Kathrein on Investor Fraud

Fixing the Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform

Fixing the Financial Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform  I waited for March 26, 2009, in great anticipation that we might see meaningful change in protecting investors. I pray that my retirement years are not stolen from me as they have been from those who we represent - those who trusted Charles Schwab, OppenheimerFunds, MassMutual and Madoff. However, March 26 came and went with little recognition of why and how this happened by those our new President entrusted to help steer these changes. Both Timothy Geithner (Secretary of Treasury) and Mary L. Schapiro (SEC Chair) testified today on improving our financial regulatory system. Geithner spoke to Barney Frank and his House Committee on Financial Services, and Schapiro spoke to Christopher Dodd's Senate Committee on Banking, Housing and Urban Affairs. Geithner's testimony can be found here, and Schapiro's here.

Before I start in on my criticism, let me say that I understand that both Geithner and Schapiro are long time industry/regulatory insiders. Change comes slow to those who have been part of the system and failed to step forward early. Certainly, it is better to talk about "failures" than to admit that they were asleep at the switch. It is better to talk in the abstract with little criticism that might incite a lynch mob.

Reading both testimonies, I am dumbfounded at how little attention is paid to the mutual fund industry that took investors' money and started pouring it into any asset available regardless of its objectives.

Geithner gives a strong statement recognizing the need for investor protection:

"[W]eaknesses in our consumer and investor protections harm individuals, undermine trust in our financial system, and can contribute to systemic crises that shake the very foundations of our financial system."

 Hear hear! Geithner then swiftly moves on to talk about mortgage lending, not investor protection. Try to sort out the following statement:

"Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system."

It's almost like the financial services industry wrote his words: "Tim, throw in words that make it look like 'things' caused us to commit fraud, and then put the blame on the 'many Americans with obligations they did not understand...'"

Let's pretend our mess was caused by poor consumers who did not know what they were buying, instead of the greed; greed of financiers who "created" packages of garbage loans, and dumped them on retirees for huge fees, profits and commissions. This slight of hand makes my blood boil.

Geithner completely leaves out the crimes of our mutual fund industry. Instead, he focuses on Money Market Funds that broke the buck. Big deal. This cost the American people a tad of what was lost in mutual funds by companies that sold "conservative," "stable" investments to retirees following the models that touted moving to bonds in your retirement years to preserve capital and earn income. The Reserves money market fund, when all is said and done, lost about three percent. Oppenheimer's Champion Income Fund lost 79 percent. Schwab's Ultra Short Term Bond Fund lost more than 50 percent.

Schapiro jumps on the fraud bandwagon too. She deplores penny stock frauds and insider selling, she touts the SEC's recent (mostly pre-Schapiro) enforcement activity, but she appears oblivious to reality, and the following statement is laughable:

"Our capital requirements go a long way to ensuring that customer funds entrusted with a broker-dealer are safe in the event the broker-dealer gets in financial trouble. Again, our focus is not to insulate broker-dealers from competition and the risks of failure, but to protect investors in the event that failures do occur. We conduct examinations of these firms to assess their compliance with laws and regulations. And when we find violations or deficiencies, we direct that corrective action be taken."

Think Bernie Madoff Investment Service (a broker dealer regulated by the SEC). Ahhhhh! Capital requirements? Protect? Examinations? Compliance? Of course note the disclaimer; "And WHEN we find..."

Schapiro does however have a solution for making sure Madoff's don't occur:

"I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets. The list of certifying firms would be publicly available on the SEC's Web site so that investors can check on their own financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide both investors and regulators with information to then evaluate the auditors."

"As part of this effort, I expect to come to you in the near term with a request for authority to compensate whistleblowers who bring us well-documented evidence of fraudulent activity."

 Ok. Let me get this straight...

1. Madoff would be required to sign a certification - big help.
2. The auditors name would be public - oh, this helped the Oppenheimer Tremont Rye fund investors who received audit reports from KPMG and Ernst & Young who believe that they are isolated from liability because they can rely on certifications by Madoff's audit or shoeshine man.
3. The SEC could now pay whistleblowers who present "well documented evidence...because when Madoff's whistleblower Harry Markopolos came to the SEC for free the SEC could not believe that anyone would blow the whistle for free!

As for mutual funds: NADA, Nothing, Zip! Certainly, Schapiro recognizes the importance of mutual funds:

"Ultimately, capital comes from investors - people who invest directly in companies; people who invest in financial institutions that lend capital; people who invest in mutual funds and other pooled vehicles that in turn invest in America's businesses; people who buy municipal securities to help fund the operations of state and local governments; and people who look to the capital markets to save, put away money for their kids' education, and prepare for retirement. Markets that attract this capital are critical to America's economic future."

But Schaprio talks only about the past enforcement efforts and current regulations. As for future change, she talks only about money market funds. She apparently does not recognize that current regulations do not work for mutual funds.

The Courts have recently thrown out the private rights of action under the Investment Company  Act, which regulates the fund industry. Because of the structure of the funds, purported independent trustees ( who often sit on the boards of 10, 20 and even 40 funds offered by the same investment adviser), and trust agreements, even state law claims are impossible to bring. That leaves the paltry resources of the SEC to enforce those laws for an industry with more than $9 trillion in assets.

Mutual Funds are sold primairly over the phone or with glossy web pages and/or brochures containing smiley faces, impressive graphics and a sales pitch. To the extent that disclosures can be found, they  are impossible to read, dispursed in a staggering array of documents with indecipherable names, never actually delivered until after the purchase, and even then rarely. The funds' advisers retain near unlimited power to change their focus overnight...if it brings in more profits. The industry is driven by a need to do what it takes to attract capital, not the interests of the investor.

Neither Geithner nor Schapiro seem to recognize these issues, nor seem to care.

Dear, dear. The more things change the more they stay the same.

Famous Madoff Qoutes: "I Suppose You Could Program a Computer To Violate A Regulation, But We Haven't Gotten There Yet"

 

Famous Madoff Quotes: "I Suppose You Could Program a Computer To Violate A Regulation, But We Haven't Gotten There Yet", 60 million people retire next ten years? "Good Luck " and "I'm very close to the Regulators...my niece married one."

And More

 

As we proceed to work our way through the Madoff litigation, we tend to focus on those cases where we believe we can best find a source of recovery for our clients. To date that has been principally the Tremont Rye Funds which were controlled by Oppenheimer and Massachusetts Mutual, audited by two of  the Big Four accounting firms, KPMG and Ernst & Young, and supposedly had a custodial bank, Bank of New York Mellon. We have focused also on the feeder funds to the Tremont Rye Funds, such as Spectrum, Future Select, Austin and Meridian. Others crop up every day. Nevertheless, these stories, at this point, are rather dry and our minds still drift over to how  Madoff pulled this off. A video of Bernie Madoff discussing his business has surfaced on the internet, and helps lead us there.

 

When I watched this video of Bernie Madoff ( and his computer guru, Josh Stampfli) participating in a round table discussion, on the future of the stock market, I expected to find a hint of irrationality or slick behavior. The link to the video, audio and transcripts can be found here. Instead we hear a very rational human being, thoughtfully discussing fraud, human behavior and profits. Download Madoff TranscriptBut we also see tremendous irony in Bernie's statements. I highly recommend anyone impacted by this scandal to watch, especially around the the 43 minute mark. An index to Bernie's more ironic statements are as follows:

 

At minute 26 Bernie Madoff states:

 

"Now, no one is going to run a benefit for Wall Street, so whenever I go down to Washington and meet with the SEC and complain to them that the industry is either over-regulated or the burdens are too great, they all start to roll their eyes, just like all of our children do whenever we talk about the good old days."

 

At minute 28 Bernie Madoff states:

 

Today, basically the big money on Wall Street is made by taking risks. Firms were driven into that business, including us, because you couldn’t make money charging commissions, primarily because the rates were lowered and because of the regulatory infrastructure you had to have dealing with clients.

 

At minute 30 Bernie says:

 

"There are so-called Chinese Walls that are required to be established at every brokerage firm. They’re called Information Barriers—a term most people would understand—to sort of wall off a brokerage firm from taking advantage of information that he has as to what clients are basically going to trade or not going to trade. There are separate divisions within the firms and it is very carefully enforced and surveilled. It doesn’t mean there are not abuses, for sure, but by and large in today’s regulatory environment, it’s virtually impossible to violate rules. This is something that the public really doesn’t understand. If you read things in the newspaper and you see somebody violate a rule, you say well, they’re always doing this. But it’s impossible for a violation to go undetected, certainly not for a considerable period of time.  And when you consider the volumes of trading, the trillions of dollars of trading that go on today in Wall Street—I mean, our firm, for example, we trade an excess of $1 trillion dollars a year and that’s one firm—and you look at what we would consider to be the infractions, they’re relatively small, primarily because of all the regulation. Most firms do try to comply with that."

 

At minute 43 Bernie states:

 

So we determined that the best thing for us to do was basically to take the human being out of the equation. That had two advantages in our industry. Number one, when you take the human being out of the equation, you solve your regulatory problems because the nature of any human being, certainly anyone on Wall Street, is the better deal you give the customer, the worse deal it is for you. You’re on the other side of the transaction. It’s like going into any store—the store sells you a television at a higher price, they’re going to make more money. They sell you the lower price, their profit goes down accordingly. As honest as you try and get people to be, there’s this normal, natural pole that you have to deal with. By taking the human being out of the equation to a great extent and turning it over to a computer to make your decision—I guess you could also program the computer to violate the regulations, but we haven’t gotten there yet.

 

At minute 69 Bernie states:

 

"The future is silence. I don’t see a lot changing in the marketplaces. It’s hard to of course say that because everything always changes, but I cannot imagine what else we’d do, from an automation standpoint..."

 

At minute 71 Bernie's states:

 

"You know, this is a psychoanalytical group, I guess, right?... I’m sort of curious—maybe because no one got a chance to ask any questions about it yet—what are human beings contributing to the marketplace?  Is there any change in their actions?

At minute 111: Bernie states:

 

"This is SEC’s concern today because they call us all the time and ask us: should we be concerned about the fact that certain firms have left certain areas of the industry and are not serving the public, or not serving even other parts of the industry itself? The answer is it’s too late, because you’ve done it. So there’s always this friction that goes on between the regulation side of the industry and the practitioners that say okay, where do you draw the line? I’m very close with the regulators so I’m not trying to say that what they do is bad. As a matter of fact, my niece just married one.  (Speaker:  My condolences) (Speaker; Did the SEC approve?) Madoff:  He’s an attorney. (Speaker:  Okay.)

Madoff:  The issue is, the way they tend to look at the industry if you’re making a profit there’s something wrong, even though intellectually they know that shouldn’t be.

 

At minute 118, Bernie states:

 

"You know, my theory—and I’ve always said this even though we were one of the ones that started all this automated algorithmic trading—was that I never wanted to get into a cockpit of a plane and see there wasn’t a pilot sitting there...But more importantly, in our firm—and I don’t know that we’re unique, but I know there are other firms that do not operate this way—we  have a group of traders that are watching the systems work and the results of the systems to make sure that from their sense of trading things look right. With all due respect to Josh and a lot of other people that we have with similar backgrounds, programmers—not that he’s a programmer—but people of his ilk can tend to believe too much in the math and in the model. They fall in love with it sometimes. Not so much Josh, which is why he’s with us, but we have a lot of people like Josh that we employ and deal with. They’re different. The thing that separates somebody that is a good algorithmic trader from somebody that is dangerous is somebody that just always believes the machine is right. There are people like that. It goes back to what Bob said about the joke of the dog. It’s supposed to make sure that nobody touches the machine. You always want to have the human factor involved in the process because that makes it better. At least that’s been our experience.

 

And most disturbing at minute 125:

 

Audience:  "My question is a little basic. It’s open for the whole audience. How do you feel that the baby-boomers retiring, starting this year, will affect the future of the stock market, considering there were probably about 60 million people who are going to retire in the next ten years?"

 

Madoff:  "Good luck."

What is the take from this...its hard to tell. Here we have a man who created the NASDAQ, and took the human element out of the trading, and yet clearly likes to spend time with people. Maybe he was bored and needed the human touch. By playing the big man on campus, and spreading largess, he was the center of attention. As he states in minute 69...."The reason why is it’s quiet. When you went up to our firm you said, “Well, I’m surprised at how quiet it is.” I find it difficult to get used to that because I’m used to a lot of noise and screaming."

 

Clearly worst punishment for Bernie Madoff will be silence.