It’s a story that is (appropriately) on the back burner in the media, but the slowly unwinding tale of The Greatest Ponzi Scheme Ever continues. In case you have (appropriately) been paying attention to other things, let me offer a quick recap.
Starting as long as twenty years ago, Bernie Madoff, a well known and successful figure on Wall Street, ran a Ponzi scheme. As with all such scams, he pretended to be putting his clients’ money in a make-believe sure-fire investment. Those few who asked to cash out were given money he raised from other investors. By 2008, Madoff’s imaginary investment empire was worth an imaginary $50 billion.
And he never got caught. Like funds of all kinds, last year he was hit by a wave of people wanting to cash out. Unlike other funds, the money he needed for the withdrawals did not exist. So before things got really really ugly, Bernie turned himself in. (Actually that’s not quite right. He confessed to his sons that he had been running a Ponzi scheme and that he planned to turn himself in. They immediately dropped a dime on Ol‘ Dad. Wall Street is a really tough place.)
That’s a pretty good plotline, but it gets better. If you are, like me, an investment professional in Boston, you have probably met a guy named Harry Markopolos. You might also remember that for several years in the middle of this decade Harry tried to make a living as a freelance financial fraud investigator, sort of a bounty hunter for the investment world. Well it turns out that one of his longest running investigations was Madoff’s ponzi scheme. Markopolos figured out it was a scam as soon as he saw the returns Madoff claimed to be getting in 1999. He then spent the following nine years trying to convince the SEC to do something about it.
We do not yet know why the SEC did nothing. Further plot thickeners such as bribery or blackmail are certainly possible, but not likely. The mundane truth is that the SEC is just not that good at what most people think they do for a living. They are regulators and not cops. There is a difference.
To illustrate this, let me change subjects abruptly to an excellent article in the Atlantic last November by Jeffery Goldberg. It is the account of his concerted multi-year effort to get himself placed on the TSA’s notorious No Fly List. He failed, although he did manage to have a nail clipper and a can of shaving cream confiscated. On other occasions he boarded planes with items that ought to have raised some eyebrows, including lengths of rope, dustmasks, full sized Hezbollah flags, and of course, the traditional box-cutter. He also used badly forged boarding passes and at one point ripped up a stack of them in view of a TSA officer. (I thought the article was hysterically funny. Most of my friends swore they’d never fly again. Go figure.)
The TSA didn’t stop Goldberg for the same reason that the SEC didn’t stop Madoff. They are regulators. They employ large numbers of comparatively underpaid and undertalented people to make sure that most folks mostly keep within regulations most of the time. That can be a worthwhile government function (not in the case of the TSA) but it’s completely different from finding the really bad guys and throwing them in jail.
If you point out an obvious wrongdoer to a cop he will arrest him and then, if necessary, work out exactly which crimes have been broken. Point out to a regulator a wrongdoer who is not obviously breaking any regulations, and the outcome will be paralysis. We don’t know for sure yet, but I will bet real money that is what happened at the SEC. They stood around scratching their heads trying to figure out what SEC rules were being broken by Madoff, couldn’t come up with any, added in the fact that there were no complaining victims, and decided to move on to other cases.
If you are confused (or outraged) that the SEC might not see any obvious violations to pursue with Madoff, you are not thinking like a regulator. Regulators work with very detailed and specific rules that they try to jam everybody and everything into. There is no such thing as “the spirit” of a regulation and no general remit for the regulator to fight evil beyond what is very specifically allowed or not. Madoff was not selling securities, as the law defines them. The SEC had a lot of rules about how Madoff could invest his clients’ money in the public markets, but nobody has alleged that he broke any rules there. (Not surprising, given that he apparently didn’t invest his clients’ money at all.) Expecting the SEC to go after Madoff under the general principle that he might have been carrying out the greatest securities related fraud in history is like expecting the airport screener to take a closer look at the unlikely items in the carry-on of the guy in the al-Qaeda tee shirt. (Seriously. Goldberg wore one. Read the article.)
Markopolos had no direct contact with Madoff. (He still mispronounces his name. It’s MADE-off, as in “Bernie made off with a whole lot of money.”) Which raises the question, why didn’t any of the thousands of other people who must have come across the same data in the course of their business come to the same conclusions as Markopolos did and alert the SEC? It’s possible a few did, but it is clear that the vast majority of financial professionals did nothing. Again, because the SEC are regulators, not cops.
Innocent or guilty, dealing with regulators is a painful drag. As a wag once put it “the process is the penalty.” Unless you are absolutely sure something is rotten you just don’t finger your fellow man to a regulator. And even then probably not. You might call the cops if you thought that perhaps your neighbor was beating his wife, but it is almost inconceivable that you would call the IRS because you knew for a fact he was cheating on his taxes.
Obviously, what the Madoff scam needed was cops, not regulators. But there were lots of cops. This was, after all, plain old fraud in fancy packaging. The police in any of the hundreds of jurisdictions where Madoff’s victims lived could have, in principle, investigated him. And of course there was the FBI. But if Markopolos had brought his story to any of these I am sure they would have all sent him back to the SEC. Wall Street fraud is their thing, isn’t it? The final irony is that had Madoff claimed to be investing his clients’ money in something other than regulated securities, Manhattan real estate for example, he almost certainly would have been stopped a long time ago.
Compared to the global economic crisis and our government’s fumbling responses to it, the Madoff story is relatively minor, almost a comic relief. It would be unfortunate, but not all that unexpected, for the two stories to become intertwined in public memory, as popular imagination blames “accounting scandals” like Enron and Worldcom for the tech bubble bursting and blames fraudsters for the great S&L fiasco of the early 1990s. We already hear vague accusations that the root cause of our problems is a failure of regulators to properly regulate. As regards Madoff, the opposite is true. The regulator did everything we could have expected of it. It was our mistake for expecting anything more.