Thursday, February 26, 2009

Madoff—Another Failure of Government Regulation

The politicians have been blaming the nation's huge economic problems on the private sector and claiming the solution is more government, meaning more regulation. The media have been quite effective in parroting this line and convincing the public this must be so. The problems of housing foreclosures, the banking crisis, the insurance giant AIG, Wall Street, the auto industry, and even the $50 billion swindle by Bernard Madoff are being blamed on insufficient regulation. If only the government had more money, more employees, and more regulations, we are told, these problems would have been avoided and that's what we need to prevent such disasters in the future.

We've discussed some of the problems before, pointing out the role of government in creating the problems in the first place, and we'll deal with some of the others in future writings. But for now, let's look at what really happened in the case of the largest Ponzi Scheme in history (if you don't count Social Security) and see whether the public's trust in regulation is justified. Was the problem really one of inadequate government funding, staff and regulations?

The Securities and Exchange Commission (SEC) is the agency that is supposed to protect the public from criminals like Madoff. His firm was heavily regulated, and the SEC investigated him in 1992 and failed to find anything wrong.

After the Enron scandal, there was clamor for more money, staff and stricter enforcement by the SEC to prevent such abuses in the future. Congress obliged. Since 2000, the SEC's annual budget ballooned to more than $900 million, from $377 million. It's full time examination and enforcement staff increased by nearly 500 people. It's percentage of full-time staff devoted to enforcement—33.5%—appears to be a modern record. And the lionizing by press corp and Congress of enforcers like Eliot Spitzer gave the SEC plenty of incentive to ferret out fraud.

In 1999, Harry Markopolos, a private trader, wrote a letter to the SEC saying that “Madoff Securities is the world's largest Ponzi Scheme.” The SEC ignored it.

On February 4, 2009 Markopolos testified before a House committee that he had issued “repeated and credible warnings” to the SEC about Bernard Madoff. In 2000, when Madoff's scheme was 3 to 7 billion dollars, Markopolos provided enough “red flags and mathematical proof” so that the SEC “should have been able to shut him down right then and there.”

Markopolos' testimony continued: “In 2005, when Mr. Madoff was at $30 billion, 29 red flags were handed to the SEC. And yet again they failed to properly investigate and shut down Mr. Madoff's operations. I told the SEC exactly where to look, providing them with a long series of clear warnings that any trained investment professional would have immediately understood. Inexplicably, the SEC never acted upon those repeated multiple warnings...I gift-wrapped and delivered the largest Ponzi scheme in history to them.”

Even more surprising, Markopolos stated: “Everything that my team and I investigated was a matter of public record....We never had the access the SEC had. We couldn't walk into his offices, collect his documents. We never saw his smoking-gun e-mails. We never talked to any of his staff.”

He also testified, “The SEC was never capable of catching Mr. Madoff. He could have gone to $100 billion” without ever being discovered.

According to the Wall Street Journal, it was private citizen Markopolos and private research shops like Aksia LLC, a hedge fund and financial advisor, who did the real work of figuring out what Madoff was doing. Likewise, it was the short sellers who first blew the whistle on Enron while the SEC was clueless. Isn't it ironic—and significant—that the hedge funds and short sellers have been portrayed as villains by the politicians, the media and the public, who call for greater regulation of them? And regulation by whom?—the SEC? That's the agency that couldn't catch Madoff even though, in Markopolos' words, “I drew them pictures. I gave them a road map. I told them what questions to ask and who to phone.”

(Incidentally, Madoff did not have a hedge fund. He was a registered investment advisor and registered broker dealer.)

It wasn't just the federal government that failed here, but state government as well. Under New York law, Madoff had to register with the Investor Protection Bureau of the office of the New York Attorney General, one of the most powerful state securities regulators in the country. Yet current Attorney General Andrew Cuomo and his predecessor Eliot Spitzer were apparently clueless about Madoff's operations. So what good was the Investor Protection Bureau?

When government cannot even protect people from fraud, why should we believe it is competent to take on far more complicated tasks, such as running the banking industry or dictating how the automobile companies should be run? Protecting the public from fraud is an appropriate function of government. But economic functions—as opposed to police functions—are best left to free markets and the exercise of individual rights, not to the command and control of the police power of government. That power destroys economic efficiency as well as the liberty and individual rights that are the foundations of economic progress.

Here's another short example of government incompetence. This month was to be the deadline for TV broadcast stations to discontinue analog transmissions and switch their broadcast signals to digital. That deadline was set five years ago by Congress. So the government had five years to prepare its citizens for the switch. People with old analog TVs would not be able to get the new digital broadcasts without a converter box. The government said it would provide all applicants with special coupons that would allow them to purchase converter boxes at discount prices. But though it had five years to do so, the government did not have enough coupons in time for people to meet the deadline. So it postponed the deadline of digital broadcasting for another four months, until June 2009—which cost the stations millions of dollars because of lease arrangements and other contractual obligations they had made to comply with the original deadline. If government could not perform this relatively simple task in five years, why should anyone believe it is competent to manage such complex economic functions as the nation's health care system and, indeed, the entire economy?

As Ronald Reagan said, “Government is the problem, not the solution.”