August 17, 1930 was a Sunday with no Journal, so again a little editorial commentary.
Today I'm going to do something a bit off-topic, but I think important and not totally irrelevant. Lest we forget, there was a guy named Bernie Madoff who was involved in a huge financial scandal that came to light late last year that also revealed an incomprehensible failure of regulation by the SEC. Revelations of such scandals are in fact pretty characteristic of severe busts (as Buffett put it, you don't see who's been swimming naked until the tide goes out). A disturbingly high proportion of my friends seem to have some misconceptions about the Madoff affair, so I thought a little editorializing was in order. I'm not sure how much impact my own blathering would make, but fortunately there is a great resource for informing yourself on the scandal available here. This is a link to the video and transcribed Congressional testimony of the guy who probably knows more about the whole affair than anyone, and spent about 10 years trying to get the SEC to do their job: Harry Markopolos. If you have a few spare hours I would highly recommend watching the whole thing - for those with strong stomachs, I'd even recommend the nauseating performance of the regulators that follows HM's testimony. However, for those of you who don't have the time, I'm including some informative excerpts here.
[Opening statement - full cost of the SEC's failure.]
First, I would like to extend my deepest sympathy to the many thousands of victims of this scheme. We know that many victims have lost their retirement savings and are too old to start over. We also know that others have lost medical services, community services, and scholarships provided by charities that were wiped out by the Madoff fraud. This pains me greatly and I will do my best to inform you, the victims, about my repeated and detailed warnings to the SEC. You, above all others, deserve to know the truth about this Agency’s failings, and I will do my best to explain them to you today. ...
As today’s testimony will reveal, my team and I tried our best to get the SEC to investigate and shut down the Madoff Ponzi scheme with repeated and credible warnings to the SEC that started in May 2000 when the Madoff Ponzi scheme was only a $3- to $7 billion fraud. We knew then that we had provided enough red flags and mathematical proofs to the SEC for them where they should have been able to shut him down right then and there at under $7 billion. ... In October 2001, when Madoff was still in a $12- to $20 billion range, again we felt confident that we had provided even more evidence to the SEC such that he should have been stopped at well under $20 billion. And again in November 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 operation.
Unfortunately, as they didn’t respond to my written submissions in 2000, 2001, 2005, 2007, and 2008, here we are today. A fraud that should have been stopped at under $7 billion in 2000 has now grown to $50 billion. I know that you want to know why there was over $40 billion in additional damages, and I hope to be able to provide some of those answers to you today.
[Were individual investors who lost money to Madoff greedy and stupid?]
Mr. ACKERMAN. ... The final question, I represent a large number of people who invested with Mr. Madoff ... The question that we get asked, all of us all the time, is, why didn’t people do due diligence? ... Could anybody have figured it out?
Mr. MARKOPOLOS. If you did not have a derivatives and quantitative finance background, it would have been very difficult to figure this out on your own as an individual investor.
Mr. ACKERMAN. The people who are blaming the victims for being stupid and not doing due diligence are off the mark?
Mr. MARKOPOLOS. A lot of the victims thought they were getting highly diversified portfolios. This is the beauty of Mr. Madoff’s scheme. He was purporting to own 30 to 35 of the bluest chip stocks, the largest companies in America, and they would see that on their statement, and they felt very comfortable owning those companies and they considered it a very diversified basket because it really was a very diversified basket.
Mr. ACKERMAN. But there was nothing they could do to check it out, that he didn’t actually buy it.
Mr. MARKOPOLOS. ... As an individual investor, you could not. But as a feeder fund, you should have been able to go to the New York Stock Exchange and see that those volumes of stock did not trade on that day at that price. They could have gone to the option price reporting authority that the Chicago Board Options Exchange offers, and you would have seen that no OEX index options traded at those prices that day. That is what you could have done and no one did that.
Mr. ACKERMAN. And the SEC could have done that, too?
Mr. MARKOPOLOS. If they knew how to do it, they could have done it. And if they had the willingness to do it, they could have done it. But they did not.
Mr. ACKERMAN. Thank you very much.
Chairman KANJORSKI. If they knew how to do it. Are you suggesting they do not know to do that?
Mr. MARKOPOLOS. I am suggesting that if you flew the entire SEC staff to Boston and sat them in Fenway Park for an afternoon, that they would not be able to find first base.
[Can the market regulate itself?]
Mr. ARCURI. ... Does the market itself, do they look at, you know, competitors who are out there, who are doing jobs that are too good to be true and say, hey, something must be wrong here; somebody needs to look into this?
Mr. MARKOPOLOS. Well, I am afraid not. They missed subprime. They missed the collateralized debt obligations, the collateralized loan obligations. They missed so much it is hard to just trust in the professionals. You need competent regulators as well, and you also need common sense.
Mr. ARCURI. My concern is this, if I am an investor and I am looking at the two prospective groups to invest my money in and one is doing everything legally and they are giving, let’s say, 5 or 6 percent, and then you are looking at a Madoff who is giving a return of, say, 10 or 12 percent, the person who is giving the 5 or 6 percent has to be looking at Madoff and saying, something has to be wrong here, someone needs to look at that. Isn’t there more pressure from the actual private sector itself to look into these?
Mr. MARKOPOLOS. I am afraid the private sector would look at the Madoff returns and say, he is getting more return, taking less units of risk, therefore I love Mr. Madoff better and I want to invest with him more. So greed often overrules common sense.
[Needed changes in the SEC and in regulation.]
The incoming SEC Chairwoman needs to come in and clean house with a wide broom. The SEC needs new senior staff because the current staff has led our Nation’s financial system to the brink of collapse. They ignored the rating agency scandals. They allowed the investment banks to engage and package and sell toxic subprime securities to investors. They ignored auction-rate securities and allowed these toxic securities to be sold to investors. They ignored mutual fund market timing until embarrassed by State regulators into acting, and they ignored the Madoff Ponzi scheme. They haven’t earned their paychecks and they need to be replaced. ...
I would urge the Congress to consider the fine examples set by the New York attorney general’s office and the Massachusetts Securities Division. They give great regulation on the big cases that are nationwide fraud cases, and they get full restitution to the victims. They are aggressive. But they are small. They don’t do a lot of examinations. All they do is take in whistleblower tips and act upon them and act vigorously. They are pit bulls against financial fraudsters. And here we have a pip-squeak of a flea in the SEC. So it is not the size of the dog, it is the size of the fight in the dog. And that is why I commend those two State regulators. They are very aggressive.
And if the SEC does not reform itself, you have an option. Just disband the SEC, zero out their budget, put all 3,500 of those people on the streets, because they are not protecting us right now; and just fund the New York attorney general’s office and the Massachusetts Securities Division. ...
Mr. CAPUANO. ... I would argue that some of those things may require us to have a little bit more complicated regulatory scheme. Is that something you have considered or not?
Mr. MARKOPOLOS. I wouldn’t say more complicated. I would say more simplified, more streamlined because remember, American business wants as few regulators as possible. They are paying for the regulation. They want a value-added proposition. For every dollar they spend toward regulation, they want to receive that value back because right now without proper regulation, there is no trust in our capital markets, which raises the cost of capital or makes it unavailable to American businesses. ...
Mrs. BIGGERT. ... should we be looking at the regulations and the laws on the books and trying to decide whether they are adequate enough to address this issue, or is this more a failure, really, of enforcement? ...
Mr. MARKOPOLOS. It is both, Congresswoman. It is, we need a few more regulations; we can leave no more dark spots unregulated and unguarded for financial predators to congregate in. ... And the second part is, we need better people in the enforcement agencies. They really need to replace a lot of their staffs, especially at the senior levels.
+ The Boring Stuff: