Regulation In Action At The SEC

Looking for examples of how smart, all-seeing, all-knowing regulators can succeed in removing all risk from human existence, we turn today to the SEC.   We'll start with a little history, and then move on to a current issue.

You may know the SEC as the guys who missed Madoff, but I'll bet you're not aware of the details of just how bad that one really was.  According to a Wikipedia summary here, Madoff started in business in 1960, and closed his business only when arrested by the FBI in December 2008.  The arrest occurred only after Madoff admitted to his sons that the business was a scam, and that he was out of money to pay redemptions; one of the sons then turned him in.  His fraud was never uncovered by the SEC.  Yet beginning no later than 1999 a guy named Harry Markopolos informed the SEC "that he believed it was legally and mathematically impossible to achieve the gains Madoff claimed to deliver."  According to Markopolos, quoted at CBS, "It took me five minutes to know that it was a fraud.  It took me another almost four hours of mathematical modeling to prove that it was a fraud."  

Markopolos didn't just inform the SEC in 1999 and forget about it.  He kept going back and back and back, providing all kinds of detail as to why it had to be a fraud.  After being ignored by the Boston SEC office in 2000 and 2001, he turned repeatedly to the New York office, to no avail.  The SEC even sent people to Madoff's office to look at documents, and they came away without finding anything.  At this link there is a lengthy 2005 written submission that Markopolos made to the SEC laying out in great detail why Madoff had to be a fraud.  For example, Madoff had explained to investors that his returns were always positive because he hedged using options.  But Markopolos tells the SEC:

Mathematically I have proved that BM cannot be hedging using listed index put and call options. . . .  [I]f BM was really buying OTC index put options, then there is no way his average annual returns could be positive!!  At a minimum, using the cheapest way to buy puts would cost a fund <8%> per year.  To get the put cost down to <8%> BM would have to buy a one-year at-the-money put option and hold it for one year.  No way his call sales could ever hope to come even fractionally close to covering the cost of the puts.

Markopolos ultimately wrote a book about his efforts entitled No One Would Listen.  Of course, the SEC should well have been able to figure this one out on their own.  But even with a guy totally on to it and laying it all out for them and literally hammering them with it for nine years, they couldn't do it. 

And then there are the hundreds of other Ponzi schemes over the years.  Always, they come to light only when the operator runs out of money to pay redemptions.  Has there ever been one single example of the SEC finding a Ponzi scheme before it collapsed on its own?  I have looked hard and asked many people.  I do not believe there is a single example. 

If there isn't a single example (or even if there are one or two), why exactly is the SEC using up taxpayer resources claiming a role in this area?  It's just a matter for criminal prosecution after the fact.   But somehow we believe that having "experts" at the SEC looking into this can eliminate the risk of crooks.  It seems that no amount of experience to the contrary can ever teach us that this can't work.

To turn to current events, today the SEC is applying its skills to the regulation of Money Market Mutual Funds.  The concept again is that the smart experts can eliminate all the risk, presumably without side effects (because if risks come with benefits, we should be entitled to have the risks). 

Again, a bit of history.  In 2008 a large money market fund, Reserve Primary, sustained a substantial loss when Lehman filed for bankruptcy, and its net asset value fell below $1 per share.  The loss came to about 2 cents per share at Reserve, meaning that they had 98 cents left to redeem each dollar share.  But there was an immediate run at Reserve, as large investors sought to get their money out immediately.  Runs also began at other money market funds, leaving them at least temporarily with not enough cash to pay redemption requests, and some say that the market "froze."  The Federal government promptly (and very unwisely, in my view) stepped in and guaranteed the assets of all money market funds.  (Those guarantees have since been rescinded, but the market has undoubtedly learned a lesson that the guarantees will return when the government wants to do it.) 

Again, one might ask, if the SEC is all-knowing and all-seeing experts, why hadn't they foreseen the 2008 money fund crisis coming and already provided for it?  The answer is, that their job is not to maintain a healthy horse, nor even to close the barn door after the horse has run away, but rather to be sure that the horse can never escape again by burning down the barn and shooting the horse.  So, carrying out that mission, the SEC put in place in 2010 a large list of money market "reforms" for the purpose, they said, of "better protect[ing] investors."  There is a list at this link.  The main ones were requiring a "minimum percentage of . . . highly liquid securities," requiring "higher credit quality" in assets held by money funds (a very complicated rule to implement), and requiring "shorter maturity limits" for securities for securities held by money funds.

The result was entirely predictable:  Since these rules took effect, you basically haven't been able to earn more than 0.01% interest on a money market fund.  Every so-called "reform" looked at the risk/reward trade-off in some area and required taking the option of the least risk.  No risk, no reward.   

I don't know about you, but I'd be perfectly willing to risk losing 2% on my money fund every once in a while, or even 5%, if I could get some regular positive returns the rest of the time.  Why am I not allowed to do that any more?  And believe me, they haven't driven the risk of loss to zero.  So now it's all downside.  Thanks, guys! 

And now this year the SEC is out with another round of proposed money fund "reforms"  Here's a link.  It's 698 pages long!   Well, what could go wrong with adding a few more (hundreds of pages of) regulations when you've already driven yields down to 0.01%?  The accounting firm PWC in a summary of the effects of the new rules states:

Existing and future sponsors will have to decide whether it will be economically viable to manage MMFs given the proposed regulation.

No kidding.  I guess the American people aren't smart enough to make their own decisions about risk and reward in money market funds.  So we just have to turn those decisions over to the people who missed Madoff.