No One Would Listen: A True Financial Thriller (50 page)

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Authors: Harry Markopolos

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Our current regulatory system was cobbled together in the 1930s, and the financial industry of that period had absolutely no resemblance to what exists today. But regulators in many cases are still bound by the basic structure created at that time and just don’t have the tools to deal with financial institutions magnitudes larger than those that existed decades ago. Unfortunately, these agencies have to confront gigantic “too big to fail—too big to succeed—too big to regulate” multinational corporations like Citigroup, Bank of America, American International Group, and all the others. While these companies once were vertically oriented (they operated within a certain narrow field), now they may have subsidiaries operating banks, insurance companies, mortgage lenders, credit card companies, money management arms, investment banks, and securities broker-dealers, and they’re operating both domestically and internationally. Relying on several separate regulators working independently to spot problems is like trying to rein in a beehive with a chain-link fence. If the SEC can’t coordinate two examinations within its own agency, there is little reason to believe that five separate agencies can successfully coordinate their examinations.
It seems to me that the existence of so many financial regulators leaves gaping holes for financial predators to engage in what I called regulatory arbitrage. They find those regulatory gaps where no agency is looking or there is some question about which agency has the oversight responsibility, and they exploit them. I’ve seen corporations in which employees have two very different business cards. One card identifies them as a registered investment adviser, which falls under SEC regulation, while the other card has their bank title, which falls under the control of banking regulators. It’s a very clever ploy: When the Federal Reserve comes in to question them, they claim to be under the SEC’s jurisdiction, and when the SEC shows up, they explain they’re under the Fed’s jurisdiction. If both the Fed and the SEC were to show up to search for fraud in the company’s pension accounts under management, that company could claim, “I’m sorry, but those are Employee Retirement Income Security Act (ERISA) accounts and they fall under the Department of Labor, so unfortunately you don’t have jurisdiction.” Obviously this structure allows firms to play regulators against each other, and literally to choose to be regulated by that agency least likely to pose any problems.
The objective should be to combine regulatory functions into as few agencies as possible to prevent regulatory arbitrage, centralize command and control, ensure unity of effort, eliminate expensive duplication of effort, and minimize the number of regulators to whom American corporations must respond.
It seems logical to me that one super-regulatory agency be formed, perhaps called the Financial Supervisory Authority (FSA). It should have all of the security and capital markets and financial regulators underneath it. To simply command and control, to ensure unity of effort and eliminate expensive duplication, I would place under its command the Fed, the SEC, a national insurance industry regulator, and some form of Treasury or Department of Justice law enforcement entity with a staff of dedicated litigators responsible for carrying out both civil and criminal enforcement for those three combined agencies. All banking regulators should be merged into the Fed, so that only a single national banking regulator exists. Pension fund regulation should be moved from the Department of Labor to the SEC. The Commodity Futures Trading Commission should be brought into the SEC, which would then become the sole capital markets regulator.
To ensure the highest degree of coordination, this super-agency would maintain a centralized database, a super-duper CALL center so that the details of any enforcement action by one agency would be online for all the other agencies to see and utilize. Spread the knowledge, share the experience, be bigger than the biggest bad guys. Bernie Madoff got caught for the first time in 1992, but apparently none of the investigators after the turn of the century knew about it. Cross-functional teams of regulators from the SEC, the Fed, a national insurance regulator, and the Treasury or Department of Justice should be sent together on audits whenever possible to prevent regulatory arbitrage. The SEC, the Fed, and the national insurance regulator would be responsible for the inspections, while the Treasury or Department of Justice would be responsible for taking legal action against offenders. American businesses need and deserve a simple, easy-to-follow set of rules and regulations, and they deserve to have competent regulation. Financial institutions currently pay high fees to support regulation, but neither they nor the public are getting their money’s worth.
Thirteenth (lucky thirteen), take away the “Get out of jail free” cards.
Right now there is no accountability in government. None. Following the accounting scandals that led to the demises of Enron, Global Crossing, WorldCom, Adelphia, and the others, Congress passed very strict laws that held corporate CEOs and CFOs accountable for their companies’ financial reporting. Under the Sarbanes-Oxley Act (SOX), these leaders can no longer claim that they don’t know what is happening in their companies. If a CEO and CFO has signed off on a company’s books, he or she has assumed responsibility for the numbers; if those books are materially inaccurate, this officer faces a 10-year prison sentence. (That has gotten their attention.) And if they have been willfully cooking their books, they face a 20-year sentence.
I propose that Congress pass legislation that holds agency heads responsible for the successes or failures of their agency under their watch. If an agency falls to enforce laws passed by Congress, then the head should be referred to the Justice Department for criminal prosecution. It is a disgrace that the regulators charged with overseeing the financial industry have gotten away scot-free. At the SEC a few of the department heads were allowed to resign “to pursue other growth opportunities,” called “pogo-ing out,” often to well-paying positions in private industry. It would be satisfying to see a few of these people sent to prison for their willful blindness in allowing our nation’s financial system to collapse; unfortunately, there are no laws on the books that make that possible. Entire government agencies can remain comatose, letting the industries they are charged with regulating commit crimes without any fear of being penalized for it.
A similar SOX making agency heads responsible for the failures of their staff would also go a long way toward eliminating so-called regulatory capture, a situation in which the regulators become beholden to the industries they supposedly are regulating. The mission of the SEC is to protect investors, but in reality it ended up serving the needs of deep-pocketed and influential industry firms.
Fourteenth, publicly censure the SEC.
Clearly the SEC has been unofficially censured. Its reputation is in tatters, its employees have been shamed. Obviously no one can take pride in being an employee of the SEC. But maybe we should make that embarrassment official. One way to light a bonfire under agencies that are under-performing or non-responsive to Congressional oversight is to publicly censure them. Call them out. Identify them for what is, a national disgrace. Then force that agency to include that censure in every communication sent out by employees—for a predetermined amount of time or until the agency proves it has rectified its problems. This is a low-cost but effective means for Congress to publicly express its displeasure over the lack of regulatory action. No one, absolutely no one, enjoys playing on a losing team.
Fifteenth, regulate and give investors some guidelines.
Bernie Madoff didn’t just steal billions of dollars; he exposed the lack of government supervision of the financial industry to a public that had already been badly burned. Madoff is already a tragedy. It would be an even larger disaster if we didn’t take the steps necessary to create fair and transparent markets.
For example, the over-the-counter (OTC) market is unregulated space. It’s where the financial industry’s cockroaches congregate, because it is a place where there is no light, only darkness. And perhaps not coincidentally, this is also where the industry’s highest margins exist, so people will fight like Mike Tyson to protect their profit margins.
That needs to change. Laws should be passed to prevent American investors from trading OTC products offshore and still receive government protection in the form of bailouts. In other words, there should be no more trading through unregulated entities like AIG’s London-based Financial Products unit, where the risk ends up getting transferred back onshore and U.S. taxpayers end up footing the bill. It seems only fair and logical that if American regulators don’t have visibility into an OTC product traded offshore, then strict risk and capital limits should be placed on U.S.-based counterparties in order to avoid systemic risk.
You can’t regulate common sense, but some sort of guidelines should be available to investors on the SEC’s web site, pointing out that if you don’t know how to model an OTC derivative yourself, then you, your company, or your municipality shouldn’t be trading them. The SEC should closely investigate all disclosures in the OTC municipal derivatives market, because this sector of the marketplace is just rife with fraud. In many instances it is still a pay-to-play market with opaque disclosure documents and even more opaque pricing mechanisms, which only serve to defraud government entities.
I have seen the state of Massachusetts lose $450 million because no one in state government knew how to price interest rate swaptions. The Massachusetts Turnpike Authority was picked off by several Wall Street firms because they were lured into OTC transactions in which they didn’t understand the pricing or the risks.
Once again, you can’t regulate common sense, but we can regulate the OTC markets so they no longer remain outposts of lawlessness. More regulation can only come from the federal government. History has now taught us that we need to shed light on those dark places in our capital markets. Everybody deserves full transparency when they are dealing with investments, and it’s up to the government to provide it.
Appendix A
 
Madoff Tops Charts; Skeptics Ask How
 
Michael Ocrant
 
 
 
 
 
 
M
ention Bernard L. Madoff Investment Securities to anyone working on Wall Street at any time over the last 40 years and you’re likely to get a look of immediate recognition.
After all, Madoff Securities, with its 600 major brokerage clients, is ranked as one of the top three market makers in NASDAQ stocks, cites itself as probably the largest source of order flow for New York Stock Exchange—listed securities, and remains a huge player in the trading of preferred, convertible and other specialized securities instruments.
Beyond that, Madoff operates one of the most successful “third markets” for trading equities after regular exchange hours, and is an active market maker in the European and Asian equity markets. And with a group of partners, it is leading an effort and developing the technology for a new electronic auction market trading system called Primex.
But it’s a safe bet that relatively few Wall Street professionals are aware that Madoff Securities could be categorized as perhaps the best risk-adjusted hedge fund portfolio manager for the last dozen years. Its $6-7 billion in assets under management, provided primarily by three feeder funds, currently would put it in the number one or two spot in the Zurich (formerly MAR) database of more than 1,100 hedge funds, and would place it at or near the top of any well-known database in existence defined by assets.
This article was originally published in
MARHedge
magazine (No. 89) in May 2001. Reprinted with permission of Institutional Investor.
 
More important, perhaps, most of those who are aware of Madoff’s status in the hedge fund world are baffled by the way the firm has obtained such consistent, nonvolatile returns month after month and year after year.
Madoff has reported positive returns for the last 11-plus years in assets managed on behalf of the feeder fund known as Fairfield Sentry, which in providing capital for the program since 1989 has been doing it longer than any of the other feeder funds. Those other funds have demonstrated equally positive track records using the same strategy for much of that period.
Lack of Volatility
 
Those who question the consistency of the returns, though not necessarily the ability to generate the gross and net returns reported, include current and former traders, other money managers, consultants, quantitative analysts and fund-of-funds executives, many of whom are familiar with the so-called split-strike conversion strategy used to manage the assets.
These individuals, more than a dozen in all, offered their views, speculation and opinions on the condition that they wouldn’t be identified. They noted that others who use or have used the strategy—described as buying a basket of stocks closely correlated to an index, while concurrently selling out-of-the-money call options on the index and buying out-of-the-money put options on the index—are known to have had nowhere near the same degree of success.
The strategy is generally described as putting on a “collar” in an attempt to limit gains compared to the benchmark index in an up market and, likewise, limit losses to something less than the benchmark in a down market, essentially creating a floor and a ceiling.

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