We know the SEC dropped the ball big time in the Madoff case. In addition to it having been the biggest scame in Wall Street history, the agency had warnings back in 1999, and there were more than a few people who publicly questioned the legitimacy of Madoff’s returns.
The Washington Post examines the question some more and comes up with a list of plausible answers:
- The man was a Wall Street pillar. He had been around forever, and he was friendly with the regulators. Even Arthur Levitt once praised him (and may have had money with him, though that’s not confirmed). Given his reputation, regulators may have just been blind.
- For several years, his investment business was not registered with the SEC, and even though he did eventually register in 2006, he may have still kept a part of the business unregistered. What’s more, the 2006 registration didn’t trigger any kind of automatic investigation.
See, the SEC tries to take a look at everyone at some point, but it has a way of prioritizing:
People familiar with the process said the SEC tends to focus on high-risk investment strategies, such as trading in derivatives. Lori A. Richards, director of the SEC’s Office of Compliance Inspections and Examinations, said that only 10 per cent of the 11,300 investment advisers registered with the SEC are examined on a regular basis — those with high-risk characteristics.
This isn’t the SEC’s fault necessarily. Like any regulatory agency it has finite resources and needs to come up with a way or prioritizing. But it’s not surprising that the SEC just didn’t know where the biggest risk would lurk, and so shose “high-risk investment strategies, such as trading in derivatives.” We missed signs of a coming banking crisis because it originating in housing — boring old housing! We’ve spent a lot of time debating the role of supposedly high-risk hedge funds, when in fact they haven’t exploded or caused much collateral damage. The best a regulator can do is come up with some crude notion for where the biggest risk lies, but really they have no idea. And if it’s a real black swan, it’ll be in the area they least expect it — not in some complex strategy but a guy who runs a Ponzi scheme consisting of his friends, old Florida retirees and sophisticated European private banks.