Thursday, April 2, 2009

An Investing Lesson from Bernie Madoff

Jon Herring
An Investing Lesson from Bernie Madoff

Petty criminals go to jail, while the biggest criminals of all are promoted, appointed and elected to the highest positions of power. Bernie Madoff didn't exactly run the country. But he did run one of the world's largest financial exchanges, when he served as Chairman of the NASDAQ.

Certainly you're familiar with the story. Madoff ran a classic pyramid scheme, where yesterday's "investors" were paid off with the of new ones. The fraud finally collapsed when there were not enough new victims to support the growing withdrawals. In a story that has become all too common in modern finance money, the former "pillar of the community" turns out to be a slick con man with an amazing lack of conscience.

Certainly Madoff must be in shackles at Guantanamo Bay right now. Perhaps he has already been tortured and moved to solitary confinement. Nope. Even worse. He is currently under home detention with a nightly curfew (a curfew!).

The mainstream press often presents a story like this as if it is an open and shut case. But like many of Madoff's investors, I would venture that there is a LOT we don't know about what went on here.

First, we are asked to believe that not one, but DOZENS 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 obfuscation of what was actually being invested in, and 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. Neither his family, his traders, his inner circle, nor his employees had any idea that anything was amiss. Puh-lease!

Neither of these scenarios is fully plausible, in my opinion. My purpose in this essay is not to dissect the scam. I'm sure the details will be forthcoming in the months ahead – if not from the mainstream press, then certainly 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.

What Have We Learned?

We certainly 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 I had in 2000 with executives of Enron at their headquarters in Houston. After my presentation, I was given a short tour and asked if I wanted to see their trading operation. It turns out that a couple dozen Wall Street analysts were there as well. We all left duly impressed.

It wasn't until a year or so later that I learned the whole thing was a sham. Not only were the company's profits "pretend", 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 – make that, 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 were going to be 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."

It has not been a good decade for the reputation of American business. There is an old proverb that says, "The fish rots from the head down." In the case of America, I am saddened to say that 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.

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 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 from 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 are finally waking up to the fact that in a fiat money system, the entire economy is based on a Ponzi scheme of ever-expanding debt.

Where Was the Regulation?

Inevitably, when a fraud of this magnitude comes to light, politicians and pundits come out of the woodwork saying that we need better regulation and more laws. Wrong! Fraud is already illegal. And as long as we have a crony capitalist system, cronyism will always trump regulation.

The regulators are invariably selected from the organizations they are meant to regulate. The public agencies become corrupted and ultimately beholden to powerful private interests.

And 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 undeserved. When investors are lulled to sleep by the illusion of regulation, they make decisions they would not otherwise make.

So What Can You Trust?

Am I suggesting that you can't trust the government... the banks... the regulators... the financial exchanges... or even the companies we invest in? Well, not necessarily. But I am suggesting that you keep a wary eye on all of the above as far as your money is concerned.

I would also suggest that you invest a portion of your 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.

Let me get your comments if this post was helpful. Stay tuned for many more helpful investment tips and educative posts.

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