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Regulation Will Stop Future Madoffs? It Just Ain't So!

Bernard Madoff is a boon to financial regulation advocates. A well-known Wall Street figure, he confessed to defrauding his clients of $50 billion, an amazing number. It is now established conventional wisdom, blared across the media, that this and other financial disasters would likely not have happened had there been proper government supervision.

With deregulation fingered as the culprit, the new occupants of Congress and the White House are expected to infuse regulatory bureaucracies with greater authority and resources.

Commentators cite the Madoff affair as proof positive against the free market. “The long, bipartisan experiment with financial deregulation has failed utterly,” declared Tim Rutten in the Los Angeles Times. “The Madoff scandal should be a wake-up call,” wrote Arthur Levitt in the Wall Street Journal, calling for more regulation of investment advising.

Levitt headed the Securities and Exchange Commission from 1993 to 2001—a period that covers the early stage of the debacle—and knew Madoff personally. He says he did not suspect wrongdoing.

In this case, as in an earlier fraud case I’ve studied, regulators in effect facilitated the deception. People made mistakes in part because of the assurance provided by government oversight. It is remarkable that a massive government failure of eight or nine years’ duration has turned into an argument for market failure and more government.

Bernard Madoff Investment Securities was a major broker-dealer that executed a large number of trades on the Nasdaq and made markets for certain securities. Madoff, a pioneer in electronic trading, had helped build the Nasdaq electronic market. He was so well respected that regulators would ask his opinion about the trading system.

As a brokerage the firm was heavily regulated by several agencies, with the SEC as the primary overseer. Besides mediating trades, Madoff traded with other people’s capital. He appeared to be unusually successful at this, making around 15 percent annually over a couple of decades with nary a losing year.

There were rumors about those stable profits. How could it be that this one man made money during times when others used the same strategy, traded the same securities, and made losses? An obvious explanation was that Madoff exploited his market-making position, from which he knew when there were significant purchases or sales that could raise or lower the price of a security. Taking advantage of the information, he could buy or sell ahead of the trades his brokerage executed. This would give him a huge edge over other traders and explain the exceptional steadiness of his returns. He could not tell people this was the source of his profits, though, since “front-running,” as it is known, is illegal.

The other explanation was that he was not making the returns he claimed to make—he was engaged in a garden-variety fraud often called a Ponzi scheme. He may have made money initially by front running but stopped doing that because he feared getting caught. Later he fell into the scheme of fabricating returns and paying some investors with other investors’ money. Only Madoff knows what happened.

In any event, his beyond-belief performance was brought to the attention of the SEC and other agencies by at least two people acting independently. One wasa hedge fund manager named Michael Berger, who was himself apprehended for concealing losses from investors in Manhattan Investment Fund.

In an attempt to get leniency from the government, Berger in early 2000 offered the SEC, the FBI, and the U.S. Attorney’s office information about Madoff and other dubious ventures. He told me and other journalists about this. In 2001 and 2002 several articles appeared in the press expressing doubts about various aspects of the Madoff operation.

Authorities had already heard about the matter from Harry Markopoulos, an analyst and trader frustrated because he failed to achieve the robust returns Madoff reported. Markopoulos used quantitative analysis to demonstrate that Madoff could not make the returns he claimed with the derivatives trading strategy he said he used. Starting in 1999 Markopoulos repeatedly discussed the matter with government officials and even submitted a report documenting his case.

The SEC investigated Madoff Securities several times. The examiners found minor violations of a technical sort but no big problem. Madoff paid a fee, fulfilled a requirement to register as an investment adviser, and was allowed to go on his way.

People who invested their own or their clients’ money with Madoff saw the press reports and heard about the SEC examinations. For instance, a Swiss bank that channeled capital to him had concerns, but according to an internal letter the executives “found comfort” that the brokerage was subject to routine audits by the SEC and FINRA, a nongovernment industry regulator.

Regulators discovered no fraud after repeated complaints and inspections. That reassured investors and aided Madoff’s game, which was officially recognized only after he confessed in December 2008—after, possibly, decades of cheating.

The Usual Fiasco

This regulatory fiasco is not unique. Berger had a similar pattern, as I show in the Winter 2009 issue of The Independent Review. Berger was able to hoodwink investors, accountants, and auditors for three years partly because an SEC-regulated broker-dealer backed him up.

These government failures are not due to lack of regulatory laws, authority, or personnel, despite an understandable campaign to make it look that way. SEC examiners had every authority to look into any aspect of the Madoffoperation. Markopoulos, the analyst, offered his services to the government to help uncover Madoff’s fraud. IfSEC staff lacked the skills, they could have employed Markopoulos or another consultant.

Some argue that the United States needs a unified, stronger financial regulator to prevent such occurrences. Yet major frauds happen in countries such as France, where the regulator is as powerful as can be. Levitt complains that the SEC does not have enough resources. Yet it appears that plenty of resources were in fact spent on the Madoff matter.

The truth is that government agents are subject to the same cognitive weaknesses and biases as market agents and make the same mistakes. Madoff’s investors took their cue from one another—as did people in other schemes. Government agents joined in the herding behavior and encouraged the delusion by exonerating Madoff of serious accusations.

Reducing the incidence of fraud requires investors to be more skeptical and alert to early signs of trickery. It requires better awareness of the mental biases we all have, which make people easy marks to smart manipulators. But the popular image of government bureaucrats as wise guardians taking care of the rest of us creates a false sense of security—a cognitive hazard that makes investors more vulnerable.

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