The SEC is very good at rooting out sophisticated fraud, especially in accounting gimicks. But they, like most human beings, are simply not that good at identifying accounting statements that are simply made up out of whole cloth. Hindsight is 20-20 though and I'm sure plenty of people will be calling for heads to roll.
The brazenness of the fraud was, in some part, the reason it was easy to keep going. The SEC is looking for people pushing the envelope. It is not looking for people who have set fire to the envelope and substituted a piece of old newspaper recently used to wrap fish.
It's actually easier for someone committing outright fraud to slide under the SEC wire, because when you're making up financial statements out of whole cloth, it's not hard to make them conform to SEC regulations. Similarly, Stephen Glass and Jayson Blair and Jack Kelley were able to get away with their frauds precisely because they fabricated things out of whole cloth. If you misquote an actual person, or misreport something that really happened, there's a strong risk that you'll be caught. But manufactured sources never complain that you spelled their name wrong or twisted their words.
In the long run, of course, such fraud guarantees that you'll be caught. But as Madoff shows, the long run can be long enough for someone entering old age to hope to beat the law of averages, Keynes-style.
On a somewhat related tangent, here's the question that really bothers me about Blagojevich: what if the reason that he thought he could get away with it is that a lot of other politicians he knows about have?
Come on, it's Chicago. Of course they have.
No duh.
Didn't 4 of the last 8 Governors of IL end up in Jail? I'd say they didn't get away with it.
I'm still struck by Blago's performance art; he sounded like he knew he was already caught and putting on a show; and taking down Jackson in the process.
Half Canadian,
Actually, a lot of them have not gotten away, whether we are taking about members of Chicago's City Council, Illinois state legislators, city officials in Chicago and its suburbs, mayors of suburbs such as Cicero, congressmen, judges, and even some governors (including Blago's predecessor George Ryan).
Megan,
I think Blago simply believed that he was smarter than those other guys that got caught, and that his people would stay more loyal to him in the face of a federal investigation than George Ryan's cronies did. Talk about self-deception! (Basically, Blago thought he could beat the corrupt politicians' "market".)
dsr's comment is spot on. Every big fraud that I know of has a paper trail that includes just one big false premise; and you don't find the fraud until you question the premise. The implication is that really successful fraudsters come in two classes - those who manage to be nowhere to be found when the premise is questioned; and those who manage to close out the paper trail before the premise is questioned. My leading example of the first group is the gang who took Sadam Hussein for several billions in return for weapons of mass destruction which weren't. Examples from the second group await posthumous memoirs; but reasonable extrapolation suggests that they are out there and enjoying life.
Madoff does not qualify as really successful.
The simple fact is auditors can find these things. I don't know enough about this case (were independent auditors required by the SEC, who were they), but if there were independent auditors involved they should have discovered the issues. That's their job.
The auditors were a shell of a firm with, apparently, one tie-dyed/tight-panted accountant.
That was the first question I asked as well.
When the auditors look at our small (100 participant) pension fund, they don't rely on the custodian statements I hand them on the brokers own forms, they contact the custodians and ask them to reply directly to the auditor. How come our fund, with about $2.5 million, has to do a annual 5500 report, accompanied by an independent auditors' opinion, and Madoff's thing apparently doesn't?
I think in a certain sense you're giving Madoff too much credit for innovative accounting scheming. I'd bet he just took advantage of a regulatory gap -- both in regulatory requirements and in SEC examination practices.
The fraud was likely a "simple" matter of keeping two sets of books that took advantage of SEC's examination practices. The SEC seems to have placed a priority on investigating the high-volume, (apparently) high-risk business, which was the regulated broker-dealer's trading and derivatives business. And didn't examine the connections between the B-D and an affiliated unregulated (until '06) "investment adviser" business.
My hypothesis is something along the following -- there was one set of books for the B-D, which was regulated and examined. It would have had a perfectly fine paper trail of customer assets and trades that all matched because that was reality. The funds invested with Madoff's "investment advisor" business would be commingled in the B-D's custody, and the total would have matched what the "investment adviser" business said should be held by the B-D on its behalf. There would be no way (or need) to reconcile the B-D's holdings with what each of Madoff's individual investors had been told were being held on their behalf. The second ficticious set of books, which the SEC never saw, was the "investment advisor"'s customer statements, which reported to investors on ficticious trades made on their behalf and corresponding changes to the investor's accounts.
The first safeguard against accounting fraud -- Madoff's auditors -- obviously failed. Madoff's auditing firm had to be in on the scheme. But a simple missing safeguard (an independent custodian for the "investment adviser" business such as is required for all regulated mutual funds) would have been a check on the auditor. It would have made it much harder for the auditor to get away with the fraud for such a long period because a custodian could have reconciled customer records with custodial holdings, exposing the fraud, at any time.
This isn't a new type of sophisticated accounting fraud that would trick a bureaucrat who'd never seen such a thing before. It's old as the hills, but it would have exploited regulatory gaps and bureaucratic practices.
My question about Blagojevich is if he thought it was only a slight degree of separation that his friends could go to bat for him on?
Shouldn't the big red flag have been that Madoff's firm was the custodian of the assets? Don't most hedge funds have outside custodians? Heck, most small brokerages have outside custodians too (Bear Stearns used to be big in providing this service for small firms, incidentally).
Complete fakes are usually easy to pick out because of the improper appearance of each number.
Believe it or not, numbers start with the digit "1" more often than "2" which is found more often than "3" etc... But when people make stuff up, they don't follow those rules.
That's one of the things they use to catch tax fraud.
Why do you talk about things that you have no experience with? Did you ever study forensics? do you have experience auditing at the SEC? YOU'RE JUST MAKING SHIT UP!
Creech,
Pension funds have their own, fairly onerous, regulatory structure (e.g., they are subject to ERISA, EGTRRA, etc.). This has spawned a cottage industry of third party administrators that help small firms navigate and comply with these regulations.
Nadezhda,
I see you beat me too it re the lack of an outside custodian.
On a somewhat related tangent, here's the question that really bothers me about Blagojevich: what if the reason that he thought he could get away with it is that a lot of other politicians he knows about have?
Of course they have, and it's not just Chicago. Trading appointments is as old as the republic itself; heck, it's as old as government itself. You just can't cross a line and offend people's sensibilities as the foolish Blago did.
Re: Madoff -- Doesn't this make the SEC look really bad -- and add more downward pressure to the already extant pressure on New York as a financial hub? Maybe he would have gotten away with this in London, but I doubt it. We've all heard lots of smugness from across the pond about how their financial regulation authority is process and concept-based, whereas the SEC is overly legalistic and rules-based. I used to be a tad skeptical of such claims, but no more.
Re Nutella's point about numbers:
Last year I bought a couple of those Great Courses DVDs on probability and statistics. Before the soporific effects of the probability DVD kicked in, the professor made a point about how it was usually easy to differentiate between a sequence of truly random numbers and a sequence made up by people trying to make it look random. What usually gave it away was that a truly random sequence will have a lot more sequential repetition, i.e., the number 4 might appear 7 times in a row somewhere. Most people trying to fudge a random sequence wouldn't type the same number 7 times in a row.
Jasper,
If I was running this scheme in Europe I'd run it out of Lux or Switzerland and add a tax avoidance (aka fraud)angle. That way, if anyone caught on, they would never report me to the authorities.
I bet tons of Europeans have been taken by fradulent tax avoidance schemes but they never report it.
How about any firm's executive caught making up financial statements "out of whole cloth" get the Saudi-style punishment, cut off their hands instead of 5 years of minimum-security, white collar resort prison? I can imagine that the threat of amputations would make then think TWICE about it?
One additional point: I've heard a lot of people make the claim that Madoff's malfeasance should have been discovered because of his unrealistic returns. But hasn't Warren Buffett also enjoyed long strings of years when his portfolio made year after year of double digit returns? I'm aware Berkshire is public, so you just have to look up the components he owns to know it's all legit, but my guess is Madoff's fund's "performance" didn't look all that implausible, given the multi-year success we occasionally see from Wall Street's brighter lights (Peter Lynch comes to mind as well). Obviously what the SEC should have done was to require Madoff to show in detail exactly how such returns were earned. Apparently they didn't.
Jasper,
Also, keep in mind that for many of the years in question, Bernie was underperforming the market. His returns were never above 13% a year - so in those years (1999 for example) when the S&P was up 25% and Bernie was only up 10% that would tend to confirm that he had figured out a way to stablize his returns.
OK, I'll admit this is a troll, but . . . Caroline Kennedy for NY Senate is fairly clearly payoff for the family's support of Obama. Is traditional quid-pro-quo politics really all that different than what Blagojevich did?
eric k: Didn't 4 of the last 8 Governors of IL end up in Jail? I'd say they didn't get away with it.
What about the other four — did they get away with it?
a truly random sequence will have a lot more sequential repetition, i.e., the number 4 might appear 7 times in a row somewhere.
Yes, this is loosely the same statistical reasoning behind the notion that if the sample size is large enough, then it's almost a certainty that some individuals will consistently outperform the market.
Jasper,
There are a couple of big hedge fund groups that have racked up spectacular returns for years, e.g., SAC Capital and Renaissance Technologies. I don't know of any allegations of fraud related to them (though I imagine they'll face a little more scrutiny now).
When I was less than half my current age, young and foolish, I stole both a very large decorated Christmas tree and an ice-cream sundae bar (on separate occasions) from a dining hall. Advice that worked then to my helpers, who were confused on how we'd sneak the thing out: you don't. Just do it in front of everybody like it's the most natural thing in the world.
It's been quite a while but I once worked in operations and compliance for a few brokerage firms. Audits routinely traced random trades from customer statement back to an original time-stamped order ticket and proof of execution. I know there is a lot less paper involved nowadays but surely there is some kind of audit trail. The thing is that they can be faked. If Madoff was faking customer statements, he was certainly capable of faking an audit trail. Don't be so fast to blame the auditors, blame the crooks.
Bill,
If the other 4 were also crooked that means the odds are only 50/50 to get away with it:-)
"What about the other four — did they get away with it?"
Bill Woods,
It's possible that they got away with something, or they simply didn't do anything personally that rose to the level of illegality.
George Ryan's predecessors, Jim Edgar and Jim Thompson, had clean reputations for the most part (especialy Edgar), and while some appointees of theirs got in trouble with the law, both have managed to avoid getting the attention of the US Attorney's office during their political careers, and after they left political life.
Although Thompson was the subject of headlines during the trial of former Sun-Times publisher Conrad Black. It appears that Thompson, who was the head of Hollinger's audit committee, failed to do proper due dilligence in examining some of the fees that Black negotiated with buyers of various Hollinger newspapers; the deals that Thompson signed off on enabled Black to cheat his minority shareholders out of their share of profits from newspaper sales. In addition, Thompson's law firm provided pro bono legal work in George Ryan's defense during his corruption trial; Thompson's law firm even supplied Dan Webb, the former US Attorney for Northern Illinois who sent hundreds of Cook Country judges to jail on corruption charges during the 1980s, as Ryan's defense attorney. So maybe Thompson, who also is a former US Attorney for Norther Illinois and who put former governor Otto Kerner in jail on corruption charges, also has some shady actions in his past.
The late Richard Ogilivie also a reputation for honesty, which has remained unsullied to this day. Ogilivie, in fact, was too honest for a poltician; he recognized that Illinois needed an income tax in order to properly finance its state government, succeeded in getting Illinois to create a state income tax, and took credit and responsibility for the state income tax. Illinois voters rewarded this honesty by voting Ogilivie out of office after only 1 term as governor.
Ogilivie's successor, Dan Walker, did go to jail, but not on corruption charges. It appears that Walker was an honest, albeit incompetent, governor; he was simply a dishonest banker. Walker went to jail 10 years after he left the governor's office for bank fraud that he committed in his post-political career.
Having rules to detect when numbers have been made up don't really help all that much. If you know them, you can always create a computer program to create number sets that won't be flagged as fake.
So now that we know this is a ponzi scheme, can someone explain in detail, using numerical examples how Social Security is different?
Of course it's because all the other politicians are doing it. How do you think he came up with the specifics? Do you think he was smart enough to realize the capability of using charitable and non-profits as a quid pro quo, as a way of funneling tax dollars to himself? Why do you think the environmental lobby is so powerful.
Hell, I saw a woman at a rich (dying member willed gas leases to them) Unitarian Church, the Shelter Rock Church, who had headed their environmental group, placing funds with various groups, get rewarded when her term was up by being appointed a lucrative post at one of those environmental groups. It was straight quid-pro-quo.
So this sort of thing is rampant not only in politics but in non-profits. The salaries at non-profits are outrageous.
The SEC has a 100% record of missing fraud when they don't look for it. They received many credible tips that things were rather dodgy there and didn't look.
In other words while the proposition that massive fraud from page one is hard to catch may be true it does not apply in this case.
As a routine matter the books of all corporations are fraudulent as modern corporate accounting often makes Alice's Wonderland seem quite sensible. For the most part SEC enforcement, such as it is, amounts to picking out a sacrificial lamb when things go bad, doing a perp walk for show nd then 4 years later settling some fraction of the total, with the obligatory non admission of any guilt, and maybe, just maybe, sending the lamb to prison for several months.
When the story is big then the Lay's and Skillings and Ebbers of the world, the top guys, must be sacrificed. Now the story is too big as we have a systematic failure as the great investment banks and huge multinational banks are bankrupt. How can anyone be to blame for that if not everyone? They can't be so Hank Paulson is Secretary of Tresury.
All of the other politicians have gotten away with it.
So, is the thesis here that this was the result of something other than a lax and chummy regulatory environment? While I am sure that fits Ms Mcardles ideology much more nicely, it has little basis in reality.
If you just want a number seqence which will be virtually indistinguishable from random, don't bother searching for computer programs. Just pick up any big phone book for residential numbers. The next to the last and ante penultimate columns read downwards (or upwards) are it.
(Figured that out decades ago when Rand were chrging a mint for a book of a million random numbers.)
I had a random number generator on a programmable pocket calculator 30 years ago. Well, strictly speaking, it was a pseudorandom number generator, but likely good enough.
Something about the SEC letting Madoff slide since, at least, the last 2 years of Clinton's presidency reminds me of the line about GM and Toyota: GM gets mediocre results from brilliant people working crummy processes, and Toyota gets excellent results from mediocre people working brilliant processes. Of course, if it's a matter of process design rather than hiring, then most of the theses about how Bush somehow screwed up everything in the world are going to need revision. Given how many people would rather admit any possibility other than that, the lessons learned from this whole mess may be, unfortunately, quite limited.
Maybe Blago assessed that the investigations on him were such a small fraction of the stuff he's into that his chances of getting caught at any one next thing were very small.
"here's the question that really bothers me about Blagojevich: what if the reason that he thought he could get away with it is that a lot of other politicians he knows about have?"
I hope you will quickly understand, Megan, how ridiculously naive/ignorant that statement sounds.
I have to note that proper auditing would have detected Madoff's fraud rather easily. (I am not saying whose responsibility it was to conduct such auditing.) The firm reported to the SEC that it had $17 billion under management. As a broker-dealer, the firm was required to maintain relationships either with Depository Trust Company (DTC) or with another, larger broker-dealer or bank to hold its securities. (Securities no longer exist as pieces of paper.) Either DTC or the purported intermediate broker-dealer or bank would have confirmed or denied $17 billion in holdings.
The question about Gov. Blagojevich that I have (and that would certainly be asked if the incoming president was a Republican): Is it business as usual for the Gov. to seek payment for a senate seat and did the Gov. receive any payment for the 2004 seat?
What Blago did was up the ante for what is ALWAYS done. Check most cities and towns and you will find that those people looking for contracts from the city give generously to the mayor's reelection etc.
How do you think Gov Palin got her brand new house built by the same people that built the stadium she wanted? Quid pro quo in that game generally means help out my campaign and I will help out your business. Blago shifted gears and wanted to trade a position (senate seat) for money. I assume this shoddyh trade entered his mind because of an awareness of how contracts are dished out.
"...what if the reason that he thought he could get away with it is that a lot of other politicians he knows about have? "
"What if?" Blago, like every other professional politician, is in business to make money.
Still yet another justification of Mencken's call for selecting officeholders by lot and hanging them when their terms are done.
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I don't think that follows. One man in the right place with smarts and dedication might make a good process run a little better. Another man with no smarts and a terrible disregard for doing a job well might make that same process go completely sour. Iow, it's easy to really make a mess of things. The converse, to put right what once went wrong, is much, much harder. Even if you have a guardian angel.
The biggest lie being told is that they are "shocked" about Blago. Oh please give me a break.
I hope Blago goes down fighting.
Are we supposed to believe the Madoff was the ONLY person in the company who knew that the account statements, thousands of them, were false? Wasn't there at least a secretary who thought the whole thing must be wrong? His sons were doing something that could be described as "work." Didn't they know sonething was wrong, althought it is now in their interest to feign ignorance of the decades-long schene, while the elderly Madoff falls on his sword for the sake of the family and the fortune secreted in the Cayman Islands. Regarding Blogo, his sin was only that he was so brazen about bribes in a situation in which his rival, Richard Daley (with whom Obama is affiliated), was looking for a way to bring his down. Why else is wife being brought into this, described as a backstage Lady Macbeth with a potty mouth, while Blogo is described as a maniac or sociopath. The truth is that most "public servants" start with little and end up millionaires 20 years later. Coincidence? Selling a senate seat is only diffirent IN SCALE from the envelopes delivered city councilmen or state legislators for zoning decisions or legislative favors. Just think about the opportunities for boddle in any tax system, for example. Blogo's sin was doing this so brazenly that the rubes got a glimpse of it, thus endangering thle whole game.
I like your analogy of the journalism scandals. When you invent a quote, you run the risk that the person misquoted will complain. But when you invent the person altogether, there is no one to complain.
"On a somewhat related tangent, here's the question that really bothers me about Blagojevich: what if the reason that he thought he could get away with it is that a lot of other politicians he knows about have?"
Of course. Just like the reason Dan Rather thought he could get away with an obviously fake TANG memo (and still thinks he deserved to get away with it) was because journalists have been getting away with less obviously fake memos for years. I learned that rule in communications class... "If you need to enhance a narrative with documents from before the 1990s, always use a monospace typewriter font." There are a lot of other rules for "enhancing" narratives with forged documents; if it wasn't necessary to pretend journalists aren't trained to do so, there would be an entire department at Phillip Merril dedicated to it.
I'm surprised that some people are surprised at what Blago hath wrought. Never underestimate the level of corruption, self-dealing, horsetrading, and logrolling that goes on in ANY major city and/or state.
Of course a LOT of people get away with this in politics, they just may be a bit more subtle. Consider:
Barack Obama is elected to U.S. Senate in 2004;
in 2005 his wife gets a promotion and an annual raise of nearly $200,000, bringing her annual income to some $316,000;
in 2006 Obama obtains an earmark for his wife's employer for $1 million.
How is this any different from Blagojevich's actions? Why isn't everyone outraged about this quid pro quo?
The reality is that the SEC is way too busy setting up ridiculous and unhelpful regulations such as Reg NMS and Reg SHO and trying to monitor compliance and not enough time on bread and butter issues. Furthermore, their regulations are written with an intent to keep things open instead of clearly defining what is and what isn't allowed. That makes it possible for them to swoop in post facto and fine people things that are not really illegal or against SEC rules: witness the Mutual Fund timing scandal. They collected plenty of fines for something which though unethical was not illegal. The SEC hires lawyers right out of law school, trains them and then those very same people go off to work in big law firms trying to befuddle them. As currently constituted the SEC and the Self Regulatory Organization, FINRA will never be able to identify such crimes because they are outsmarted, outgunned and completely unfocussed on what is important versus what isnt. They need a back to basics kind of person to run the thing and a new esprit de corps in order to undo 30 years of anti-regulatory management mischief.