An exchange with a reader reveals that what he got from this post was not the possibly interesting theory that blatant fraud maybe harder to uncover than envelope pushing, but that I'm excusing the SEC. I'm not. It's early days yet, but I'm going to go ahead and assume that at least several people at the SEC deserve to be fired for their pitiful oversight. Similarly, I think it was perfectly just to fire Howell Raines over Jayson Blair.
That outright fraud is hard to detect doesn't mean that it's okay to let it go undetected for decades. It's hard to know exactly what one could have known, in another's place; hindsight bias is damn-near overpowering. But I'm going to go ahead and say that both the SEC should have known that a firm with a tiny audit firm and no outside custodian needed a very hard second look.
So it's not by way of excusing the SEC or the fund managers who didn't pick it up; not at all. I'm just interested in the theory that it might actually be harder to detect outright fraud than "aggressive" accounting or financial structuring. The aggressive have to work with the stubborn material of relaity, and there is a limit to how far they can bend it to their will. The fabulist, on the other hand, can cut "reality" to suit.
Consider some of the most famous frauds of the last few years. Compare Michael Bellesiles to Stephen Ambrose and Doris Kearns Goodwin, for example. It was much, much harder to convince people of Bellesiles' guilt--in part, yes, because he was closer to the establishmen than Ambrose and Goodwin, but also in part because it was so hard to check his sins. Ambrose and Goodwin had text that was easily compared with other texts. Bellesiles had counts that only he had ever done of often imaginary archives located in out-of-the-way places. Indeed, had he confined his fraud only to imaginary archives, he might never have been caught.
Or think of Jayson Blair, Stephen Glass, Jack Kelley; the latter two got away with their crimes for years. As long as they faked their notes, there was no one to complain. The longest and most successful fraud was committed by Jack Kelley, who was also the most total fabulist--but careful to make the "events" he wrote about occur in remote, hard-to-check locales, with sources and quotes that were just slightly too good, rather than outright unbelievable.
Think of Worldcom, with its outright fraud. Some analysts could, and did, think there was something wrong about Enron--its off balance sheet activity was multiplying too fast. Enron was brought down by those fears, which trashed its credit and thus destroyed its ability to trade. But Worldcom didn't get fancy with special purpose vehicles; they just flat out claimed that their operating expenses were actually investment, like you classifying your electric bill as an investment in the electric utility. They created an entire reality with their estimates that internet usage was doubling every nine months. They were brought low not by crack outside investigators, but because the holes in their cash flow became too big to hide, and their own internal auditors spotted the problem.
It seems to me that Madoff falls into that same category, and that he was so successful because, like Jack Kelley, he kept his fraud modest. He didn't produce spectacular returns--he underperformed the market when it had a good year. What he did was produce unbelievably steady returns. His fund was just slightly too good to be true. And because he was in a position to create, with his trading firm, a complete alternate reality for investors, it took a long, long time to catch him.
There were red flags; that doesn't mean that the fraud couldn't be detected. It just meant that it was less likely to be detected before serious money was lost. Which is probably a valuable guide to making this sort of thing less likely in the future.
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Christopher Cox obviously thinks the SEC didn't do a good enforcement job:
He didn't produce spectacular returns--he underperformed the market when it had a good year.
I wonder if that underperformance was because he was trying to get back to par? I don't think there's any chance that Madoff has been running a Ponzi scheme for as long as he's been on Wall St -- so it's going to be very interesting to hear when he made the decision to falsify (probably, like many embezzlers, with the initial plan of making good eventually when his luck turned around), and then how it morphed into a full blown Ponzi scheme once the possibility of a trading windfall making things right receded into impossibility. Maybe I'm wrong -- maybe he was a brazen sociopath from the beginning -- but I doubt it.
The lesson here seems to me that even the most prominent, the most highly-respected, when faced with the decision of cheating or losing it all (the position, respect, money) will decide to cheat with some real probability. In fact, those who have risen to such positions have done so because they wanted it SO BADLY and were willing to commit so much to get there. So it's no surprise they might be willing to cut corners to hold on.
The 'most trusted names on Wall Street' need to be watched like hawks.
I think the issue is that you and others are focusing on the bad apples, when the issue really is systemic. This also echoes the torture debate. Yes, Madoff was a bad apple. He was enabled and encouraged by the buddy network, and used imbalanced information to screw people. This is always the result of unregulated markets.
There is simply no excuse for the fund-of-fund managers who placed client money with Madoff. These people should be out of the business in disgrace, and one would hope some of the lost client money can be clawed back from the fees they have collected. These fund managers took huge amounts of money for nothing more than not being complete idiots, and they turned out to be complete idiots.
I think MM is spot on here about fabrication versus embellishment and that the analogy with journalism is enlightening. The implicit comparison between Horlick et al's respone to Madden and Raines's blustery self-righteousness is quite appropriate, as is the widespread scorn they have elicited in response.
If what Madoff did represented a systemic problem, we wouldn't have a financial system to worry about.
Wallyz,
In what sense was the market unregulated? There was an appalling lack of due diligence by fund managers whose job includes making sure they aren't investing in complete frauds, but what Madoff did is more than just break regulations. He will get big jail time.
This is always the result of unregulated markets.
This is a highly regulated market -- but the regulators totally screwed up. Madoff was referred to the SEC years ago, and the SEC failed to pursue it.
As others have noted, this occurred in a highly regulated market. But so did the other financial schemes Megan mentioned -- Enron, Worldcom, etc. I think the lesson is, fine, regulate, but recognize that doing so will never negate all fraud. That's partly because the regulators are human, and partly because fraudsters will find cracks in any system.
One correlation is that more regulation is frequently NOT the answer to a problem like Madoff -- certainly not without careful analysis and testing, the sort of thing that Congress so blatantly did not do when it passed Sarbox.
Wallyz--I would love to hear how this Madoff incident "echoes the torture debate." That aside, I'm also curious how a regulatory regime in which regular disclosure to the public or contractual counterparties and investors and effectively kicks you out of the game for life if you violate any of the rules systemically *encourages* behavior like Madoff's. As others have pointed out, Madoff's industry is pretty heavily regulated, so it's pretty tough to say that Madoff was actually more likely to engage in fraud under our current system than in a truly unregulated market. Then again, perhaps you think that a regular reporting requirement increases the pressure to falsify reports?
Perhaps you mean to say that, instead of being encourage, Madoff simply wasn't sufficiently deterred from engaging in fraud. If that is the case, you ought to have some sort of answer for this question: What level of fraud is acceptable to you, and how much are you willing to pay (think detection, enforcement, regulatory burdens on non-fraudulent productivity, etc.) to achieve that result?
have you talked to risk management folks? to hedge fund managers? investment bankers?
they all knew madoff and then all knew he was a fraud.
that's where the issue is bigger than a bad apple. all sorts of people knew and yet the sec did nothing.
so it isn't true that the out and out fraud was difficult to spot. the players all knew the score--and didn't care.
I think that we might be able to stipulate a difference between de jure and de facto regulation. Having the laws on the books doesn't mean someone is actually enforcing them.
It seems apparent that the SEC was tipped multiple times to Madoff and did nothing about it. All the regulations on the books meant nothing here, since the SEC sat with their collective thumbs in someplace extremely dark.
Oofff, I hate when I don't close my tags.
I had forgotten about Michael Bellesiles. I wonder who did the peer review on his book.
Perhaps the more something is regulated, or is perceived to be regulated, the less due diligence will be done by "ordinary folks?"
Heck, Ma, I read the FBI is all over those scams from Nigeria, so the fact that this e-mail says
"This offering complies with all U.S. Treasury, Interpol, and Dept. of State regulations." must make it legit.
And now a word in support of Bernie Madoff...
Well, not exactly, but I think one reason he could pull this off as others could not is that for many many years he was one of the GOOD GUYS.
I was in financial markets journalism from the late 1980s through the late 90s. The Madoff family (Bernie the trader and Peter the philosopher) were always at the vanguard of pushing for market transparency and using technology to improve the trading process (cf. Cincinnati Stock Exchange). And Bernie was president of NASDAQ. No rogue hedge fund manager he, but part of the equity trading establishment, though at the edgy end.
So the Madoff tragedy is more classical than most realize. Yes, many lost money and many were foolish, and we may never know what demons he dealt with. But he is no ordinary crook. Dare I say Nixonian in his complexity?
The interesting thing is that he could have got away with it.
Right now, major funds are crashing left right and centre. All he had to do was claim he had bet wrong on subprime and sorry, all the money is gone.
Do that the same week that Bear Stearns went down, and he might have walked.
Regulation worked just like its supposed to.
The major purpose of regulation is to keep out the competition so as to help the fat-cats get ever fatter.
All he had to do was claim he had bet wrong on subprime and sorry, all the money is gone.
Is this really the case? It seems shockingly implausible. Don't fund collapses prompt at least some investigation from the SEC? If not, anybody running a hedge fund could abscond with billions of dollars and blame it on a bad bet.
I wonder if that underperformance was because he was trying to get back to par? I don't think there's any chance that Madoff has been running a Ponzi scheme for as long as he's been on Wall St -- so it's going to be very interesting to hear when he made the decision to falsify (probably, like many embezzlers, with the initial plan of making good eventually when his luck turned around), and then how it morphed into a full blown Ponzi scheme once the possibility of a trading windfall making things right receded into impossibility.
I bet we'll see a bunch of these over the next couple of years - and specifically, money market mutual funds which fudge the numbers to avoid 'breaking the buck'. They will pretend the fund is still worth a full dollar per share, pretend to have slightly worse than normal returns once interest rates recover, once they really get back to a dollar they'll hope no one finds out. A few will find themselves around $0.90 or so, and won't be able to make up the difference before someone audits them. (I suspect a few others will or already have baldly 'self-insured' by openly topping the fund up from the firm's own equity to cover the loss, esp. if it is only a cent or so.)
WHOA, WHOA -- putting people like Ambrose and Goodwin, who had several failures to attribute (and none that I know of shown to be intentional or with any possible motive for gain) with people who outright made up stories for gain or to avoid doing work? Making an attribution mistake is not fraud; on a wide scale, it could be plaigerism, but in smaller quantities, it's just an embarassing mistake. Very unfair to make these comparisons.
We need to be able to make distinctions better. I recall that Zoe baird hired two illegal immigrants who lived on-site. Thereafter, people with a one-day-a-week illegal cleaning woman was said to have a "Zoe Baird" problem.
Eliot Spitzer prosecutes prostitution rings in which women are trafficked and effectovely held as slaves, and is said to be a hypocrite for seeing a willing, educated, high-priced woman.
Fraud problem, illegal immigrant problem, sex crime problem? They are not the same.
On the subject of making things up, the media often misquotes people, and then unless it's significant will not print a correction. So it's worse to make up stories about fake people than to mischaracterize facts about real people.