SEC missed Madoff warning signs

by Frank James

Investors who apparently lost billions of dollars in Wall Street broker Bernard Madoff's alleged $50 billion Ponzi scheme weren't the only big losers.

The Securities and Exchange Commission was staggered by the revelation, as it was once again exposed as an inadequate enforcement agency, unable to spot problems with Madoff others had observed and, ultimately, ineffective at protecting investors.

As The Wall Street Journal reported in a Dec. 13 2008 story, Madoff didn't fool everyone.

Harry Markopolos, who years ago worked for a rival firm, researched Mr. Madoff's stock-options strategy and was convinced the results likely weren't real.

Mr. Markopolos pursued his accusations over the past nine years, dealing with both the New York and Boston bureaus of the SEC, according to documents he sent to the SEC reviewed by The Wall Street Journal.

The same story mentioned that Jim Vos, who heads a company called Aksia LLC that advises investors did some investigating and found a huge red flag in the form of the auditor Madoff used:

Until at least November, 2006, the firm, which claimed to manage billions of dollars and be among the largest market makers in the stock market, used as its auditor Friehling & Horowitz, a small New City, New York firm.

Mr. Vos says his firm hired a private investigator and determined that the accounting firm had only three employees, one of whom was 78 and lived in Florida, and another was a secretary, and that it operated in a 13 foot by 18 foot office. His firm felt that was too small an operation to keep an eye on such a large firm operating a complicated trading strategy. A message left for the accounting firm was not returned.

So there were strong suspicions about Madoff. Even so, the SEC apparently was unable, even when being warned of questionable activities, to apply enough scrutiny to discover the alleged fraud.

This clearly adds to doubts about the SEC's ability to police financial markets at a time when the markets can ill afford to have new doubts emerge about the federal government's oversight of those markets.

Those doubts were already high. The SEC and it's chairman Chris Cox have been blamed for lax oversight especially of the financial instruments called derivatives that financial institutions loaded up on which, after the mortgage crisis hit, wound up devastating their balance sheets. Indeed, under Cox the SEC actually reduced enforcement.

As the New York Times reported in October, the SEC also eased requirements for how much cash Wall Street institutions had to be keep in reserve which, when the crisis hit, made the institutions like Bear Stearns, Lehman Brothers and the rest far weaker than they might have otherwise been.

It's all but certain that the Madoff affair, added to what's happened on his watch before now, will reignite calls for SEC Chairman Cox to resign. Sen. John McCain, when he was the Republican presidential nominee, said Cox should be fired.

Since the SEC is an independent commission, a president can't fire an SEC chair and Cox's term runs to 2010.

But calls from the White House and Congress can cause a chairman to head for the hills as happened with the controversial Harvey Pitt in 2002. Expect those calls to increase. Madoff was likely the last straw for Cox's chairmanship.

As the WSJ reports in a story today:

An enforcement case 16 years ago gave the Securities and Exchange Commission its first shot at figuring out how Bernard Madoff could rack up favorable returns with such uncanny consistency. After that, it received repeated warnings from outside whistle-blowers and at least twice looked into Mr. Madoff's brokerage itself.

The revelations are the latest blow to the reputation of an agency that has been criticized for insufficient enforcement and the failure to better monitor the dangerous risk-taking on Wall Street that triggered this year's financial crisis. Congress and the incoming Obama administration already were planning a regulatory revamp, and the Madoff case may make the SEC's chances of survival shakier.