Lone Letter-Writers and the SEC

A long and interesting article by Michael Lewis and David Einhorn making a good case that the SEC has suffered from regulatory capture. One thing in particular jumped out at me, because it resembled an earlier NY Times story on a 2004 SEC rule change:

To that end consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.

* * *

Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, and so Mr. Markopolos could not have made money directly from Mr. Madoff’s failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: he declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the S.E.C.’s cursory investigation of Mr. Madoff pronounced him free of fraud.

Similarly, in that earlier NY Times story, the SEC in 2004 allowed the big investment banks to be more highly leveraged. No commenters opposed the rule, except for one guy:

A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.

“With the stroke of a pen, capital requirements are removed!” the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. “Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?”

He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.

Mr. Bole, who earned a master’s degree in business administration at the University of Chicago, helps write computer programs that financial institutions use to meet capital requirements.

He said in a recent interview that he was never called by anyone from the commission.

“I’m a little guy in the land of giants,” he said. “I thought that the reduction in capital was rather dramatic.”

To be sure, regulatory agencies are often inundated with crank letters from random individuals -- which inevitably means that such letters are received with a presumption of irrelevance -- and it's easy in retrospect to point out warning signs that an agency should have seen (check out the over 168,000 comments received in the FCC's media consolidation proceeding, Docket 06-121).

Still, in both of these cases, the SEC brushed off a letter that was, on its face, rational and credible, and that wouldn't have been lost in a stack of thousands of other comments. And it's rather remarkable that the supposed regulatory experts are being shown up, time and again, by a single person who is simply paying closer attention to what's going on.