As Bernie Madoff goes to his reward today, we should be asking how this could have happened. Not only Madoff and Allen Stanford, but also dozens of “mini-Madoffs” have been unearthed since the market collapse in September and October, which seems to have reminded the SEC that it has an law enforcement function. Not surprisingly, regulators are ramping up their enforcement divisions, and Congressmen are planning legislation to increase enforcement budgets.
A little late to close the barn door.
While Christopher Cox, SEC chairman from 2005 until this January, makes an obvious target, there is a deeper phenomenon at work than just the Bush administration’s hands-off attitude toward corporate fraud (an attitude largely shared by the Clinton administration). That is the general tendency of people – investors and officials alike – to underestimate the risk of fraud during a boom and overestimate the risk of fraud during a bust.
This issue is discussed in a paper by Amitai Aviram published in my own school’s Yale Journal on Regulation (but since you can’t get it from their website, get it from SSRN).
Aviram’s first point is that people tend to ignore fraud risk in good times and worry about it in bad times. There are many reasons for this. Falling asset values and credit crunches make it harder to perpetuate certain types of fraud, such as Ponzi schemes, but there are other factors. In one form of cognitive bias, people ascribe good outcomes to their own investing “skill,” and bad outcomes to exogenous factors they cannot be blamed for, such as fraud. The discovery of a few well-publicized instances of fraud creates an availability bias, where people miscalculate the incidence of fraud.
Typical enforcement patterns only exacerbate this cycle. According to Aviram, the traditional academic model of enforcement is that you set a budget such that, at the margin, the marginal cost of enforcement equals the marginal benefit of enforcement. In practice, however, this model is affected by political pressures. In a boom, when the public underestimates the risk of fraud, there is no percentage in presenting yourself as a crusader against big corporations or Wall Street – especially when they are being portrayed in the media as heroes, as Enron was prior to 2001. But in a bust, the way to score political points is to go after the “crooks and robbers,” which is especially convenient after they have been pointed out to you by the markets (Enron, Madoff). This leads to underenforcement during the boom and overenforcement during the bust. (Or, I might say, severe underenforcement during the boom and maybe sufficient enforcement during the bust.)
Here’s what this looks like:
That’s the annual percent change in the S&P 500 plotted against the annual percent change in the number of SEC enforcement actions. I would have liked to see a regression, or at least a correlation, but this is a law paper, after all.
So, yes, it’s the fault of regulators who are too soft on industry, but they also share the misperceptions of the public at large, which wants to believe that everything is just fine when the market is going up. Of course, regulators are supposed to know more than the public at large.
Aviram has a discussion of the role of conspicuous law enforcement itself in reinforcing or counteracting these misperceptions. This discussion is wishy-washy, because he leaves open the question of whether conspicuous law enforcement increases or decreases risk perceptions. (Again, this is a law paper – no equations and few numbers, just concepts.) But I think it’s pretty clear that it decreases risk perceptions. Let’s put it this way: On the day that you learned about Bernie Madoff, did you feel more secure because you felt like the SEC was doing a good job protecting you? Or did you feel less secure because if Madoff could get away with it for so long, who else could? Let’s assume I’m right and then follow Aviram’s reasoning. In that case, this cyclical enforcement pattern makes things even worse, because the lack of enforcement during good times makes people feel even more secure, and the “over” enforcement in bad times makes them even more paranoid. Therefore, he concludes, enforcement should be expressly counter-cyclical, which requires insulating the regulators from public pressure to be lax during a boom.
Thus, when conspicuous law enforcement increases risk perception [my assumption], implementing the correct long-term policy will cause fear and anger among the public in the short term. Nonetheless, if the goal of anti-fraud laws is to maximize long term efficiency, the public’s immediate sentiments should not be a consideration for abandoning the optimal (long-term) policy. In fact, the law enforcer should be shielded from precisely these short-term pressures.
Aviram cites central banks as an example of an institution that is appropriately counter-cyclical. But let’s not fault him for that. The paper was first written in early 2007, and few people could have foreseen what happened since. Indeed, the implicit prediction that we would see a blossoming of enforcement energy in a market bust – after most of the damage has been done – turns out to have been dead-on.
The Baseline Scenario 
Have you ever heard of a Ponzi Scheme being stopped as soon as it began? I doubt it. That’s because it mirrors a particularly lucrative investment for quite a long time. How many people are going to let you close down there investor because you suspect that his returns are too high? They’re more likely to respond that you’re high.
There’s no stopping a Ponzi Scheme until it runs its course. It’s a perfect crime for a fairly long time. Also, notice, Madoff admitted his guilt. Stanford isn’t so stupid it seems. He doesn’t believe that the government can even figure out how a Ponzi Scheme works, let alone convict him of running one. He might turn out to be right.
I suggest reading this post from Scientific American:
http://www.sciam.com/article.cfm?id=limits-on-human-comprehension&print=true
“David H. Wolpert, a physics-trained computer scientist at the NASA Ames Research Center, has chimed in with his version of a knowledge limit. Because of it, he concludes, the universe lies beyond the grasp of any intellect, no matter how powerful, that could exist within the universe. Specifically, during the past two years, he has been refining a proof that no matter what laws of physics govern a universe, there are inevitably facts about the universe that its inhabitants cannot learn by experiment or predict with a computation. Philippe M. Binder, a physicist at the University of Hawaii at Hilo, suggests that the theory implies researchers seeking unified laws cannot hope for anything better than a “theory of almost everything.”
Perhaps with Ponzi Schemes, we’ve simply run up against the limits of human knowledge.
Remember back to the days when the SEC et al were going after Martha Stewart (2004)? The feds moved heaven and earth to send her up the river, and the whole time Madoff’s chortling in his NYC offices. Where was the resource allocation there?
Good point. Why they went after Martha like a bunch of lunatics is now a joke isn’t it? Especially in light of Madoff’s mess. Again, especially considering that a whistle-blower pointed out Madoff’s scheme for more than 10 years. It’s quite pathetic. Appeal should be denied, wife looked into, and everyone who helped to run his office should be looked in to. And at least 10 more people should head off to prison.
This is an excellent article. But aside from the theories that Aviram puts forward, and all the great technical analysis on baselinescenario there is a deeper issue – culpable exploitation of a lack of information.
A key factor in this crisis is that when it really mattered, no financial institution could trust another and the public information about it. That, in turn, is powerful evidence that every institution knew its own disclosures were trash. And that reflects woefully bad disclosure and accounting standards.
The absence of good information created an environment where many of the people who ran the securitized mortgages market, were, in all likelihood, consciously parcelling bad loans together with good loans. And, in all likelihood, they did that because they knew that their duties of disclosure meant their misdeeds would be very hard to detect. Fraud was probably systemic. So it’s not just the mini-Madoffs that need attention in this crisis. It is the madoff-ication of the system.
Go to the Wikipedia page on the Savings & Loan Crisis, and then look in the Footnotes for the FDIC’s “Lessons of the Eighties: What Does the Evidence Show?”. A key lesson the FDIC took was the need for uncompromising disclosure. It’s time that policymakers put that at the foundations of the finance system.
“Underestimate the risk of fraud during a boom” is a kind of euphemistic way to put it. Connive at it, turn a blind eye to it, deliberately weaken enforcement, is more like it. Maybe it’s because the boom is powered by a considerable degree of fraud to begin with, and in that climate it’s all intertwined. If they investigated fraud adequately, it would put a damper on the boom. In the down times, policing for violations is politically popular, it shows they’re doing their job to clean up the mess, especially if they go after second- and third-tier offeders and leave the top fraudsters alone.
nice graph!
The procyclical enforcement behavior may also contribute to economic cyclicality. More aggressive enforcement actions in a downturn affects both those committing as-yet-uncovered frauds and the rest of the industry. E.g., the SEC steps up the number of visits to companies, who then have to incur costs to comply with document requests, interview requests, etc. As the SEC generaly never announces that it exonerates anyone who is investigated, procyclical enforcement may induce companies to adopt policies in a downturn that reduce efficiency or curtail some normal business activity in order to reduce the subjective probability that the SEC will pull their name for some potentially suspicious activity and, thereby, reduce the expected value of reputational costs associated with being investigated.
Isn’t it curious that the banks have not been implicated in all of this. How can an “investor” continually deposit and withdraw millions of dollars in cash and not set off alarms. As an invididual if I try to move more than $10,0000 there are holds put on my funds, there are phone calls asking me about the fund movement and even follow up letters explaining “un-ordinary money movement”. Why then was this guy able to not set off alarms and raise concern?
I have to reply to this one. To say that Ponzi schemes such as the one that was run by Bernie “Mad Man” Madoff are beyond human comprehension is absurd. After all, Madoff, a human, is the one who created and orchestrated the whole thing. A Ponzi scheme is fairly simple to operate, so long as money keeps coming in. What is difficult, and I think that you were getting at this, is finding out where the money went. Most people don’t keep receipts for purchases made with fraudulent money, but if you look at Madoffs home(s), his cars, his wife’s jewelry, his clothes, his sons clothes, his charitable donations, etc., you can find what the money was spent on, but not the money. As for what wasn’t spent, its obviously in bank accounts somewhere. It would be nice if those banks with accounts in Madoff’s name or his wife and son’s names could provide information to investigators.
Madoff is a smart man, but he is not god, and did not create a universe. It is a simple scheme, a scheme that most people could think up on their own if given the need, desire, or opportunity.
On NPR, a story was told about a third grader that ran a Ponzi scheme in his elementary school cafeteria. The child running the scheme explained to his classmates that if they would give him some of their delicious snacks today, he would bring in an enormous, delcious cake on the last day of school. He claimed that if you could give him your fruit rollup today, or your rice krispy treat today, he would guarantee you a piece of that cake. He kept this going on for most of the school year until parents called administrators saying that a child was stealing their kids snacks. As it turns out, the kid running the scheme had stashes of nutter butters and fruit snacks of all kinds, and his mother had never heard about this alleged cake. When the kids asked for their snacks back, guess where they were? In the scammers belly!
So, like his third grade counterpart, I am going to go out on a limb and guess that whatever Madoff skimmed off the top of this Ponzi scheme is long gone, and the rest of the money is likely already in the hands of late-in-the-game investors. Some people did come out on top through Madoff in reality- thats how he got away with it for so long.
So, to get back to my point, it seems obvious to me where the money is. Getting it back, however, may be more difficult than any astrophysics.
The Baseline Scenario is teriffic, but . . . it is really way too late in the day to be writing about “congressmen.” There are, after all, plenty of women in congress. One of them is even speaker of the house.
Remember Ray dirks and the Equity Funding Scandal?
He went directly to the SEC, too.
SEC did nothing until Dirks advised his clients to short the stock — then they prosecuted him…
go figure.
OK, he’s a fraud and a criminal. The biggest one ever, maybe.
But did he ever make money the old-fashioned way in the markets? (Forgive me if that sounds naive…) Does he have any legitimate investment skills…’cause he’s got plenty of time, and other than breaking rocks in the hot sun, what productive use can he be put to in jail? Kind of a forced-labor brokerage, if you will, where the commissions are $0, the supervision intense (cuff him to a couple of former SECers who were malfeasant), and the upside all to the good of his victims. And sweeten it by exempting all he makes for them from capital gains taxation. What’s not to like?
How is this idea different from J.K.Galbraith’s description of “the bezzle” in his 1954 book “The Great Crash, 1929”? Is there any kind of limit to pulling ideas out of the literature of fifty years ago without attribution?
I think part of the problem for the federal government when it comes to enforcing these “crimes” is that the government doesn’t recognize them as morally wrong because the “government” as a collective does the same thing. I am not exactly certain how what Madolff’s pieces of paper represents differs from what the Federal Reserve does when it issues treasure bonds and bills. I guess if anything it would be the difference Charles Ponzi’s actual scheme offered compared to Amway.
How do you think a kid feels about smoking when both of his parents are heavy? His parents have told him over and over again that it is wrong. So if somebody looks over Madoff’s books, they might recognize it as not being too different then what is legitimate.
I think I realize know why economics is not stressed in grade schools. They are afraid the bright young minds will think, “wait a minute, how is this all gonna work?” and pretty soon enough of them will realized it couldn’t. It seems that our economy is chocked full of, “Do as I say not as I do.”