In the days immediately after Bernie Madoff's arrest, some enforcement experts I talked to speculated that the errant financier might have been an honest investment manager for much of his career. They said it was likely that he started scamming his investors only after he found himself underwater at some point and got desperate. After all, they reasoned, no one had ever gotten away with a Ponzi scheme for so long, more than 20 years. (The eponymous Charles Ponzi himself was discovered after only two years.) As we know, Madoff did. And the report from the Securities and Exchange Commission’s inspector general, released earlier this week, finally explains why: sheer regulatory incompetence over two decades, through several SEC chairmen, both Democratic and Republican.
The scariest thing about the report, perhaps, is that it isn't about what happened in the past as much as it's an indicator of what our future looks like. The Madoff Ponzi scheme was a relatively simple scam: all anyone in enforcement ever had to do over the years was to obtain documents showing that wily old Bernie wasn't doing any trading at all. They never did. This is the same agency, slightly tweaked, that we're going to depend on to root out fraud in the mind-bogglingly complex world of over-the-counter derivatives that is even now resuming its old habits.
From June 1992 to December 2008, the SEC received six substantial complaints relating to Madoff and almost consciously turned away from a fraud that was staring it in the face. Perhaps the most startling line in the report is about how easily Madoff could have been discovered very early, sparing thousands of people the anguish of losing much of their life's earnings. In 1992 the SEC received credible information that a Madoff "associate" had been conducting a Ponzi, but focused narrowly on him and "never thoroughly scrutinized Madoff's operations even after learning that the investment decisions were made by Madoff and being apprised of the remarkably consistent returns over a period of numerous years that Madoff had achieved with a basic trading strategy." All the inspectors had to do was to check whether he was making the trades he said he was by getting records from the Depository Trust Company, a third party; in other words, all they needed to do was to corroborate what the alleged suspect was telling them, which is standard operating procedure for any local police department investigating a burglary. Instead they simply asked for Madoff's records and went away. "Had they sought records from DTC, there is an excellent chance that they would have uncovered Madoff's Ponzi scheme in 1992," the IG report concludes.
Time and again, the SEC examiners simply didn't follow leads or failed to comprehend what was being said to them. Beyond that, the SEC examiners were repeatedly intimidated by Madoff, who at one hearing grew "increasingly agitated" and attempted to "dictate to the examiners what to focus on in the examination and what documents they could review." When the investigators reported this encounter to their superior, "they received no support and were actively discouraged from forcing the issue," the report says.
What's astonishing is the contrast this makes to the old days when the SEC was a feared agency under Judge Stanley Sporkin and tough investigators like Irwin (Bulldog) Borowski. The likely reason is that financial markets and the firms that traded in them were so much simpler in those days. Up until the 1980s there were basically about 10 firms that controlled about 75 percent of the market. It was all easier to watch. With the advent of electronic trading (which Madoff himself did much to make happen) and vastly richer globalized finance, the markets spun out of the orbit of the SEC and its fellow agencies like the Commodity Futures Trading Commission. The markets have grown so huge in sophistication and so complex, and the firms so well compensated, that the regulators are simply overmatched. And so they'll remain.
SEC chairwoman Mary Schapiro is an earnest and honest person, but let's face it, she was part of the whole process by which regulators have been eclipsed and marginalized. She ran the Financial Industry Regulatory Authority, which Harry Markopolos (the Madoff whistle-blower) didn't even bother to go to first (he went to the SEC). Schapiro's statement this week that "many changes we have made since January will help the agency better detect fraud" is not reassuring. Nor is her revelation that she has "begun to hire new skill sets."
The Obama administration and the Congress are intent on revamping regulation using most of the same agencies and methods. But "what this report tells us is this body, the SEC, is infected with gangrene," says Bill Singer, a former attorney for the American Stock Exchange and the National Association of Securities Dealers. Indeed, it is likely that at least some of the auditors cited in the IG report are still working there (an SEC spokesman, John Heine, said the commission could not comment on that question). This issue connects up to the debate over executive compensation on Wall Street—if it's not somehow reined in, can the regulatory agencies ever hope to compete in brains and competence? Interestingly, this was always Alan Greenspan's excuse for why he didn't believe regulation of derivatives would work: federal regulators, grads of lesser schools who are poorly paid and in general just not as smart as the people they're supposed to be regulating, would simply never be able to keep up, he said. Greenspan was probably right about that. But the answer is not to give up on regulation; it's to rethink it from the bottom up.
One idea is to create a brand-new culture combining government supervision and self-regulation—mainly by encouraging smart whistle-blowers in the markets like Markopolos and Jim Chanos, the hedge-fund manager who rooted out Enron's fraud, with rewards. But all in all, as Singer says, what's needed is "a wrecking ball, not whitewash and paint."