“Wall Street” finance

When news broke of Bernard Madoff’s alleged $50 billion worldwide Ponzi scheme, news accounts first protrayed him as a shadowy hedge fund manager outside the scope of regulation by the Securities and Exchange Commission. But as the sheer magnitude of the fraud became clearer, so did the picture of Madoff’s place in the Wall Street-Washington world.

Madoff’s businesses were actually subject to a variety of financial regulations, something Madoff would actually use as a selling point to investors. Last year in a speech, Madoff said, “In today’s regulatory environment, it’s virtually impossible to violate rules.” He registered as an investment adviser in 2006, and had been under the SEC’s extensive regulatory framework for securities broker-dealers since he founded his firm almost 50 years ago.

And far from being a shadowy figure, Madoff was a pillar of the financial establishment. He showered campaign contributions on politicians, mostly Democrats. He was also quite chummy with many of the financial regulators charged with overseeing him.

For instance, Clinton administration SEC Chairman Arthur Levitt, who has championed onerous mandates like the burdensome Sarbanes-Oxley accounting mandates to preserve “market intergrity,” appointed Madoff during his SEC tenure to what the New York Times describes as “a large advisory commission … that explored the rapidly changing structure of the financial markets.”

An even closer connection was SEC assistant inspections director Eric Swanson who, according to CNBC reporter Charles Gasparino, “was part of the team that examined Madoff’s brokerage firm” in 1999 and again in 2004. “During those exams, the SEC team said it found almost nothing wrong,” Gasparino writes in The Daily Beast. In 2007, after leaving the SEC, Swanson married Madoff’s niece Shana, who is the regulatory compliance attorney at her uncle’s firm

While there is no evidence of wrongdoing with regard to Madoff by either Levitt or Swanson, SEC officials, for whatever reason, looked the other way, despite numerous allegations and “red flags,” some received as early as 1992. And since 1999, rival investment manager Harry Markopolos had sent the agency detailed analysis of why he though Madoff consistent postive returns were mathematically impossible without running a Ponzi scheme or insider trading. In a 2005 submission he made to the SEC that was recently made public by the Wall Street Journal, Markopolos charged that it was “highly likely” that “Madoff Securities is the world’s largest Ponzi scheme.”

But despite the SEC’s incompetence in heeding these warnings, many are still arguing that to prevent future Madoff-type frauds, we need more regulations that give more power to the SEC. But it’s hard to see how any additional powers could have made a difference in this case, given that the SEC almost seemed determined to look the other way for violations of the most basic rules against securities fraud that had long been in place.

Since hedge funds were among Madoff’s clients (and biggest victims, as this WSJ editorial points out), calls are again being intensified for further hedge fund regulation to bring them under the cumbersome registration process for investment advisers. (The SEC already has full authority to investigate hedge funds and other unregistered investment entitities if there are suspicions of fraud.) This is what the agency tried to do a few years ago, only to have a three-judge federal appeals court panel throw out the rule in 2006 in a unanimous finding that the agency had stretched the law.

But the SEC can’t argue that this would have helped them prevent Madoff’s fraud, because, as noted above, Madoff had registered as an investment adviser in 2006, and was registered as a broker-dealer for decades.

This broker-dealer registration gave the SEC full power to investigate all affiliated businesses. As MarketWatch commentator David Weidner pointed out (in a column with a curious headline about “lack of regulation” that is the exact opposite of the author’s point — often columnists, unlike bloggers, don’t wite their own headlines), “Broker-dealers are supposed to be the most scrutinized of the investment community. If Madoff was running separate businesses, the SEC and FINRA should have been looking at all of them as a whole.”

In fact, the fact that Madoff was under such heavy regulation probably helped him in constructing the alleged facade. As business reporters Binyamin Appelbaum and David S. Hilzenrath wrote in their perceptive Washington Post article, “the fraud Madoff allegedly constructed was successful in part because it avoided the appearance of risk.” The article quoted an expert as saying that SEC regulators “had to make judgments, and they decided to look at derivatives, short sales, insider trading, all the things that Madoff never had.”

So The SEC was too busy hounding unregistered hedge funds, short-sellers, and entrepreneurial companies for trivial minutiae from Sarbanes-Oxley and other mandates to notice the fraud right in front of them. The regulators didn’t just “drop the ball,” as President-Elect Barack Obama recently asserted. They lost focus on where the most important “ball” was.

Getting that “ball” back by paying attention to warning signs about where the real fraud is, and rolling back the mounds of red tape on honest investors and entrepreneurs that also wastes the time the agency has to go after the real problems, must be the number one priority of newly designated SEC chairman Mary Schapiro.