Fallout from Madoff scandal: new safeguards?
Congress ponders its options – from better investment policing to a new watchdog.
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Madoff is accused of running a classic Ponzi scheme, in which early investors are paid off with money from later ones. His actions were special only in their size, according to Tamar Frankel, a Boston University law professor and expert on financial regulation.Skip to next paragraph
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Generally speaking, Ponzi schemes promise large returns, often in the context of a bubble economy, which makes the promised gains more believable. The con artists appear trustworthy – steadily paying off all claims, until the scheme collapses and they can pay no more.
Ponzi schemes often take a toll on the economy. In 2002, according to court records, they caused over $9.6 billion in losses, Ms. Frankel told the House committee in a prepared statement. In several years in the 1990s, losses surpassed $1 billion.
When the fever of speculation in a market bubble creates a follow-the-herd phenomenon, Ponzi schemes flourish. Experience in other countries, particularly those in the Balkans, has shown that the schemes can grow to the point that they "undermine the financial system," said Frankel.
New rules won't necessarily stop new Ponzi schemes, Frankel suggests. What's needed is for the government to enforce existing laws in time. She recommends changing the way government regulates, with federal officials conducting thorough and frequent examinations of broker-dealers, investment advisers, and money managers.
"These examiners should be top-notch experts, well paid, and highly valued," she said.
For his part, Mr. Young of Brookings emphasizes that in today's environment, hedge funds should provide more information to the government. Madoff's operations were billed as a legitimate hedge fund, though they were not.
This improved transparency could be carried out with a two-pronged effort, with both voluntary industry disclosure and some regulatory investigation, says Young. Hedge funds are lightly regulated. "This allows too much of a gap for fraudsters to enter the market," he adds.
The Securities and Exchange Commission came in for much criticism at the Jan. 5 House hearing, which was a preliminary meeting prior to the beginning of the next Congress.
SEC inspector general David Kotz told lawmakers that he is so concerned over the agency's failure to unmask Madoff, despite tips pointing to the Madoff scheme as fraudulent, that he is expanding the inquiry called for last month by SEC Chairman Christopher Cox.
Kotz will look at the relationship between a former SEC attorney, Eric Swanson, and Madoff's niece, Shana, who are now married. At the SEC, Mr. Swanson investigated his future father-in-law's activities in 1999 and 2004, and found nothing wrong. The SEC's watchdog will also look at the general operations of the SEC's enforcement and inspection divisions.
Leon Metzger, a former hedge-fund executive, told lawmakers that the SEC and the Commodity Futures Trading Commission should merge.