04/13/2009 05:12 am ET Updated May 25, 2011

Madoff Could Have Fleeced his Victims Legally

What should Bernard Madoff's victims have known and when should they have known it? And what about the hidden 2007 George W. Bush administration decision that helped enable Madoff's crimes?

The first question has a simple answer: most of them should have known from the start not to invest with Madoff, because they were buying into hedge funds. Even if the fund manager is honest, it's not prudent to place your life savings -- or in at least one case, your entire charitable endowment -- in a hedge fund, a risky asset class. Perfectly legitimate hedge funds can clobber investors, as Carlyle Capital did last year. The Madoff victims dominating the news -- upper-middle-class men and women who handed much or all of their life's savings to Madoff -- should never have been at the scene of the crime in the first place. Hedge funds are the Wall Street equivalent of baccarat tables. Never gamble with anything you cannot afford to lose!

Commentators are now lamenting that Madoff's funds were unregulated, but that's because they were hedge funds. (Here is their Securities and Exchange Commission listing under the category for high-risk investments.) The logic of the hedge fund is that it does not require close regulation because only sophisticated, wealthy people and institutions buy into these instruments: such persons and institutions are assumed able to bear losses, and also to understand that portfolio theory says to place only a fraction of what you possess in risky ventures. In order to buy into a hedge fund, the SEC asks you become an "accredited investor," attesting your net worth is at least $1 million, or that your income is at least $200,000 annually and you expect your income to remain at that level. That is, you attest that you are well-enough off to take a big loss and still be okay.

Perhaps as part of pretending to be genuine, Madoff required marks to sign waivers acknowledging they had been warned of a possible loss. All legitimate hedge funds require such documentation. Putting retirement money into an investment that warns of losses is the kind of move those approaching retirement are supposed to avoid. Retirement money belongs in Treasury bills, certificates of deposit, blue-chip bonds or S&P mutual funds. Mutual funds can decline -- reputable S&P funds are down around 35 percent since October 2007 -- but also bounce back, and there is no chance of them going broke. (Broad-market mutual funds would zero out only if Western society collapsed, in which case it would make no difference where you invested.) Hedge funds tank on a distressingly regular basis. Just ask investors in the SageCrest hedge funds, which went bankrupt last summer after about $600 million of investors' $650 million was lost on bad bets.

Most hedge funds impose a minimum $1 million initial purchase, in order to ensure that only those who can afford a loss buy in. Madoff"s funds had a $2 million buy-in, a reason all Madoff victims interviewed by today's Wall Street Journal lost more than a million dollars. (Those who pooled funds to meet the Madoff minimum were circumventing an SEC rule intended to protect average people from Wall Street vultures.) The high buy-in was part of Madoff's con-man appeal, along with his preposterous claim to possess "algorithmic technology," whatever that means; Madoff made it seem he was guarding the doorway to a super-secret money machine reserved for a select few. Fairfield Sentry, a Madoff feeder, had a $100,000 minimum buy-in, unusually low, so a middle-class person might have entered the Madoff swindle via Fairfield or a similar feeder. But the same basic reasoning applies. Unless you could afford to lose $100,000, what were you doing putting your retirement nest egg into a hedge fund?

Madoff intermediaries told marks that the financial genius they represented had invented an investing formula that eliminated risk. Adults are supposed to know that salespeople will say anything to get a commission! Anyone who said, "I bought Florida swampland sight unseen because the salesman assured me a major shopping center was about to open nearby" would not receive much commiseration. Many people are financially unsophisticated, or don't read warning forms; many want to believe there are incredible super-secret insider wealth formulas. But in the end, adults must be responsible for their voluntary choices. People whose savings were funneled to Madoff without their knowledge or consent are deserving of unlimited sympathy. Those who actively sought out Madoff became crime victims: but the first step to that status was their own "assumption of risk," as the saying goes. Had most Madoff investors simply followed conventional financial theory about retirement, most would still have their money.

What might the Bush Administration have done to lessen the Madoff damage? In 2006, the Securities and Exchange Commission proposed to raise the requirement for individuals to engage in risky investments to a net worth of at least $2.5 million above home equity. That definition would have barred the upper middle class from hedge-fund investing; in 2006, SEC chair Chris Cox said hedge funds "are not for Mom and Pop," and should be made harder to place money in. But the SEC postponed the rule change after a White House panel said in early 2007 that hedge funds should have only nonbinding self-regulation.

Had the 2006 rule change gone through, many who invested in Madoff Securities in 2007 and 2008 would have been prevented from doing so -- such Madoff victims have every right to be furious at Bush's financial bozos. The rule still needs to be changed, to prevent other average people from investing retirement savings in other risky funds. Let's make sure what happened to the Madoff victims does not happen to anyone else.