The full details of the financial crisis triggered by subprime lending had just about been absorbed, when the much-discredited financial system in the developed countries, especially the US, was hit by another quake. This was the mid-December revelation that one more of the venerated Wall Street figures, Bernard Madoff, and his investment firm, Bernard L. Madoff Investment Securities LLC, had indulged in fraud on a massive scale, leading to losses estimated by Madoff himself at $50 billion.

While the details are still being investigated, reports suggest that the fraud amounted to a straight-forward Ponzi scheme in which new capital raised was partly used to pay-off old investors, so that they could earn a stable and reasonable return, independent of fluctuations in the market. It was when Madoff could not continue doing this any longer that the plot was revealed. It was because markets slumped, investors sought to redeem their investments and new money was hard to come by, that the operation collapsed, resulting in bankruptcy and criminal indictment for Madoff and huge losses for his clients. According to reports, Madoff’s secret had to be revealed, when the company was faced in the first week of December with redemption requests totalling $7 billion from investors.

As the details of Madoff’s operations are being unearthed, the main question that is being asked is how he managed so successfully for so long to conceal their nature. The Madoff story is a mystery for a number of reasons. To start with, Madoff seems to have defrauded a large number of investors, dull and savvy, large and small. In fact, at the time of writing, close to $22 billion of the $50 billion in assets Madoff claims to have lost, has still not been traced to investors. Since Madoff’s fund outperformed the market, the stable return he promised attracted a wide range of direct and indirect investors, who appear not to have spent too much time trying to understand the method that underlay his success. Investors varied from banks like Santander, Bank Medici and HSBC, to fund managers like Fairfield Greenwich and Tremont Capital Management, to the pension funds of policemen in Fairfield, Connecticut and teachers in Korea. Indirect exposure was large because there were a number of Fund managers, who served as “feeder funds” for Madoff’s operation, mobilising money from clients and transferring the money to Madoff for investment.

That investors as diverse as these were all simultaneously fooled for so long is all the more intriguing because the investments made by some were huge. There are five identified investors with exposures of between $1 and $1.5 billion, another four in the $2.1 billion and $3.3 billion range, and one, Fairfield Greenwich, with an exposure of $7.5 billion, which is more than half of the assets of $14 billion it manages. With such large investments and high exposure, we should have at least expected these agents to have scrutinised Madoff’s operations and accounts closely. That they did not detect the fraud seems to suggest that the financial industry is not merely overcome with greed but is short of intelligence. Stable returns must be a cause for concern rather than the basis for comfort.

Even aside from the stable and reasonable returns offered by Madoff, there were other more obvious reasons to be cautious about investing in his firm. For example, despite his high profile as a successful broker-turned-investment manager, Madoff’s operations were audited by a small entity, Friehing and Horowitz, which reportedly employed just three people and had not been peer reviewed for a decade and a half on the grounds that it does not audit any firm. In addition, Madoff himself was known to be reserved and guarded about his activities. To choose to hand over millions or billions of dollars to an entity of this kind is downright foolish.

But it was not just individual investors who were foolish. Big banks set up “feeder funds” that mobilised capital to be invested through Madoff as well as lent large sums to these funds so as to make leveraged bets on Madoff. Moreover, leading accounting firms like PwC, KPMG and Ernst & Young that audited these feeder funds did not detect the fact that Madoff’s operations were, in his own words, “one big lie”. Thos who were fooled included some of the best in the businesses, who are normally presented as being too well informed and too savvy to indulge in speculative investments without knowing that they are doing so. Not everybody was fooled, of course. Deborah Brewster of the Financial Times (December 12, 2008) quotes Thorne Perkin, a Vice President at Papamarkou Asset Management, as saying: “In the past few years at least half a dozen smart, sophisticated people have come to us and asked about investing with Mr Madoff. We looked into it and didn’t invest mainly because we could not understand how the returns were arrived at, and we do not recommend investing where we cannot work out where the returns come from.” But such advisers seem to be more the exception than the rule.

This only strengthens the view that financial markets cannot be left to themselves on the grounds that they know best and those seeking to regulate these markets and institutions cannot be equally well informed, making self-regulation the better alternative. The Madoff scandal is not only one more confirmation that the so-called “model” financial markets of the US are neither transparent nor efficient, but also proof that so-called savvy investors can either be thieves or fools. This would not matter so much if their activities and their effects were confined to a private world of the rich. But if either directly because of the exposure of institutions like pension funds and indirectly because of the systemic effects (transmitted through excessively exposed banks and corporations) of the failure of institutions like Madoff Investment Securities, the ripple effects are economy wide, regulation recommends itself.

Unfortunately, the Madoff episode is one more indication of the adverse consequences of diluted regulation. Christopher Cox, the Chief of the Securities and Exchange Commission in the US has been quoted as having confessed that ““over a period of several years, nearly a decade, credible information was on multiple occasions brought to the agency, and yet at no point taken to the next step.” Madoff’s methods, which included maintaining false documents and disclosing information that was wrong was not detected but declared by Madoff himself. This is despite the fact that the SEC reportedly had launched two investigations, as recently as in 2005 and 2007, into the investment adviser’s operations.

Faced with criticism, the SEC has decided to launch an internal investigation into how its systems failed to detect the fraud. The difficulty is that even while there is recognition now of the need for intervention, the emphasis is more on intervention to reduce losses and limit systemic effects. There are no signs of commitment to fundamentally revamp or overhaul the regulatory system. While everyone now admits that the regulatory system has failed and markets do not work well, the desire to design a regulatory structure that minimises failure seems absent. This can only be because financial interests are strong enough to win a bail-out with tax payers’ money and yet prevent adequate scrutiny and control.

January 1, 2009.