Madoff Scandal Illustrates Cognitive Hazard

December 18, 2008

By Chidem Kurdas 

In the past week a new and dramatic chapter was added to the decades-long history of hedge fund fraud. Barnard Madoff, a well-known, long-time money manager, confessed to a Ponzi game that cost his clients $50 billion. The specific nature of his scheme and the exact amount of the money lost is still not clear.  

What is pretty clear is that over the years the US Securities and Exchange Commission (and probably other government agencies) were repeatedly warned of fraud at Madoff Investment Securities. Rumors about Madoff circulated for a decade. At least two different people told the SEC over the years. There were articles in the press.  

The firm was a heavily regulated broker-dealer over which the SEC had extensive authority. At various times regulators investigated and found minor violations. Madoff paid a fee, fulfilled some bureaucratic requirement and went on his merry way. He also made very generous donations to the Democratic political establishment. Click for story 

This regulatory failure is no exception. An earlier hedge fund fraud incident I’ve studied showed a similar pattern—Manhattan Capital’s manager was able to hoodwink investors, accountants and auditors for three years partly because an SEC-regulated broker-dealer backed him up. Click for article in The Independent Review  

In 2000, that manager tried to trade information regarding the Madoff shenanigans in exchange for leniency for himself. The prosecutors did not give him a deal and don’t appear to have done anything about Madoff.  

Government failures like this are usually greeted with demands for more government—more regulation, enforcement and agency budgets. By contrast, market failures are greeted with demand for less market—less freedom of action and voluntary compliance. The result of this asymmetry is an expanding spiral of regulation-regulatory failure-more regulation.  

When the1990s stock bubble burst in 2000-2002, fraud was discovered in supposedly regulated corporations like Enron, Tyco and WorldCom. Congress passed the Sarbanes-Oxley Act to prevent future problems. Now, another round of regulation is widely expected.  

As governmental oversight expands, people see less reason to learn how to protect themselves. After all, you’re paying Uncle Sam to do that for you. We all have cognitive biases, which cause us to make systematic mistakes as investors. With growing regulatory oversight, we have less incentive to try to correct those biases and face unpleasant truths. Hence, cognitive hazard.  

Madoff’s investors were under an illusion. Knowing that the firm was a US regulated brokerage and the SEC looked into it and found nothing seriously amiss would have strengthened their illusion. Regulation is making the victims more likely to fall into financial fraud.

4 Responses to “Madoff Scandal Illustrates Cognitive Hazard”

  1. lxm Says:

    If the SEC can’t do truth discovery well, how can you argue that individual citizens can do a better job? That’s just crazy. We need more effective regulation and better enforcers, not less. Regulation is difficult and may often fail but it is better than the alternative.

    Read Krugman’s column today http://www.nytimes.com/2008/12/19/opinion/19krugman.html?ref=opinion

    He argues that little separates Madoff from the currently unindicted financial mavens other than maybe a little bit of willful disbelief in the actual chicanery of their schemes.

    Bottomline: they are all thieves if they can figure out how to get away with it.

    So maybe regulation didn’t work too well. But let’s not forget that Chris Cox, SEC chairman, didn’t believe in regulation. See http://tpmmuckraker.talkingpointsmemo.com/2008/12/cox_worked_to_dismantle_the_se.php one of many articles documenting Chris Cox at work.

    So if it’s important to you, go ahead and believe that the success of this fraud is all the fault of ineffective regulation. But from where I sit it’s fraud that is pervasive and government action that discovers any piece of it, even belatedly, is a victory.

  2. Mark Says:

    Maybe you underestimate the tenacity of the SEC. They seemed to do this pretty well.


  3. Yeah we just need to finally get the good regulators in, then everything can be regulated all good-like. The previous 100 years of ineffective regulators was just bad luck.

  4. chidemkurdas Says:

    Yes, 500 years of ineffective regulators in Europe must have all been just bad luck, if you want to believe greater government oversight can really improve the financial system. The effort by Krugman and others to blame this debacle on Cox or Bush administration policies is absurd. Madoff’s problems started in the 1990s. A previous fraud case with the same pattern also happened in the Clinton years. Click for story http://www.independent.org/publications/tir/article.asp?a=712


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