Madoff and the SEC

Slate's "Big Money" says Madoff's fraud exposes how bad the SEC was at doing its job. I don't know that this is true.

Sure, the SEC ignored the detailed memo submitted by dogged whistleblower Harry Markopolos, but all those submissions were anonymously submitted, because Markopolos feared retribution by Madoff. Government agencies get a lot of mail from cranks, and it doesn't seem efficient or desirable in a free society to launch federal investigations on the strength of anonymous accusations.

We can regret, in hindsight, that the SEC didn't catch Madoff sooner, but the fact that the SEC didn't launch an investigation over the anonymous Markopolos memo isn't a basis for criticizing the agency; if anonymous tips start bringing down government heat, we'll replace the possibility of an undetected fraud with the certainty of malicious and false anonymous tips damaging honest business.

And it would be unfortunate to tolerate such excess, because we don't need more oversight from the SEC to protect against people like Madoff. He operated with limited oversight because his clientele was rich and sophisticated, and should have been able to watch out for their own interests.

There are a whole lot of specialized entities that only manage money for wealthy and institutional investors, precisely because the SEC allows such funds to operate with little regulatory oversight on the premise that these investors can protect themselves from fraud.

Funds that are managing the savings of ordinary workers and families face much more stringent regulatory scrutiny because these investors are thought to be more vulnerable to fraud and less capable of understanding where their money is going.

But the fact that some sophisticated investors failed to protect themselves doesn't disprove the presumption that they were capable of doing so. Any of the fund managers who were directing capital to Madoff could have done the same analysis Markopolos did.

Increased SEC examination of lightly-regulated funds will consume public resources while destroying the abilities of these funds to develop proprietary investment strategies.

The funds chose to be hedge funds in the first place because they saw more upside to lighter regulatory involvement, even at the cost of closing off sources of capital who the regulators offer higher protections. The sophisticated investors chose to invest with the hedge funds, anticipating higher returns, even though they knew other types of funds offered more regulatory protection for investors.

After 9/11, the government created its new TSA agency to manage airport security. Now, before travelers get on an airplane, they must throw away their toothpaste, strip off their shoes and belts, and often submit to pat-downs. For this embarrassment and inconvenience, travelers get almost zero marginal safety benefit.

Putting similar inconvenient restrictions on investment would probably offer a similarly marginal benefit at the much higher cost of delaying recovery, especially since the Treasury is relying on hedge funds to buy toxic securities as part of its bank rescue.

The lesson of Madoff is greater skepticism of too-good-to-be-true returns and more diligence by investors. It may be appealing to call for a regulatory environment where this sort of thing cannot happen, but the cure would be worse than the disease.