With $7 trillion in wealth disappearing in the U.S. in the past year, it hasn’t been a banner time for anyone involved in the financial markets. But it may be the Securities and Exchange Commission that has taken the biggest bath.
The storied investment banks that it oversaw have basically disappeared — out of business or transformed into bank holding companies. And on top of that comes the Bernard Madoff scandal, in which the Wall Street figure operated a $50 billion Ponzi scheme under the SEC’s nose despite repeated warnings that he must be defrauding investors.
The 2005 letter from investment maven Harry Markopolos to the SEC arguing that Madoff had to be a scammer has become justly famous. Titled “The World’s Largest Hedge Fund is a Fraud,” Markopolos outlined no fewer than 29 red flags raised by Madoff’s operation. According to The Wall Street Journal, the SEC and other regulators examined Madoff at least eight times in the course of 16 years and found nothing more than technical violations.
An egregious failing, of course. But Peter Van Doren of the free-market Cato Institute points out the difficulties inherent in the SEC’s task. The average SEC examiner’s inbox must be flooded with complaints and leads, many of which have no merit, in a chaotic environment characterized by trillions of dollars of trades a day. The SEC is in the position of the old British Foreign Service official who after a career spanning 1903-1950 recalled, “Year after year the worriers and fretters would come to me with awful predictions of the outbreak of war. I denied it each time. I was only wrong twice.”
Except the SEC makes a practice of being wrong. It missed the Enron and WorldCom debacles. In response, it successfully petitioned for a massive heap of new financial regulations in the form of Sarbanes-Oxley, which didn’t make a whit of difference as the SEC missed the impending implosion of the investment banks and one of the most notorious financial frauds in U.S. history.
Part of the problem is that the SEC has to try to outfox people paid very well, and with every incentive, to outfox it. As David Smick writes in The World Is Curved:
A well-intentioned government bureaucrat is no match for the kind of creative and clever market wizards, and their lawyers, who begin searching for legal means around any regulatory constraint the instant the regulations are put in place. Today a senior Securities and Exchange Commission (SEC) officer earns between $143,000 and $216,000 per year. Even junior executive decision-makers at Goldman Sachs garner annual compensation packages in the millions of dollars.
Then there’s the more fundamental problem that it’s almost impossible for the SEC to know what the market — the collective wisdom of countless millions of people, acting on an array of information too vast to quantify — doesn’t know. Markets aren’t perfect. They are given to speculative manias, but they are easier to identify in retrospect than at the time. Yes, there are always Cassandras famous for their prescience after a bubble bursts, but forgotten are all the times the bears warned against robust and healthy economic growth.
If the market is wrong, it is also brutally self-correcting. Enron and Lehman Brothers were gone before SEC officials could think much about what new regulations they were going to advise Congress to pass, doomed to be found lacking in due course.
When it comes to Madoff, as one wag observed, he ran afoul of one of the oldest regulations on the books, “Thou Shalt Not Steal.” What the market needs now is not regulatory overkill, but reforms to make sure that incentives are properly aligned — e.g., bond rating agencies shouldn’t be paid by the firms issuing the bonds — and that the system is as transparent as possible.
Even the shrewdest rules won’t avoid the next bubble and bust, after which the SEC or some other regulatory agency will again inevitably be found wanting.