When cops dont act, blame the market?
|December 20, 2008||Posted by Staff under Progress Report, The Progress Report|
When cops dont act, blame the market?
Madoff and the Failure of the SEC
Most people make no distinction between liberty and license. What people have in mind when they condemn the market is license — a free-for-all in which anything goes; when they commend the market, its liberty — enjoying your rights thanks to your neighbors respecting them. If you could experience economic freedom, youd earn what you get and keep what you earn, untaxed. If you lived in economic justice, youd receive a fair share of societys surplus. Together, both are the geonomic prescription. However, in most places surplus is not shared but concentrated. As the low hanging fruit, it becomes too tempting to those of little character and big stature. This 2008 article was posted on the website of the Ludwig von Mises Institute (venerating the Austrian School), Dec 18. Its author is a student at Auburn University majoring in accounting and minoring in finance.
by Briggs Armstrong
Bernard Madoff, former chairman of the NASDAQ stock market, was arrested on December 12 for committing fraud. In Madoff’s own words, he referred to his operation as “all just one big lie” and “basically, a giant Ponzi scheme.” His big, giant scam bilked clients of $50 billion.
For those unfamiliar with Ponzi schemes, its perpetrator pays returns to existing investors from the funds of new investors. Huge charities and wealthy individuals in both the United States and Europe accepted Madoffs invitation to invest in his hedge fund, satisfied with his returns (generally in the low double digits). But when the market tanked and his investors needed cash or lost faith in stocks, they asked for their money back and Madoff could not redeem everyones chits.
Hedge funds differ from mutual funds in key ways. They have:
- * considerably higher barriers to entry for potential investors,
* more complex compensation structures,
* less stringent regulatory requirements than mutual funds, and
* the leeway to often generate higher returns than the average mutual fund; indeed, most mutual funds under-perform compared to the S&P 500 benchmark.
Given the size of losses and the celebrity of some victims, many in the financial press are asking, “Where was the SEC?” How could anyone run a fifty-billion-dollar Ponzi scheme without the SEC ever noticing?
The SEC turned a blind eye, for the market did spot the problem; it even reported it to the SEC. Yet all of the warnings were ignored by the SEC, which failed its fiduciary obligation to investors.
In the absence of SEC regulation, there is private policing. To investigate the funds in which they plan to entrust their money, prospective investors who lack the knowledge or resources to do the investigation themselves hire specialists. In response to the consumer demand, “due-diligence firms” have emerged to provide, for a fee, their expert opinion about specific hedge funds.
Due-diligence firms use the fees collected from their clients to hire professionals to meticulously review hedge firms for signs of deceit. One such firm is Aksia LLC. After painstakingly investigating the operations of Madoff’s operation, they found several red flags. Aksia even uncovered a letter to the SEC dating from 2005 which claimed that Madoff was running a Ponzi scheme. As a result of its investigation, Aksia advised all of its clients not to invest their money in Madoff’s hedge fund.
In this case, the SEC failed to protect individuals and charities from something as simple and old as a Ponzi scheme. It also failed to save investors from the house of cards made up of mortgage-backed securities, credit default swaps, and collateralized debt obligations that resulted from the housing bubble. The SEC is becoming increasingly irrelevant and people are beginning to take notice.
Instead of rely on the market’s self-policing mechanism, many will argue there is too little regulation and that the SEC needs more power to protect investors. It is in the nature of government, when its failures are exposed, to claim that if only it had more power it could have performed its duties in the manner it had promised. Too many of the governed agree, ignoring that government failed to protect investors while a market entity at least informed them, and acting on sound information in the business world can keep one safe.
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