Tuesday, December 16, 2008

To Catch a Thief

Now that Bernard Madoff has been arrested for pulling off a $50 billion Ponzi scheme, editorialists are naturally wondering what to do, and the Wall Street Journal is taking the opportunity to warn against using the incident as an excuse for more regulation. With the hard-nosed, clear-eyed thinking for which the free market's champions are famous, the WSJ tells us that "The reality is that it is impossible for the SEC or any regulator to prevent every financial fraud, just as it is impossible for city police to prevent every burglary." So I guess the message is that we should just accept that every now and then someone will steal $50 billion and not expect government to prevent it. The last thing we want is for "every enforcement failure [to] become an excuse for more enforcement."

Sorry, but what the WSJ analysis overlooks is that at least some smart people did detect the Madoff fraud. Aksia LLC, which advises clients about which hedge funds to invest in, warned against investing in Madoff as early as last year. How did they spot the potential fraud? As they recounted in a recent letter to their clients, they just did the basic due diligence. They noted many suspicious things: Madoff's vast fund was audited by a 3-person audit firm (and only one of the three employees seemed really active); the market in which Madoff traded was too small to support the huge sums he claimed to trade; he didn't have enough actual holdings; and so on. And with their suspicions heightened, the Aksia LLC people checked up: they actually visited Madoff's offices to check up on his vaunted technology, but found only paper tickets and no apparent electronic access to his holdings.

So it seems that what was really necessary to catch this thief was some due diligence. Not taking everything on faith, but actually checking up on some basic details.

Now, why couldn't the government have done that? The WSJ may be right that the SEC doesn't need any new enforcement powers as a result of this incident, but it sure does seem like we could use some more actual exercise of the powers the SEC already has. It seems like they were just asleep at the switch, doing a "heckuva job" doing nothing while the crisis was building. I don't know how related this is to the fundamental problems we've seen in the Bush Administration all along, but it does seem thematically related to the attitude that the government should mostly do nothing and let us all take care of ourselves, whether there's a real or an economic hurricane coming in.


The Pedant said...

I think the WSJ's analysis is spot-on.

Sometimes, people with evil intent get away with heinous crimes. In hindsight, we should have listened to the warnings, but such things aren't necessarily obvious up front. This is true not just for financial crimes but for serial killers, kidnappings, etc.

As part of massaging Washington, Madoff was a generous contributor to both political parties for the past decade, had a former congressman lobbying for him since the mid-1990's, and his daughter married a high-ranking SEC enforcement officer shortly after his retirement: http://www.politico.com/news/stories/1208/16608.html

Madoff co-opted the system in a way that's non-partisan - he didn't exploit a particular quirk of either the Clinton or Bush administration and seems to have glad-handled both. It's obvious in retrospect that he was handling a Ponzi scheme, but his rate of return was such that superficially it looked like he was investing in a very conservative manner.

In short, Madoff spent a lot of time developing a criminal scheme, and as such was hard to catch. Just because a criminal is clever enough to evade the cops for a while doesn't mean there's a systemic failure of the police.

The Pedant said...

Also: http://tpmmuckraker.talkingpointsmemo.com/2008/12/why_didnt_sec_look_closer_at_m.php

Madoff was responsible for the creation of NASDAQ and advised the SEC for a while. He knew what would set off their alarms and structured his business accordingly.

The more information comes out, the more Madoff seems like a smart, criminal guy who was able to take advantage the system because of his position and abilities, not for any easily determined failing on the part of the regulators (except perhaps for not being three times as well-funded as they are, a problem not unique to Bush).

Jon Siegel said...

Your points are well-taken, but at the same time I still think that if private investment advisors like Aksia LLC, who don't even have any regulatory or subpoena power, could spot that something was wrong with Madoff by just doing basic due diligence, then the government, which has much more authority, could and should have done the same thing.