Saturday, December 27, 2008


When petty criminals get caught, they go to jail i.e. incarcerated (a politically correct word for castration). The biggest criminals of all however, get promoted, appointed and elected to the highest positions of power.

While Mr. Bernie Madoff didn’t exactly run the country, he did once run one of the world’s largest financial exchanges, when he served as Chairman of the NASDAQ.

I’m sure that by now you’re all familiar with the story. Madoff ran a classic pyramid scheme, where yesterday’s “investors” were paid off with money from new investors. This is called a Ponzi scheme and is illegal. Bernie’s fraud finally collapsed when there were not enough new victims to support the growing withdrawals. In a story that’s become all too common in modern finance, the former “pillar of the community” turned out to be a slick con man with an amazing lack of conscience.

You’d expect that Bernie must be in shackles at Guantanamo Bay right now. Perhaps he has already been tortured and moved to solitary confinement. Nope. Even worse! He’s currently under home detention under a nightly curfew (a curfew!).

The media often presents a story like this as if it’s an open and shut case. But like many of Madoff’s investors, I’d bet there is a great deal about what went on here, we don’t know.

First, we’re asked to believe that not one, but tens of sophisticated hedge funds and international banks circumvented their internal risk control procedures and did not carry out even the most elementary due diligence. They invested in a black box system with constantly high returns, a lack of third party oversight, a total mystery of what was actually being invested in, with a one-man accounting firm auditing the multi-billion dollar operation.

We are also asked to believe that Madoff orchestrated the entire fraud, acting alone. His family, his traders, his inner circle, his employees had any idea that anything was amiss. COME ON!

Neither of these scenarios is believable, in my opinion. The purpose here is not to dissect the scam. I’m sure the details will be forthcoming in the months ahead – if not from the mainstream media, then surely from other reliable sources. Rather, my intent is to discuss what we can learn from this situation and how can it guide your investing in the months and years ahead.

Have We Learned Anything?

YES we have learned that we cannot always rely on what we hear and what we see at first glance. I am reminded of a sales meeting a friend had in 2000 with executives of Enron at their headquarters in Houston. After his presentation, he was given a short tour and asked if he wanted to see their trading operation. It turns out that a couple dozen Wall Street analysts were there as well. All left duly impressed.

It wasn’t until a year or so later that everyone learned the whole thing was a sham. Not only were the company’s profits “fiction”, but so was the trading floor. It might as well have been a movie set. Enron had staffed and decorated the trading floor to impress, pronounced deceive Wall Street analysts into believing that the company was operating a thriving energy trading operation.

In a BBC article, Enron employee Carol Elkin said, “It was an elaborate Hollywood production that we went through every year when the analysts came there to impress them to make our stock go up. It was absurd that we were doing this. But the most absurd part was that it worked.”

There is an old proverb that says, “The fish rots from the head down.” In the case of the USA, I’d say the proverb applies. The New York Times suggests that Madoff’s scam “may be the largest Ponzi scheme in history.” Unfortunately, it is not even close.

Do you know of the Ponzi Scheme of “Unfunded Liabilities”?

There is no bigger Ponzi scheme than those operated by the Federal government – Social Security and Medicare. Both programs are nothing but an inverted pyramid with money from new contributions going to pay for withdrawals. The only difference is that Charles Ponzi and Bernie Madoff didn’t force people to give them money.

However, the eventual result will be the same, just on a much larger scale. As the withdrawals inevitably swamp the new contributions, both programs will end in disaster and disgrace. And for that matter, what is the difference between Madoff’s scheme and that of the big banks who have finally had to admit that their own financial statements were bogus and many of their “assets” worthless.

If nothing else, I hope that people will wake up to the fact that in a fiat money system, the entire economy is based on a Ponzi scheme of ever-expanding debt.

Regulation? What Regulation?

When a fraud of this magnitude comes to light, politicians and their gurus come out of the saying that better regulation and more laws are needed. Wrong! Fraud is already illegal. And as long as we have a crony capitalist system, cronyism will always trump regulation.

Regulators are invariably selected from the organizations they are meant to regulate. The public agencies become corrupted and ultimately beholden to powerful private interests. In any case, regulation can actually be part of the problem. The SEC has helped to foster a mentality of trustworthiness in the financial system that we now know was totally undeserved. When investors are mesmerized by the illusion of regulation, they make decisions they would not otherwise make.

Who or What Can You Trust then?

If you can’t trust the government… the banks… the regulators… the financial exchanges… or even the companies we invest in who can we trust? Well! We just have to learn to keep a wary eye on all these organizations as far as your money is concerned. I would also suggest that we invest a portion of our assets in the rare asset that has no counterparty risk – physical gold and silver. Gold that you can hold in your hand. If all else fails, you still have something that has maintained its value and has been desired for virtually all of human history. Think about it for the New Year. END