Some stunning revelations have been disclosed in the David Kotz 477 page report on SEC's colossal (and in normal societies, terminal) blunder with Madoff. Primary among them is that everyone's favorite liquidity provider RenTec was not only an indirect investor in Madoff via its Meritage Fund of Funds, not only was fully aware based on internal correspondence that Madoff was a pyramid scheme, but that it did nothing to notify the authorities, and also decided to keep half of its investment with Bernie, even after numerous internal emails certifying the illegitimacy of the fund way back in 2003.

Turns out in 2004 the SEC was conducting a routine examination of RenTec, when it encountered, among other likely very juicy things which however the SEC has no idea how to interpret, some correspondence in which the RenTec brass basically made it clear that everyone in the firm was aware that Madoff was a ponzi, and yet that convinced the fund to only trim its holdings by half in a Total Return Swap controlled by HCH Management, a vehicle managed by Madoff, which traditionally is simply a investment mechanism allowing massive leverage. TRS'es have also recently gained notoriety for allowing hedge funds to sidestep public disclosure thresholds, as best seen in the CSX-Children's Fund case: "As discussed in CSX Corp. v. The Children's Investment Fund Management, TCI argued that it was not the beneficial owner of the shares referenced by its Total Return Swaps and therefore the swaps did not require TCI to publicly disclose that it had acquired a stake of more than 5% in CSX." Not all too shocking that RenTec, or more specifically Medallion, uses comparable mechanisms... however in venues controlled by Bernie? Now that's juicy.

According to an internal email from November 13, 2003 from Nat Simons, son of the Jim, who has been with the firm since 1994, and who, according to RenTec's marketing book, runs Rentec's "internally owned Fund of Funds" and "Manages fundamentally driven direct investment portfolio" to select firm members had this to say:

Committee members,

We at Meritage are concerned about our HCH investment [Renaissance’s indirect investment with Madoff]. First of all, we spoke to an ex-Madoff trader (who was applying for a position at Meritage) and he said that Madoff cherry-picks trades and “takes them for the hedge fund.” He said that Madoff is pretty tight-lipped and therefore he didn’t know much about it, but he didn’t really know how they made money. [A colleague] heard a similar story from a large hedge fund consultant who also interviewed an ex-trader. The head of this well-respected group told us in confidence that he believes that Madoff will have a serious problem within a year. We are going to be speaking to him in 11 days to see if we can get more specifics.

Another point to make here is that not only are we unsure as to how HCH makes money for us, we are even more unsure as to how HCH makes money from us; i.e. why does [Madoff] let us make so much money? Why doesn’t he capture that for himself? There could well be a legitimate reason, but I haven’t heard any explanation we can be sure of. Additionally, there is a $4 billion Madoff pass-through fund (Fairfield Sentry) that charges 0 and 20% and it’s not clear why Madoff allows an outside group to make $100 million per year in fees for doing absolutely nothing (unless he gets a piece of that). The point is that as we don’t know why he does what he does we have no idea if there are conflicts in his business that could come to some regulator’s attention. 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. To put things in perspective, if HCH went to zero it would take out 80% of this year’s profits.

Perhaps the best reason to get out is that we really don’t expect to make an outsized return on this investment. Sure it’s the best risk-adjusted fund in the portfolio, but on an absolute return basis it’s not that compelling (12.16% average return over [the] last three years). If one assumes that there’s more risk than the standard deviation would indicate, the investment loses it's luster in a hurry.

It’s high season on money managers, and Madoff’s head would look pretty good above Elliot Spitzer’s mantle. I propose that unless we can figure out a way to get comfortable with the regulatory tail risk in a hurry, we get out. The risk-reward on this bet is not in our favor.

Please keep this confidential.

Nat [Simons]

According to the report, "HCH appears to be a reference to HCH Capital Ltd., an affiliate of Khronos, LLC. Simons Interview Tr. at p. 9." We will get back to HCH and Khronos in a second.

Regarding the size of Meritage's investment in HCH, it was likely not insignificant, based on this disclosure: "To put things in perspective, if HCH went to zero it would take out 80% of this year’s profits." As for Meritage, which is run by Jim's son Nat, it is a "$5 billion fundamental vehicle that invests the assets of founder Jim Simons and other Renaissance principals and employees and was once part of Renaissance’s flagship Medallion Fund." Its General Counsel and Chief Compliance Officer is Nat's wife, Laura Baxter-Simons, and the fund's most recent public holdings can be found here. What is also interesting about Meritage, is that it was the seed investor for hedge fund Hutchin Hill, which is run by former Goldman and SAC quant, Neil Chriss. But that's a story for another night.

As to the reason why RenTec/Meritage had to invest indirectly, the report had this to say:

Renaissance invested with Madoff indirectly because Madoff would not accept a direct investment from them. Broder Interview Tr. at pgs. 6-7. Broder speculated that the reason for Madoff’s refusal was that Renaissance employees “were too smart.” Id. at p. 6.

Maybe a little too smart. But definitely smart enough to learn how to generate some very curious liquidity algorithms. Yet Broder's statement betrays an amusing breed of hubris... One knows what they say about what happens to pride before falls and such.

So once RenTec was made aware of Junior's views, the concerns percolated, and were recapped best by 15-25% Medallion equity holder and RenTec Chief Scientist Henry Laufer Ph.D., whose role at RenTec is to "conduct special strategic projects [and to give] final sign off on any changes to investment systems":

I share the concern at Meritage about the HCH investment.

In Nat’s note, I am most worried about the new information in the statement that “Madoff cherry-picks trades and ‘takes them for the hedge fund’.” We at Renaissance have totally independent evidence that Madoff’s executions are highly unusual.

I do not know what to make of the consultant saying

“Madoff will have a serious problem within a year.”

In all, I very much agree with the sentiment[,] “It’s high season on money managers, and Madoff’s head would look pretty good above Elliott Spitzer’s mantle. I propose that unless we can figure out a way to get comfortable with the regulatory tail risk in a hurry, we get out. The risk-reward on this bet is not in our favor.”

A last quote, from Jim, I believe: “If you are going to panic, panic early.”

Henry [Laufer]

Looks like RenTec is one of those places where a quote from the head honcho is required material for any distribution, especially when said head honcho is on the distribution list. Yet, Jim's quote may some day soon prove oddly prophetic.

So how did RenTec manage to so effectively reverse engineer Madoff's book?

Because they did not hold a direct investment with Madoff, they had to perform due diligence using only publicly available information and customer statements provided to them by two other Madoff clients. Laufer Interview Tr. at pgs. 15-16; Broder Interview Tr. at pgs. 13-14. They had no communications with Madoff or BMIS. Broder Interview Tr. at p. 14.

And here is how Junior explains the lack of reporting of their suspicions to the SEC:

We did feel that despite the fact that we’re kind of smart people, we were just looking at matters of public record. I mean, you know, it wasn’t hard to get these statements. These statements, you know, hundreds of – lots and lots and lots of people had Madoff statements. So we didn’t really feel that we were dealing with something which is proprietary, and therefore the conclusions that we came to were something that was – you know, other people were unlikely to come to. And it’s not like we needed a PhD in mathematics to do the … study on the OEX.94 Right? I mean, this is just – just looking at the size of the market.

Of course, it had nothing to do with trying to figure out a way to capitalize on their insight into what would eventually become the biggest Ponzi in history (until the eventual implosion of Social Security of course), as that would be somewhat unethical...

Yet at least RenTec is perfectly objective about their reverse engineering was trying to achieve. According to Henry Laufer:

And we would have loved to figure out how he did it so we could do it ourselves.

Good to know what noble causes drive RenTec to figure out what makes a massive criminal enterprise tick.

So did RenTec immediately bail out of the CHC TRS once the epiphany of Madoff's crookedness struck then? Of course not:

After performing their due diligence, Laufer stated that “we were very worried” about the investment with Madoff. Laufer Interview Tr. at p. 33. However, opinions diverged at Renaissance about whether to entirely divest itself of the investment. Simons Interview Tr. at p. 28. Broder and Simons wanted to get out of the investment. Broder Interview Tr. at p. 35; Simons Interview Tr. at p. 27. But one piece of information “helped to allay concerns” of other employees: “[W]e were aware that … [Madoff] had been investigated by the SEC.” Id. at pgs. 17, 28. Because of the competing viewpoints, Renaissance stated they initially reduced their investment by approximately one half and later got out of the investment entirely for unrelated reasons.

So RenTec wants the gullible SEC to believe that it would not eliminate its Madoff holdings just because the Ponzi had been audited in 1992, a whole 12 year prior to the time all these events were occurring? Good for them, and apparently the SEC bought it. Yet those astute enough to see beyond this amusing diversion would love to know what the real reason for Simons' persistence in holding on to Madoff was (and what was the final date of TRS disposition), as well as what was the ultimate P&L compliments of Madoff's gullible investors.

Going back to the original point by Nat "why does [Madoff] let us make so much money?" maybe it would be useful to uncover just how much money RenTec did make off Madoff's so called operations, and by implication how much RenTec should be on the hook for, if the Madoff trustee actually does his job properly of recovering capital for Bernie's bankrupt investors. After all has it not been the case that Madoff in essence never really traded? So just what exactly was Bernie doing managing a highly complex instrument such as a TRS? Inquiring minds want to know so much more.

And speaking of ever more questions, just how is Khronos involved? "HCH appears to be a reference to HCH Capital Ltd., an affiliate of Khronos, LLC." Has the $2 billion Fund of Funds, run by David and Rafael Mayer been compromised by Madoff a little more than has been let on? While Khronos seems to be a big fan of Einhorn, it doesn't seem to be too actively involved in the investing world these days. And we all know how much clout FoF's have these days, after the whole Fairfield Sentry fiasco.

We will have some additional color on Khronos soon, in the meantime, we would like to bring your attention to an interesting paper by Markov Process International, whose purpose, since we are discussing reverse engineering of funds, is to do just that, however not to Madoff, but to RenTec's non-employee investment vehicles, RIEF.

We won't discuss this paper at the time, save to highlight the conclusions:

During the recession of 1989-92, the hypothetical portfolio underperformed the index for four consecutive years–about 65% in total. During the technology “bubble” of 1999-2000, it underperformed by about 25%, trailing the index in each consecutive year.

Thus, the fund’s monthly 95% VaR computed in March 2007 is equal to 8%, indicating a potential 8% monthly loss during a twenty month period (assuming constant exposures).

If RIEF has an 8% VaR, one wonders where Medallion stands, and if adding a zero to the number would not be conservative. Then again, Medallion is in the noble liquidity provisioning business (and its entrails spill over absolutely in every corner of the market). And, if as Zero Hedge likes to warn on occasion, there is a total collapse in the computerized liquidity landscape that so many have gotten all too fond of, Medallion's VaR would really be 100%. Although with the "abundance" of public data on what really happens behind the scenes at those 2,600 cores, one can only hope that the SEC is up to par in determining just what the risk potential is in East Setauket (and we are not even talking about alleged abuses of impropriety)