Bernard Madoff, once a respected investment adviser, may have perpetrated one of the biggest financial scams in history. Federal authorities are now trying to sort out what amounts to an enormous Ponzi scheme after Madoff admitted wrongdoing to employees of his firm. The scam's price tag could be as high as $50 billion, a staggering revelation since many rich investors actively sought to have Madoff manage their money.

Some questioned Madoff's consistently stellar returns years ago, but inquires by the Securities and Exchange Commission (SEC) never turned up anything. H. Nejat Seyhun, the Jerome B. and Eilene M. York Professor of Business Administration, teaches finance at the Stephen M. Ross School of Business. In the following Q&A, he says the Madoff scandal is exactly what the battered financial markets didn't need right now. But it could result in a more responsive SEC going forward, since the regulatory agency is under intense scrutiny for dropping the ball.

How did so many people who should have known better get duped by Madoff?

Seyhun: I don't know exactly. I think it's partly human nature. Every one of his clients wanted to believe Madoff. He probably told some of them that they were special. I know one investor personally who said he suspected he was getting somewhat better than the market rate, and that he was getting it as a favor. There may have been a lot of that. There were probably a lot of clients who thought they had a special personal relationship with Madoff and thought he was doing them a favor by providing some extra return for them. This reminds me of an old joke: A finance professor secretly gives each of his students a blue bead and asks them to keep it a secret. When students ask publicly in the classroom, Who is your favorite student? the professor replies, The one with the blue bead, of course. (Now you know why we get high teacher ratings!) It seems to me that Madoff ran a blue-bead operation as well.

What kind of red flags were missed?

Seyhun: There were a lot of red flags. Obviously, you had (Boston investment adviser) Harry Markopolos writing letters to the SEC claiming specifically that Madoff was running a Ponzi scheme. He wrote dozens of letters over nine years and the SEC didn't investigate carefully enough. Madoff told his investors that he was buying put options below the market and selling call options above the market to finance the put options. That's sort of like portfolio insurance, except that you are paying for that insurance by selling the market's upside. This would, exactly as Madoff claimed, smooth out returns. The only problem is that once you do this, there's no way of getting 10 percent or 15 percent returns year in and year out. The actual returns would be near the risk-free rate, a Treasury bill rate.

Here's another red flag: Madoff was purporting to actively manage up to $50 billion in this fashion. You would have to buy and sell a lot of options, day in and day out, so there would be a huge amount of volume wherever he traded. All the SEC had to do was look to see whether there was such volume. There wasn't. The volume was one-tenth of what he would have generated. So it wouldn’t take rocket science to see something was wrong. They could have simply checked the options volume. Furthermore, he hired a tiny, three-person audit firm (including the receptionist) for his $50 billion operation.

The most obvious thing people missed is that you don't get something for nothing. Here he is, delivering incredibly smooth returns between 10 percent and 15 percent year in and year out regardless of the market conditions. One investor said that this year, when the market is down 35 to 40 percent, his position was up five percent year-to-date because of Madoff's investments. That should have been a red flag. How could anyone deliver that return in this market? Anyone who can do that would not manage other people’s money. He (she) would just manage his or her own money.

Should regulators from the SEC have been able to pick up on this?

Seyhun: Absolutely. Madoff was registered as an investment adviser. As a result, the SEC would have the right to go through his books and investigate him. It wasn't like he was dealing with a few qualified institutional investors. He was dealing with the public at large. The SEC did investigate him on multiple occasions and every time they came up short.

How did he dupe the SEC?

Seyhun: That we don't know yet, fully. We need to wait and see what details will emerge. Madoff was chairman of Nasdaq and he had a good name. It wasn't like he was a fly-by-night operation. He had good connections, he contributed to charity, he had a lot of respect, and all of that might have played a role in nobody suspecting him.

Is this going to lead to a change in the financial regulatory structure?

Seyhun: I'm not sure if it's going to change the whole regulatory structure, but it should certainly result in more effective enforcement. If something as big as this goes on and he's not caught, that's a problem. If they can't catch a $50 billion Ponzi scheme before the guy effectively turns himself in, what can they catch?

I think a couple of things are going to happen. People will question their investment advisers and money managers more carefully and be more vigilant on their own. And the SEC needs to be more vigilant regardless of somebody's name or their position. It also brings this to my mind: With this going on undetected for so long, is it just the tip of the iceberg? Are there more, smaller Ponzi schemes out there?

What kinds of specific changes might we see because of this?

Seyhun: More vigilance and more disclosures. The SEC probably will require more reporting from entities who have never reported before. For instance, even huge hedge funds don’t report anything about their operations at all. We might see reporting requirements for hedge funds above a certain size. And reporting on not just what they have, but on what the potential liabilities are. A lot of the current problems that we're experiencing right now came not from regulated commercial banks but from entities such as investment banks, where the Federal Reserve did not have direct supervisory authority. Now, everybody is becoming a bank holding company and more are under the Fed's regulatory authority. Some have suggested these multiple regulatory bodies will be consolidated into one agency so the right hand knows what the left hand is doing. We have different federal authorities -- the Fed, the SEC, the Financial Industry Regulatory Authority (FINRA), and the Commodities Futures Trading Commission (CFTC)-- dealing with different institutions.

One regulatory change I would like to see is with the settlement, clearing, and safekeeping of securities. Currently, this is done by the Depository Trust and Clearing Corporation (DTCC), and the ownership of the securities is registered at the level of the brokers. The regulations need to be changed so that securities are registered not in brokers' names but in the ultimate beneficial owners' names. Furthermore, clients should be able to obtain a password from their brokers and directly verify the existence of the securities in their own name at the DTCC. We don't want to over-regulate; however, the Madoff scandal has exposed this glaring weakness in the U.S. regulatory environment and this needs to be corrected as soon as possible. The rest of the problems are already covered by the regulations in existence. Unfortunately, these existing regulations have not been sufficiently followed. Had the SEC done that, they certainly would have caught Madoff.

Is this going to further shake confidence in the U.S. financial system and make investors even more skittish than they already are?

Seyhun: I think so. I think we're already seeing the effects. People simply do not know the extent of their losses yet. We're waiting for the other shoe to drop. We don't know what the aggregate losses are, and how the losses are going to be divided. If you can't trust a well-known name like Madoff then they may simply decide not to put their money in the stock market and these kinds of investment vehicles. And that would have important repercussions. The cost of risk capital would be higher, and we'd get fewer risky activities and less innovation.

Could this scandal actually deepen and extend the credit crisis?

Seyhun: Yes. The current crisis we're in is also a crisis of confidence. Even though the interest rate is nearly zero, the cost of risk capital is still quite high. So people don't want to make loans as a result. This scandal could further increase the risk premium. When well-known names like Citibank, Lehman, Bear Stearns, AIG, and Madoff get in trouble, investors wonder, who is safe, who they can deal with. Maybe nobody. So they'll put their money in T-bills and wait the crisis out. That will make the credit crisis much worse.