Saturday, December 27, 2008

Mad Dog and the SEC

"The stunning fraud Wall Street pillar Bernard Madoff [BM] is accused of has raised questions about whether federal regulators were lax in failing to scrutinize his operations and respond to alarms raised about them. ... SEC inspectors would have performed regular inspections of his securities brokerage operations as part of the agency's oversight program. SEC officials stress that it was Madoff's separate and secretive investment-adviser business that was used to perpetrate the alleged scheme, and that examinations of the securities operations wouldn't necessarily have detected irregularies. The hedge fund business didn't register with the SEC until September 2006. ... 'The agency can't help but look bad', said Barbara Roper, director of investor protection at the Consumer Federation of America. 'It does raise questions ... about the quality of the enforcement division generally'. ... A wrinkle in the case is the complaint dating back nine years by a securities industry executive named Harry Markopolos. He contacted the agency's Boston office in May 1999, telling SEC staff they should investigate Madoff because it was impossible for the kind of profit he was making to have been gained legally. The SEC's Boston office has been accused in the past of brushing off a whistleblower legitimate complaints, in a case that brought the resignation of the head of that unit in 2003", Marcy Gordon at the Houston Chronicle, 13 December 2008.

"The cops can't catch every crook, but a sophisticated financial system should be able to spot a multibillion-dollar Ponzi scheme operating in its midst. A failure by the authorities to catch [BM's] allegedly fraudulent activities could count as one of the biggest regulatory slip-ups of recent times. The [SEC], with substantial enforcement powers and a specific mandate to protect investors, received warnings about Mr. Madoff over several years. ... And if the agency did follow up on such leads and found nothing, the public should be told the details", Peter Eavis at the WSJ, 13 December 2008.

"An enforcement case 16 years ago gave the [SEC] its first shot at figuring out how [BM] could rack up such favorable returns with such uncanny consistency. After that, it received numerous warnings from outside whistle-blowers and at least twice looked into Mr. Madoff's brokerage itself. ... 'This is a debacle for the SEC,' said Joel Seligman, an SEC historian and president of the University of Rochester in New York. 'The commission has a lot to answer for'," Kara Scannell at the WSJ, 15 December 2008.

"The [SEC] will examine the relationship between a former official at the agency and a niece of Bernard L. Madoff [BLM], after the SEC's chief admitted, 'apparent multiple failures' to oversee the firm at the center of an alleged $50 billion Ponzi scheme. In an extraordinary admission that the SEC was aware of numerous red flags raised about [BLM] Investment Securities LLC, but failed to take them seriously enough, SEC Chairman Christopher Cox ordered a review of the agency's oversight of the New York securities-trading and investment management firm. ... Cox's statements represent a strong rebuke of an agency already facing criticism of its response to the credit crisis. Mr. Cox said an initial review of Mr. Madoff's firm found that 'credible and specific allegations' made as far back as 1999 'were repeatedly brought to the attention of the SEC staff, but were never recommended to the Commission for action.' ... Harry ... Markopolos pursued his accusations for years, dealing with the SEC's regional offices in New York and Boston, according to documents reviewed by the [WSJ]", Aaron Lucchetti, Kara Scannell and Amir Efrati at the WSJ, 17 December 2008.

"[SEC] investigators discovered in 2006 that [BM] had misled the agency about how he managed customer money, according to documents, yet the SEC missed an opportunity to unconver the Ponzi scheme. ... Under pressure to deliver, Mr. [Harry] Markopolos and a colleague at their Boston investment outfit tried to reconstruct Mr. Madoff's puported strategy. Their results paled in comparison, and Mr. Markopolos began suspecting possible fraud. ... Mr. Markopolos argued his case: A key part of Mr. Madoff's strategy relied on buying and selling options of the Standard & Poor's 100-stock index. But Mr. Markopolos said his research showed there weren't enough S&P-100 options in existence at the time to support Mr. Madoff's stated strategy, given all the money he seemed to be managing. So something else must be going on. ... In November 2005, Mr. Makopolos sent [Meaghan Cheung, a supervisor in the SEC's New York office] ... a series of 29 'red flags,' ranging from in-depth mathematical calculations that purported to show the Madoff investment stragtegy couldn't work, to little more than rumor or innuendo", my emphasis, Gregory Zuckerman and Kara Scannell at the WSJ, 18 Deecember 2008.

"Yet surely I'm not the only person to ask the obvious question: How different, really, is Madoff's tale from the story of the investment industry as a whole? The financial services industry has claimed an ever-growing share of the nation's income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it look as if much of the industry has been destroying value, not creating it. ... Last year, the average salary of employees in 'securities, commodity contracts and investments' was more than four times the average salary in the rest of the economy. ... But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion. ... Well, Madoff allegedly skipped a few steps, simply stealing his clients' money rather than collecting big fees while exposing investors to risks they didn't understand. ... At the crudest level, Wall Street's ill-gotten gains corrupted and continue to corrupt politics, in a nice bipartisan way", my emphasis, Paul Krugman at the Houston Chronicle, 20 December 2008.

Barron's, 22 December 2008, reprinted in large part, a 7 May 2001 article, "Don't Ask, Don't Tell", about BM's operations. "What's more, these private accounts have produced compound annual returns of 15% for more than a decade. ... When Barron's asked Madoff how he accomplishes this, he says, 'It's a proprietary strategy. I can't go into it in detail'. ... Still, some on Wall Street remain skeptical about how Madoff achieves such stunning double-digit returns using options alone. Three options strategists for major investment banks told Barron's they couldn't understand how Madoff churns such numbers using this strategy".

"Markopolos's work was a roadmap for any team of competent investigators to expose the fraud. ... The revolving door there is the biggest problem: Many [SEC] staff regulators who are ambitious and competent quit to pursue jobs in the financial industry that pay multiple times their former government salaries. ... I heard the excuses about why cases that we, the examination staff, uncovered failed to warrant actions by the [SEC] enforcement staff. .. Too complicated. ... Too politically connected. ... It is time to rethink the structure of the regulatory system because what we have isn't working", Eric Bright letter to the WSJ, 23 December 2008.

"Instead of encouraging maximum disclosure and protecting investors, the SEC often aimed and fired at small guys and let the Madoffs of the world get a free pass. It would take 50,000 successful $1 million penny stock-scam prosecutions to equal the Madoff scam and that is just for starters", Mark Baum letter to the WSJ, 23 December 2008.

"Options traders say anyone who did a bit of homework on [BM's] 'proprietary trading strategy' could see it was unworkable given market conditions in 2008. ... 'All it took was simple math--"What's the open interest of the S&P 100 option, and how many trades does he say he's making?'" said Jow Kinahan, chief derivatives strategist at brokerage thinkorswin", Rob Curran at the WSJ, 24 December 2008.

The SEC staff is preoccupied with form-filling and looking for other employment.

Think, the SEC opened 671 cases in the year ended 30 September 2008, my 9 December 2008 post. So?

The SEC will never be called to answer for anything.

This is SEC business as usual, step on ants and let elephants dance.

Markopolos "audited" Madoff's books and the fools at the SEC didn't understand what he did.

Yes Mr. Krugman. If the profits were "an illusion", I ask, "Where were the CPAs"?

Until I read this Barron's article I was agnostic on CPA lability arising from audits of Madoff's "feeder funds". Now I believe they should pay through the nose. Do these CPAs audit other investment banks? Were there "red flags" to pursue? Who is kidding whom? Are the Big 87654 ready to be sent to the Gulag? Can they substantiate anything? These incompetents were on "inquiry notice" seven years ago. Plaintiffs' bar, good luck! Will the PCAOB investigate this? Or is it afraid of what it might find?

I agree with Bright.

Yes Mr. Baum.

The SEC can't do "simple math".


Printfaster said...

Wading through the investment banking, CDO, CDS, AltA, SiV, TAF, TSLF, yadda, yadda mess,

I am coming increasingly in favor of less government oversight. The problem with government oversight is twofold: One, investors assume a "Good Housekeeping" stamp from the government; no such warranty exists, yet is it imputed, witness losing our Fannie Mae. That leads to number two: The moral hazard of the government turning the imputed warranty into a real warranty creates both a moral hazard and a big government deficit.

Also I am not enamored with the "Good Housekeeping" crowd, the SPs, Moodys, and Fitch's. A pox on their house. It would seem that the CPAs fall under the same blanket.

What remains is what I call "investor due diligence". Funny thing that. If you cannot understand the investment, or if you think you do, you are a fool for investing in it. Let the investment marketer prove its worth to you, and if they cannot, you are granted a foolscap.

The role of CPAs in this is do an honest job in exposing things to the uninitiated. If they cannot explain their audits, then investors should reject them, instead of turning to "expert opinion".

The public needs to seek to be educated, or their fate as swindlees is a deserved one.

Anonymous said...

Yes... laxity reigned at the SEC... bad stuff...

Is it too complex to be policed?

Is the staff not rigorous?

Big wakeup call.

Independent Accountant said...

CPA failures are an old story. I refer to a 1760-page green book prepared in 1976 about them by Congress. In 32 years, Congress has done nothing effective to clean up the CPA business. The rating agencies are similarly conflicted. It's the classical agency problem run wild. The SEC is a hopeless mess. It's a victim of "regulatory capture". It spends more time concealing fraud than exposing it. Fannie and Freddie did what Congress wanted them to do, make bad loans for poltical purposes.

No, this stuff is not too complex to be exposed. The SEC staff has no incentive to expose it and expends too much effort chasing down insigificant cases. By and large, in my experience, the SEC staff is composed of glorified clerks. Suppose one hits on something big, look at what happened in the Aguirre fiasco.

Anonymous said...

You're breaking my heart IA...

I just read about Aguirre... combine that with Madoff and yup... protecting the powerful seems to be an operative approach...

Anonymous said...

Regular people have no business being in the market. However they are
forced into it due to the poor stability of our currency. The income
tax thief doesn't help (especially on fictious "inflation" income).

If the currency held value across time then just saving money under the
mattress would work. Keep in mind that prices would gradually go down
over time, possibly about 2%/year.

A diversified pool of well secured bonds (with real assets behind them)
paying something like 2% would likely be the normal investment (yielding
a real return of 4%).

It all boils down to a bad currency.