small number of people are capable of successfully detecting liars. For more on the Ekman-Levine debate, see the extended commentary in the Notes.
5 SAFE stands for Security Analyst File Environment. I love it when people start with the acronym and work backward to create the full name.
Chapter Four
The Holy Fool
1.
In November 2003, Nat Simons, a portfolio manager for the Long Island–based hedge fund Renaissance Technologies, wrote a worried email to several of his colleagues. Through a complicated set of financial arrangements, Renaissance found itself with a stake in a fund run by an investor in New York named Bernard Madoff, and Madoff made Simons uneasy.
If you worked in the financial world in New York in the 1990s and early 2000s, chances are you’d heard of Bernard Madoff. He worked out of an elegant office tower in Midtown Manhattan called the Lipstick Building. He served on the boards of a number of important financial-industry associations. He moved between the monied circles of the Hamptons and Palm Beach. He had an imperious manner and a flowing mane of white hair. He was reclusive, secretive. And that last fact was what made Simons uneasy. He’d heard rumors. Someone he trusted, he wrote in the group email, “told us in confidence that he believes that Madoff will have a serious problem within a year.”
He went on: “Throw in that his brother-in-law is his auditor and his son is also high up in the organization, and you have the risk of some nasty allegations, the freezing of accounts, etc.”
The next day Henry Laufer, one of the firm’s senior executives, wrote back. He agreed. Renaissance, he added, had “independent evidence” that something was amiss with Madoff. Then Renaissance’s risk manager, Paul Broder—the person responsible for making sure the fund didn’t put its money anywhere dangerous—weighed in with a long, detailed analysis of the trading strategy that Madoff claimed to be using. “None of it seems to add up,” he concluded. The three of them decided to conduct their own in-house investigation. Their suspicions deepened. “I came to the conclusion that we didn’t understand what he was doing,” Broder would say later. “We had no idea how he was making his money. The volume numbers that he suggested he was doing [were] not supported by any evidence we could find.” Renaissance had doubts.
So did Renaissance sell off its stake in Madoff? Not quite. They cut their stake in half. They hedged their bets. Five years later, after Madoff had been exposed as a fraud—the mastermind of the biggest Ponzi scheme in history—federal investigators sat down with Nat Simons and asked him to explain why. “I never, as the manager, entertained the thought that it was truly fraudulent,” Simons said. He was willing to admit that he didn’t understand what Madoff was up to, and that Madoff smelled a little funny. But he wasn’t willing to believe that he was an out-and-out liar. Simons had doubts, but not enough doubts. He defaulted to truth.
The emails written between Simons and Laufer were discovered during a routine audit by the Securities and Exchange Commission (SEC), the agency responsible for monitoring the hedge-fund industry. It wasn’t the first time the SEC had run across doubts about Madoff’s operations. Madoff claimed to follow an investment strategy linked to the stock market, which meant that like any other market-based strategy, his returns ought to go up and down as the market went up and down. But Madoff’s returns were rock steady—which defied all logic. An SEC investigator named Peter Lamore once went to see Madoff to get an explanation. Madoff’s answer was that, essentially, he could see around corners; he had an infallible “gut feel” for when to get out of the market just before a downswing, and back into the market just before an upswing. “I asked him repeatedly,” Lamore recalled later:
I thought his gut feel was, you know, strange, suspicious. You know, I kept trying to press him. I thought there was something else…I thought, you know, he was getting some sort of insight into the overall broad market that other people weren’t getting. So I repeatedly sort of pressed him on that. I asked Bernie repeatedly over and over again, and at some point, I mean, I’m not sure what else to do.
Lamore took his doubts to his boss, Robert Sollazzo, who had doubts too. But not enough doubts. As the SEC postmortem on the Madoff case concluded, “Sollazzo did not find that Madoff’s claim to be trading on ‘gut