Fallout from Madoff scandal: new safeguards?

If there is a lesson to be drawn from Bernard Madoff's alleged $50 billion financial fraud, it is that the United States needs a new legal and regulatory structure to protect investors in the 21st century.

That appears to be the consensus among Democrats, and some Republicans, on Capitol Hill as lawmakers look toward action in the coming Congress. Proposals range from creating a new securities supercop by combining existing agencies to blocking top regulators from taking jobs in industry to simply increasing the resources devoted to market scrutiny.

"This country will not work if we are not able to restore the confidence of investors that there are places they can put their money that will be both remunerative to them and productive for society," said Rep. Barney Frank (D) of Massachusetts, chairman of the House Financial Services Committee, at a Jan. 5 hearing.

The bottom line is this: The world of finance has become far more complicated in recent years. Washington needs to respond accordingly, according to many experts outside government.

The Securities and Exchange Commission, for instance, should be "a highly performing agency with the equivalent of engineers on every floor," says H. Peyton Young, a senior fellow in economic studies at the Brookings Institution.

The scale of Mr. Madoff's alleged fraudulent activities has continued to shock lawmakers and government officials, as its human cost has become more apparent in recent weeks.

In essence, Madoff is accused of pulling off one of the greatest cons in US, if not world, history, by scamming thousands of investors out of $50 billion while posing as a shrewd financial operator with a proprietary system that guaranteed steady, high returns.

Allan Goldstein is one of his apparent victims. A retired New York fabric distributor, Mr. Goldstein had built up a retirement fund of about $4.5 million, all of it invested with Madoff.

Goldstein estimates that he can make two more mortgage payments by cashing in his life insurance policies. After that, he is likely to lose his home. Everything he has worked for over his 50-year career is now gone, he told the House hearing on Jan. 5.

He'd thought US markets were the best-regulated in the world. "I believe my government has failed us and we have suffered tragically as a result," said Goldstein.

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.

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.

"Clearly, our regulatory system ... failed miserably and we must rebuild it now," said Rep. Paul Kanjorski (D) of Pennsylvania.

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.