Harry Markopolos's Regulatory Revolution?

I received a phone call during the day from an astute money manager. He was flabbergasted as he listened to Harry Markopolos's testimony (Please click here to view the testimony on The Huffington Post).

Indeed, Harry Markopolos’s written testimony to Congress makes for fascinating reading. It exposes the regulatory shortcomings that plague the U.S. financial system. You can also read the condensed Markopolos if you want to glance over some highlights, but nothing compares to listening to his testimony.

Markopolos told Congress today that he contacted the SEC in 2000 after examining Madoff’s investment strategy and determining in four hours that returns exceeding 10 percent weren’t possible. Markopolos, in almost a decade of communication, said only one SEC staff member understood Madoff’s scheme and “the threat it posed to the public.”

“My experiences with other SEC officials proved to be a systemic disappointment and lead me to conclude that the SEC securities lawyers, if only through their investigative ineptitude and financial illiteracy, colluded to maintain large frauds such as the one to which Madoff later confessed,” Markopolos said. Madoff “had a lot of help,” Markopolos said.

U.S. lawmakers, who began investigating Madoff’s case last month, are hearing from Markopolos for the first time as they try to determine how regulators missed his alleged $50 billion Ponzi scheme, the biggest in history.

The proceeding may shape the SEC’s fate as Congress debates whether to bolster the regulator or turn its responsibilities over to another agency.


Markopolos today said losses from the alleged fraud probably will be $15 billion to $25 billion, less than the $50 billion estimate based on what prosecutors said Madoff told his sons before his December arrest. Losses among European investors, including royal families Markopolos declined to identify, likely will exceed losses in the U.S., he said.

Markopolos, in his written testimony, said Madoff’s resume and connections on Wall Street made him fear for his life as he and a team of advisers scrutinized Bernard L. Madoff Investment Securities LLC. His testimony included 310 pages of e-mails and financial documents.

“Our analysis lead us to conclude that Mr. Madoff’s fund and the secret walls around it posed great danger to those questioning and investigating them,” he said in the document. “He was one of the most powerful men on Wall Street and in a position to easily end our careers or worse.”

Markopolos described repeated meetings with SEC investigators in Boston and New York, saying they appeared to lack the financial expertise needed to understand his warnings or brushed them off. He later tried to alert the media, without success, he said.

“BM’s math never made sense, his performance charts were clearly deceiving, and his return stream never resembled any known financial instrument or strategy,” he said, referring to Madoff by initials. “To believe in BM was to believe in the impossible.”

Markopolos in 2005 shared his concerns with Meaghan Cheung, a branch chief in the SEC’s New York office. Markopolos said he gave Cheung with a 21-page report alleging that Madoff was paying off old investors with money from fresh recruits.

“Ms. Cheung never expressed even the slightest interest in asking me questions,” Markopolos said. “She never initiated a call to me. I was the one always calling her. She was unresponsive and mostly uncommunicative when I did call.”

SEC spokesman John Nester declined to comment.

Cheung apprroved an internal memo in November 2007 to close an SEC investigation of Madoff without bringing any claim. She later left the agency.

No active telephone number was listed for her in two Internet directories. On Jan. 7, she told the New York Post she had worked hard to pursue fraud at the agency for 10 years.

“Everyone in the New York office behaved ethically and responsibly and did as thorough an investigation as we could do,” she told the newspaper.

After more interactions with SEC officials, Markopolos said by last year he had “truly given up on the BM investigation.” Federal prosecutors arrested Madoff Dec. 11 after he allegedly confessed to his sons that his investment-advisory business was “one big lie.”

SEC Chairman Mary Schapiro, sworn in Jan. 27, should assess the staff and determine what skills it lacks, Markopolos said.

“My bet is that Ms. Schapiro will find that she has too many attorneys and too few professionals with any sort of financial background,” he said.

The regulator will only attract employees who understand balance sheets, income statements, derivatives and complex trading strategies if it adopts the “industry’s compensation guidelines,” Markopolos said.

Schapiro should set up a central office to respond to all whistleblower complaints, which are handled by the agency’s regional bureaus on an “ad hoc basis,” he said. Markopolos also said the new chairman should consider relocating the SEC to a city in the U.S. Northeast from Washington.

“Washington is a political center not a financial center,” he said. “If the SEC wants to attract the top talent, relocating its headquarters to somewhere between Rye, New York, and New Haven, Connecticut, is where this agency will best attract the foxes with industry experience it so desperately needs.”

Ms. Shapiro might want to start by hiring Mr. Markopolos given that he has earned a senior regulatory job.

The problem with regulators is that they are always one step behind the ball. Even when guys like the amazing Harry Markopolos gift-wrap fraud cases, they still seem to bungle it up.

And it's not just a U.S. problem. In Canada, a single regulator is long overdue but despite repeated calls from concerned investor groups, some are still resisting this proposal.

Canada’s top financial watchdog Wednesday cautioned world leaders against watering down supervision of banks amid a rush to develop an overarching approach to tracking systemic risks in global markets:
Julie Dickson, the Superintendent of Financial Institutions, said a broad drive to improve “system-wide” safeguards “should not [be] about diluting the supervisory focus on individual bank risk.”

The cautionary note came as finance chiefs prepare for a series of international gatherings in the lead up to a summit of the Group of 20 nations in London.

Influential policymakers have been advocating for a more macro (as opposed to micro) approach to managing risks in the banking system that tends to emphasize the role central bankers can play in preventing future crises.

But Ms. Dickson Wednesday leaned against this prevailing wisdom.

“A sound banking system is made up of sound banks. The optimal path to a sound financial system is sound risk management by individual financial institutions. This is done bank by bank,” she said.

This view potentially puts her at odds with leading voices in the international debate.
For example, Adair Turner, the head of Britain’s Financial Services Authority, said one of the lessons from the financial crisis was that “regulators were too focused on the institution by institution supervision of idiosyncratic risk.”

But Ms. Dickson yesterday appeared to directly challenge this view, citing the collapse of major financial institutions as evidence oversight was not overabundant.

She argued “we would not have as many global banks on life support” if regulators had in fact paid “too much attention to institution by institution supervision.”

The regulator also suggested it would be a mistake to place too much faith in the ability of economists and central bankers, not generally thought of as short on self confidence, to do a better job than regulators in anticipating and preventing crises.

“Very smart people have tried to moderate the real economic costs imposed on society by phenomena such as business cycles . . . [Yet] in spite of the best efforts of macro-economists, we have not repealed the business cycle, nor have we escaped the problems associated with it,” she added.

But the superintendent stressed that “regulators need to focus on the forest as well as the trees” and have “a mandate to look at system wide issues.”

For example, regulators should have been asking themselves during boom times “whether it was ever realistic to expect the banking system to regularly deliver returns on equity in excess of 20%, without taking excessive risk?”

Canada’s top bank regulator also acknowledged the need to explore the intricacies of the relationship between banks and the real economy.

“We need to ask these questions, while recognizing that we are mere mortals,” she said. The regulator delivered the remarks at a special meeting that brought together supervisors from countries where RBC, Canada’s largest bank, operates.

It was the first meeting of its kind in Canada following a recommendation for “colleges of supervisors” to meet regularly to discuss cross-border banks.

The meeting was attended by regulators of RBC’s operations in the U.S., U.K., Luxembourg, Bahamas, Barbados, Jamaica, Dutch Antilles and the Cayman Islands.

Ms. Dickson's remarks are surprising given that OSFI has taken virtually no responsibility for the ABCP fiasco that decimated thousands of unsuspecting investors:

After a marathon 17-month restructuring process, many holders of $32-billion of frozen ABCP on Wednesday exchanged their stalled paper for new long-term bonds they hope will allow them to redeem at least part of their investment when they mature in nine years.

Thanks to the collapse of the market for asset-backed commercial paper market in 2007, the story of the 20 issuing trusts that created the market and their exposure to the credit default swap market is now well known.

But some questions surround the rapid rise of the group of bond insurers that, thanks to the fact they were not regulated and therefore unhindered by red tape, managed to provide guarantees on about $200 billion of corporate debt through the use of credit default swaps with very little collateral to back it up.

Many point the finger at the Office of the Superintendent of Financial Institutions, which regulates banks and insurance companies. OSFI has consistently denied any responsibility.

Speaking at an industry conference on Wednesday, Mark White, a senior director at OSFI, said it is not his group's job to regulate trusts, even ones that operate as insurance companies.

Asked by a reporter if there was any discussion between OSFI and other regulators prior to credit crunch about the emergence of bond insurers and their extraordinary growth, White declined comment, saying he was not employed at the regulator at the time.

The Ontario Securities Commission, OSFI and the securities industry's self-regulatory body launched investigations in the aftermath of the meltdown of the ABCP market, but the likelihood of any serious penalties now is limited because the restructuring included a provision for legal immunity for all the players in the ABCP market. Not only are the firms that made and sold the paper exempt from lawsuits under the deal, they are also protected from being fined.

Some observers are angry about that.

"I think (that by failing to do their job) the regulators in Canada made possible the sale of this toxic product into the market," said Diane Urquhart, an independent analyst working for some of the noteholders.

At the start of the credit crunch, ABCP markets around the world fell apart but only in Canada were investors left holding the notes, a unique twist caused by faulty legal agreements in the paper that enabled so-called liquidity providers to avoid their obligations.

According to Urquhart, the faulty liquidity agreements resulted in a "made-in-Canada problem."

About 170 individual investors will get all their money back after the restructuring, but the rest of the note holders are not so fortunate. More than 200 institutions and companies holding more than 98 per cent of the frozen ABCP will get restructured bonds maturing in about nine years. Observers say it is unclear if there will be a secondary market for the bonds.

The truth of the matter is that our regulators fell asleep on the switch and now they are playing the old political game of covering themselves instead of accepting responsibility for the mess they neglected to take seriously.

When it comes to regulation, you need smart people who are proactive, not reactive. Regulators need to be fiercely independent and they need to have the resources to attract the best and the brightest or else they'll get slaughtered by investment firms looking to bypass regulations.

We need a major regulatory overhaul of our financial markets and pension funds. As George Soros said in the past, it's not about more regulation but about better regulation.

Will Harry Markopolos's testimony start a regulatory revolution? The revolution has already started as financial markets imploded across the world. But the question is will whistleblowers like Harry Markpolos be taken seriously in the future and will the laws and governance structures protect them?

As I listened to Harry Markopolos today, another Greek American came to my mind - James Chanos. It was seven years ago, almost to the day, that Mr. Chanos testified to the House Committee on Energy and Commerce on developments relating to Enron Corporation.

Mr. Chanos was widely credited for uncovering the fraud at Enron. A barrage of regulatory and legal responses followed that fraud case including the famous Sarbanes-Oxley Act.

What amazes me is how little regulators learned from their past mistakes. By ignoring the past, they allowed this mess to snowball into a global systemic crisis which now threatens the global financial system and global pension funds.

We need more people like Harry Markopolos and Diane Urquhart to come forth exposing frauds and mismanagement, but unless regulators actually do something to finally get transparency and accountability into the banks and pension funds, they are doomed to repeat the same mistakes in the future.

Let's hope that with Paul Volcker leading the charge, regulators will stop dropping the ball and get to work cleaning up this financial mess, implementing safeguards that will ensure it never happens again.