Friday, September 11, 2009

The Badly Bungling SEC: An Eye-Opening Tale

Today I want to return to the blistering report that the SEC's Office of Inspector General issued earlier this week. In 22 highly detailed pages, the SEC's internal watchdog retraced a succession of mind-boggling blunders that allowed Bernard Madoff, king of the Ponzi schemers, to escape detection for more than a decade and a half. In fact, the SEC wasn't even investigating Madoff at the time of his arrest; his own sons turned him in. He turned out to be the mastermind of a $65 billion fraud that suckered investors from pension funds and charitable foundations to wealthy individuals.

I want to return to this story because it's really important to appreciate how much rot we have in our financial regulatory system. Arguably, the SEC is worse than corrupt: with corruption, at least you have someone to arrest and you can purge any lesser wrongdoers from your ranks. Here we have what CBS News called nothing less than "jaw-dropping incompetence," and it appears to have been systemic. The inspector general's summary paints a picture of SEC examiners and investigators who are about as credulous as a bunch of six-year-olds on a snipe hunt.

From where I sit, the agency's lack of any investigative smarts or zeal whatsoever is the real, profound problem.

I mean, sure, there were the typical bureaucratic delays before the SEC's handful of half-hearted investigations got underway ("the start of the examination was delayed for seven months," pg. 10, "there was a significant delay (8 months) before the examination was commenced," pg. 12, "the enforcement staff delayed opening a matter under inquiry for the Madoff investigation for two months," pg. 17). But over a period of 16 years, even these long delays pale in significance. They don't explain how Madoff could wriggle free, again and again, from the SEC's clutches even as the regulators had a bounty of suspicions and evidence repeatedly dumped in their lap. (Harry Markopolos, who knew inside and out the kind of options trading that Madoff was supposedly doing to score his profits, chose a rather unsubtle title for his 2005 complaint to the SEC: "The World's Largest Hedge Fund is a Fraud.")

Neither does "inexperience" turn out to explain much of the regulator's failure; it's just a convenient excuse. True, there's an example given where a staff attorney fresh out of law school did most of the work in one of the five SEC probes into Madoff's operation. This does raise questions about why she was appointed to the team -- surely there was a more experienced hand somewhere yes?

Still, the bottom line is that even a newly minted lawyer should have a certain basic analytical skill set -- and that's all that was needed to put Madoff behind bars six times over. Despite the supposed complexities of Madoff's trading schemes, the case could have been cracked by anyone who had a critical mind.

Remember, Madoff bilked all his investors through a Ponzi scheme. And a Ponzi scheme is like a shaky house of cards: you pay the first wave of investors by using money from the second wave, and make sure you keep growing so that the structure doesn't collapse. Of course the brains behind the fraud have to invent a front for outsiders, fabricating at least a few superficial documents to "explain" the profits. A dogged investigator (or even a not-so-dogged one) can unmask a Ponzi artist though by simply daring to shine a light behind the curtain. In other words, was Madoff making trades that would support his reported gains?

That's Ponzi Basics 101. But the SEC's clueless cops, on numerous occasions, passed up opportunities to verify Madoff's trades through a third-party source, such as the Depository Trust Company (DTC).

The investigators also missed easy, obvious stuff.

For instance, go all the way back to 1992. The SEC was investigating an investment firm, Avellino & Bienes, suspecting a Ponzi scheme. The regulator finally ordered that all the investors in A&B be repaid. And they were, but no one thought to inquire where that repayment money was coming from. It so happened that Madoff controlled A&B's investments, so the SEC investigators should have asked if a larger Ponzi scheme might be paying off the investors in the smaller one. An SEC examiner later said that looking at the source of funds was just "common sense." You don't need a degree from Harvard Law School to possess that.

Also there's a litany of instances where Madoff was caught by the SEC investigators in lies and inconsistencies. But they either accepted his pat explanations or never bothered to push harder to get at the truth.

Often they didn't bother to reach out for help, as a good cop would when faced with something he couldn't wrap his head around. When they did, they were sloppy. Look at February 2006, when the SEC's enforcement division contacted a sister division, in economic analysis, seeking aid in analyzing Madoff's trades. For two and a half months, no response came. The economic analysis staffers at last did review certain documents and concluded that Madoff's money-making strategy would not have done as well as he reported. Incredibly, however, this observation was never conveyed back to the people over in enforcement.

In that instance, someone might want to blame the economic analysis crew, but let's be fair: if you're a big-city cop investigating a case, and you don't hear from the fingerprint department in a reasonable amount of time, you grab the phone and give 'em a call. Failing to do so has nothing to do with inexperience. It's sheer bureaucratic laziness.

Madoff himself couldn't believe the agency's rank incompetence. He said he was once asked for his DTC account number, so his trades could be checked. At that point he figured the jig was up: an investigator would call DTC and it would be "end game, over." But the SEC never followed up, leaving him scot free and "astonished," he said.

And so this gross, almost unimaginable incompetence plagued the SEC, through Democratic and Republican administrations. The report reveals the agency to be so amazingly dysfunctional that, in my opinion, we may be better off abolishing it and starting anew.

By the final page of this document, the essence of the tragedy becomes all too clear: Madoff's fraudulent activities could have been uncovered quite simply at any time between 1992 and 2008.
When Madoff's Ponzi scheme finally collapsed in 2008, an SEC Enforcement attorney testified that it took only "a few days" and "a phone call ... to DTC" to confirm that Madoff had not place any trades with investors' funds.