to handle the task at hand, so they need to be replaced en mass, every single one of them. The Senate and the House needs to be gone quickly. They've failed this nation and they need to pay for that failure by being booted out and replaced. The same people that got us into this mess are not going to be able to solve it. They have too many vested interests to protect and so they need to be removed. We need to take back control of our nation from these folks. These people are vermin.
NP: What people don't realize is this that this is why the price of gold is so high, because people are betting against our economy. I remember in 2005, for the first time I had a little bit of spare cash, and I had friends that were traders so I asked them what should I invest in. They told me not to buy shares, but to buy gold. At the time I thought they were kidding since the general school of thought was that there was actually more gold in the world than people realized, so it wasn't such a valuable resource. But it wasn't really about the gold, it was people taking the money out of the economy because they didn't want to invest in a corrupt system. An investment in gold is really an investment against a corrupt system.
HM: It is. It's a direct bet against currency, the currency being whatever you call it, the Euro, the dollar or the yen.
NP: And against stocks and shares, and what they represent.
HM: Right. And they want something that's going to do well in times of turmoil. Gold is not really an investment, it's a hedge -- it's a bet against currency and it's a bet against government. And it's forecasting the odds of a collapse as being very, very high. Right now, the Greek two-year note is yielding what? Forty-four percent. Well, the last time I saw a two-year note yield forty-four percent was WorldCom, and the investors received that yield for approximately two months before Enron went under.
It's only a matter of time before you're going to see countries failing. It's hard to predict which ones will go down first. The only thing that's kept the United States from going the way of Argentina and defaulting is that we own the world's reserve currency, but it's not to say that we can't default in the future or that we won't default in the future. We're almost going to have to. It's either going to be a hard default, meaning a currency devaluation. Or it's going to be a soft default, which means high inflation. It's the same thing as defaulting though if you have a deflationary environment.
NP: Because you're devaluing the currency by default anyway with inflation.
HM: Yeah, you're just devaluing it a lot slower through inflation instead of doing it by fiat, overnight devaluing the dollar by proclamation, you just do it slower through an inflationary process. Each is a default. One's a hard default, one's a soft default. In the end, anybody that holds US debt is going to find themselves either not being repaid or being paid with far cheaper dollars.
And who's going to suffer? Us. The citizens. Why? Because our politicians have no courage whatsoever. And they don't represent us. They represent the status quo that they're trying to protect, and we know that that can no longer exist. And yet they refuse to come to grips with this problem. So they need to be gone. They need to be removed. But that's just my personal opinion. I'm not a politician. Don't pretend to be. Don't want to be.
NP: In a way, to have a modicum of sympathy for them, they're just victims of circumstance too. They can't afford to do the right thing because then they don't get elected.
HM: Right, they don't get the money. No one is going to give them campaign donations. These guys are beholden to corporate donations. Otherwise they can't run those races. They're very expensive races to run. We need to change our way of doing business politically, and we haven't so far, so maybe it's going to be forced on us from the outside through a financial crisis that we can't get out of.
NP: One question before I leave you...Obviously there's only so much an individual can do in the face of a complete shit storm. How are you shoring up your own finances for what may come?
HM: I have zero debt. I paid off my home mortgage two years ago. I have no debt on the cars. I have pre-funded the kids' college educations as long as they go to public university, not private. I'm 85% in cash even though it has no yield. I have 5% weight in Japan, which I'm probably going to eliminate soon, and a 10% weight in dividend paying oil stock.
I would expect to see deflation and then inflation. I think we're stuck in a deflationary spiral right now, but eventually we'll see inflation. Right now we're following the Japanese experience, and they've had a miserable experience for 21 years. We're making all the same mistakes that the Japanese did. It's almost like they wrote the playbook in Japan and we're following it.
NP: For those that aren't familiar with what happened in Japan, what was their playbook?
HM: The playbook was stimulus programs that failed repeatedly, public debt that piled up such that it can never be repaid, an aging population receiving entitlements at too young of an age. Nothing was financed, everything was kept off the books, so the true debt picture was never revealed to the populous. And it was instability in government, where governments were repeatedly booted from office and removed by an angry electorate, and I think that's where we are now. We have a very angry population here, and none of the politicians are telling us the truth.
NP: Right, that's the big concern here. You have an angry electorate that's on the cusp of voting back in the people that caused the deficit in the first place.
HM: Right. Putting in the same people that caused the problem is not a solution. If you always do what you've always done, you'll always get what you've always gotten. I think that denial is a lot more than just a river in Egypt, and we're in denial.
NP: What would you say to the American electorate over the next 12 months?
HM: Wake up. Vote for an independent candidate that is not a career politician. That's our only hope for salvation and common sense in government.
NP: Well, on that note, I will bid you farewell...And given your summary, I shall expect you to be putting your name into the pool so I can vote for you.
HM: No, no, no. I have three boys at home, I don't want to go to Washington. I like chasing bad guys. Someone's got to chase bad guys. That's what I do for a living. I think I'm going to keep at that. I don't want to run for office, I want to run from it. Maybe in a few years. Maybe 2016, but certainly no time soon. My boys are too young. Boys need a father.
NP: Well, I'm holding you to it at 2016.
HM: Oh no, that's the worst fate. I'd rather just do it like a jury pool -- loser has to go to Washington.