After a disastrous year that spelled the demise of Bear Stearns and Lehman Brothers and the end of Merrill Lynch's independence, Bernard Madoff's alleged $50 billion swindle has added new urgency to calls to reform regulation of the U.S. financial system.
"Clearly, our regulatory system has failed miserably, and we must rebuild it now," U.S. Rep. Paul Kanjorski, a Pennsylvania Democrat, said Monday at a House Financial Services Committee hearing on the Madoff mess.
The question is how. There is already a reform blueprint in place, cobbled together nearly a year ago by outgoing Treasury Secretary Henry Paulson. In a 212-page document released in March, he outlined a streamlined system that emphasizes principles rather than rules, and aims to do a better job keeping tabs on the sophisticated financial activities that didn't exist when Depression-era laws creating the current system were put in place.
Paulson's plan, if adopted, would merge the Securities and Exchange Commission with the Commodities Futures Trading Commission, transfer some authority over securities firms to the Federal Reserve, and create oversight for market risk and business conduct, among other things. It also would emphasize the industry's role in self-policing.
Critics of the Paulson plan, however, point out that even those changes wouldn't do much to stop major financial frauds such as Madoff's alleged Ponzi scheme, a classic financial crime that is stunningly simple in contrast to the mortgage-backed securities and auction-rate securities fiascoes of the last year and a half.
Some think that rather than merging the SEC out of existence, the focus should be on reallocating what the various regulators are responsible for overseeing and reviving the SEC's enforcement authority.
The SEC has 3,500 employees, the Financial Industry Regulatory Authority has another 3,000 and the various state securities regulators, all combined, have another 3,000 or so. Putting the FIRA squarely in charge of the biggest broker-dealers and the states in charge of the smaller ones would free up the SEC to oversee the whole process.
Under the current system, the SEC tends to pursue cases against small firms that are easy prey while wrist-slapping the biggest firms for infractions. Instead, it "should focus on the big firms because they are the ones that cause all the problems," said Peter Chepucavage, a former SEC staff attorney.
Reform will be a priority with the new Congress about to start its 2009 session. The Madoff scandal has shaken investors' confidence in the markets, and economic rebound depends on restoring that confidence.
"Our hope is that the hearings are an important step in bringing greater scrutiny to the asset management industry and to provide greater protection to investors who have been preyed upon by unscrupulous firms and individuals," said Stephen Weiss, a lawyer for a group of Madoff investors, one of whom testified before Congress on Monday. "It is also essential that the scandal help bring about enhanced oversight of investment managers by the SEC."
It's not just the SEC that fell down on the job, though it is taking the brunt of the criticism and has turned an investigation on itself.
The FIRA, which regulates broker-dealers, examined the Madoff brokerage operations at least every other year since the late 1980s without finding major infractions, lawmakers said Monday.
Both the FIRA and the SEC got annual financial statements from the Madoff firm. Neither one noticed what lawmakers call obvious red flags, not least of which was audits signed off by a small, obscure accounting firm.
Firms the size of Madoff's, reported at $17 billion at the beginning of 2008, would normally be audited by a major accounting firm.
The dimensions of the alleged fraud are still being measured. The Securities Investor Protection Corp., which is overseeing the bankruptcy of the Madoff firm, mailed out 8,000 claim forms to potentially harmed investors on Monday, the first official number on how big the victim pool might get.
That 8,000 includes people with open accounts at Madoff for the last year. It doesn't include older investors or those who invested through feeder funds.
Testifying at the hearing Monday, was Allan Goldstein, 76, who had his entire retirement account invested with Madoff. As of November, the value of the account was $4.2 million. Now he's had to cash in his life insurance policy to pay his mortgage.
"We had considered Madoff Securities not as a get rich quick scheme but as a buffer against risk," Goldstein told the House panel. "I believe my government has failed us, and we have suffered tragically as a result."
