Sunday, September 6, 2009

L'Affaire Madoff I: A Night to Remember

Late in the evening of April 14, 1912, everything that could possibly go wrong did and 1,517 people lost their lives. The story is well known: the RMS Titanic was on its maiden voyage across the Atlantic. It was a dark, moonless night, and the crew in the crow’s nest didn’t have binoculars (in an oversight, they hadn’t been loaded on the ship). An iceberg in the ship's path wasn't spotted in time. The ship turned to avoid it, but scraped against it, causing the iceberg to slice through several of the ship's water-tight compartments that supposedly made it unsinkable. If the ship had been going more slowly, it could have made the turn without hitting the iceberg. If it had been going more quickly, it would have hit the iceberg dead on. While still suffering damage, it likely would have remained afloat.

Error piled on top of error. The ship didn't have enough lifeboats to evacuate all of the passengers and crew. Many of those that were launched were not full because passengers refused to believe the ship could sink. The nearly Californian ignored Morse Code, signal lamp and rocket flare distress calls.

I was thinking of this as I read the SEC Inspector General's report on the agency's investigations of Bernard Madoff. (Full disclosure: I was on a panel with Madoff at a conference at Baruch College in 2001. That's the only time I met the man. Honest.) The full report runs 477 pages (I confess, I just read the executive summary. It was enough).

Although the Inspector General finds no SEC personnel had directly attempted to influence the investigations, the SEC did not perform a thorough and competent investigation. This was despite receiving six substantive complaints and the SEC's awareness of articles in "reputable publications" that questioned Madoff's investment returns.

The report states that the most of the evidence appears to support a conclusion that Madoff had been operating a Ponzi scheme since at least 1992, and the SEC had an opportunity to detect it as far back as then. There were a number of factors listed as to why the investigation was botched for so long.

  • Most of the investigative staff was very junior with limited training and experience. Often they were litigators with little experience with equity and derivative trading. The first complaint from Harry Makropolos (who eventually testified before Congress of his attempts to get the SEC to investigate Madoff) was not acted on because the Boston District Office's Assistant District Administrator didn't understand the information he presented. Madoff frequently gave evasive and inconsistent answers to questions that were not followed up.

  • Madoff would try to intimidate the examiners. He would let them know that he knew senior people at the SEC. He told them Christopher Cox would be appointed SEC Chairman several weeks in advance of the appointment, and said that he (Madoff) had been on the short list for the position.

  • Although complaints specifically raised the possibility that Madoff was operating a Ponzi scheme, the SEC never focussed on that, even after it learned that the "Madoff's well-known market-making business would be losing money without the secretive hedge fund business." One was focussed on front-running because "that was the area of expertise for [the investigation] crew." Another focussed on whether Madoff should be required to register his hedge fund with the SEC and whether his disclosures to investors were adequate (they weren't, of course, but they appeared to be).

  • Little effort was made to obtain third-party verification of the hedge fund's holdings and trading. When the few that were made uncovered more red flags, they were ignored. After the fraud was exposed, it took only a few days to confirm that Madoff had not used any of the investors' funds to make trades.

  • One investigation was terminated before it was completed. This often occurs as enforcement priorities shift.

  • There seems to be a serious problem of silos at the agency. The Office of Compliance Inspections and Examinations' broker-dealer group (who were in charge of the investigation) did not request assistance from the investment adviser group. At one point, the OCIE and the SEC's Northeast Regional Office were conducting separate investigations unbeknownst to each other. After they discovered the overlap (due to Madoff telling one team he had already given the SEC the information they were requesting), there was little effort to compare notes. The investigators asked the SEC's Office of Economic Analysis for assistance in reviewing Madoff's trading, but did not provide copies of the detailed complaints about that trading. After 2 1/2 months, an OEA expert on options trading concluded that Madoff's purported "split-strike" trading strategy would not be expected to "earn significant returns in excess of the market." This analysis was never passed on to Enforcement staff.

  • Madoff used the fact that he had been examined by the SEC as a marketing tool to convince reluctant new investors they should invest with him.

One bright spot of the Titanic tragedy was that the various inquiries, coupled with public outrage, brought changes that made travelling by ship much safer. We can only hope that the SEC will learn the lessons of the OIG report and we won't see someone outdo Madoff.

Some Weekend Reading

There were two interesting articles in today's New York Times. On the front page was "Wall Street Pursues Profit in Bundles of Life Insurance" by Jenny Anderson, reporting on new products Wall Street is creating that sound a lot like the old products that got us into this mess. Interestingly, some of the firms have approached DBRS for a rating. DBRS was the only firm that would rate asset-backed commercial paper with so-called Canadian-style market disruption clauses (which provided that a liquidity guarantee was only provided if commercial paper could not be issued at any price by any issuer). The freezing of the ABCP market in 2007 was Canada's equivalent to the subprime fiasco in the U.S. Although DBRS subsequently stopped rating the paper, the Canadian Securities Administrators are considering whether greater oversight of credit rating agencies is required.

The second, in the magazine, is "How Did Economists Get It So Wrong?" by Paul Krugman. It details the internecine fights among schools of economists (the "saltwater" and "freshwater" economists) and concludes that a belief that markets are always efficient and will always find the correct balance are mistaken.