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to enforce laws passed by Congress, then the head should be referred to the Justice Department for criminal prosecution. It is a disgrace that the regulators charged with overseeing the financial industry have gotten away scot-free. At the SEC a few of the department heads were allowed to resign “to pursue other growth opportunities,” called “pogo-ing out,” often to well-paying positions in private industry. It would be satisfying to see a few of these people sent to prison for their willful blindness in allowing our nation’s financial system to collapse; unfortunately, there are no laws on the books that make that possible. Entire government agencies can remain comatose, letting the industries they are charged with regulating commit crimes without any fear of being penalized for it.

A similar SOX making agency heads responsible for the failures of their staff would also go a long way toward eliminating so-called regulatory capture, a situation in which the regulators become beholden to the industries they supposedly are regulating. The mission of the SEC is to protect investors, but in reality it ended up serving the needs of deep-pocketed and influential industry firms.

Fourteenth, publicly censure the SEC. Clearly the SEC has been unofficially censured. Its reputation is in tatters, its employees have been shamed. Obviously no one can take pride in being an employee of the SEC. But maybe we should make that embarrassment official. One way to light a bonfire under agencies that are under-performing or non-responsive to Congressional oversight is to publicly censure them. Call them out. Identify them for what is, a national disgrace. Then force that agency to include that censure in every communication sent out by employees—for a predetermined amount of time or until the agency proves it has rectified its problems. This is a low-cost but effective means for Congress to publicly express its displeasure over the lack of regulatory action. No one, absolutely no one, enjoys playing on a losing team.

Fifteenth, regulate and give investors some guidelines. Bernie Madoff didn’t just steal billions of dollars; he exposed the lack of government supervision of the financial industry to a public that had already been badly burned. Madoff is already a tragedy. It would be an even larger disaster if we didn’t take the steps necessary to create fair and transparent markets.

For example, the over-the-counter (OTC) market is unregulated space. It’s where the financial industry’s cockroaches congregate, because it is a place where there is no light, only darkness. And perhaps not coincidentally, this is also where the industry’s highest margins exist, so people will fight like Mike Tyson to protect their profit margins.

That needs to change. Laws should be passed to prevent American investors from trading OTC products offshore and still receive government protection in the form of bailouts. In other words, there should be no more trading through unregulated entities like AIG’s London-based Financial Products unit, where the risk ends up getting transferred back onshore and U.S. taxpayers end up footing the bill. It seems only fair and logical that if American regulators don’t have visibility into an OTC product traded offshore, then strict risk and capital limits should be placed on U.S.-based counterparties in order to avoid systemic risk.

You can’t regulate common sense, but some sort of guidelines should be available to investors on the SEC’s web site, pointing out that if you don’t know how to model an OTC derivative yourself, then you, your company, or your municipality shouldn’t be trading them. The SEC should closely investigate all disclosures in the OTC municipal derivatives market, because this sector of the marketplace is just rife with fraud. In many instances it is still a pay-to-play market with opaque disclosure documents and even more opaque pricing mechanisms, which only serve to defraud government entities.

I have seen the state of Massachusetts lose $450 million because no one in state government knew how to price interest rate swaptions. The Massachusetts Turnpike Authority was picked off by several Wall Street firms because they were lured into OTC transactions in which they didn’t understand the pricing or the risks.

Once again, you can’t regulate common sense, but we can regulate the OTC markets so they no longer remain outposts of lawlessness. More regulation can only come from the federal government. History has now taught us that we need to shed light on those dark places in our capital markets. Everybody deserves full transparency when they are dealing with investments, and it’s up to the government to provide it.

Appendix A

Madoff Tops Charts; Skeptics Ask How

Michael Ocrant

Mention Bernard L. Madoff Investment Securities to anyone working on Wall Street at any time over the last 40 years and you’re likely to get a look of immediate recognition.

After all, Madoff Securities, with its 600 major brokerage clients, is ranked as one of the top three market makers in NASDAQ stocks, cites itself as probably the largest source of order flow for New York Stock Exchange—listed securities, and remains a huge player in the trading of preferred, convertible and other specialized securities instruments.

Beyond that, Madoff operates one of the most successful “third markets” for trading equities after regular exchange hours, and is an active market maker in the European and Asian equity markets. And with a group of partners, it is leading an effort and developing the technology for a new electronic auction market trading system called Primex.

But it’s a safe bet that relatively few Wall Street professionals are aware that Madoff Securities could be categorized as perhaps the best risk-adjusted hedge fund portfolio manager for the last dozen years. Its $6-7 billion in assets under management, provided primarily by three feeder funds, currently would put it in the number one or two spot in the Zurich (formerly MAR) database of more than 1,100 hedge funds, and would place it at or near the top of any well-known database in existence defined by assets.

This article was originally published in MARHedge magazine (No. 89) in May 2001. Reprinted with permission of

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