May(doff)day

First of all, it is Monday afternoon and as of right now we still have good old Blago as our governor so, sadly, it looks like I was wrong about that one. I'm still hoping for a quick resolution, but am preparing myself for this thing to drag out for weeks and possibly months.

I also awoke today to see that some dude named Bernie Madoff is perhaps the greatest magician of our time: he apparently made $50 billion disappear overnight. Before we get to the specifics, there is something that irks me. The four articles about this that I saw today had the following headlines: "Stocks Edge Lower as Madoff Victim List Grows", "Alleged Madoff Fraud Victims Include Big Banks, Super Rich", "List of Madoff's Victims Keep Growing, Likely to Extend Beyond Clients", and "How to Get Money Back from Bernie Madoff." So, basically, a lot of information about who has been affected and to what extent, but next to nothing about what actually happened. I think it's yet another example of our ADD media. Apparently they broke the story of what Madoff did on Saturday and so if you missed it - too bad; they're moving on. In that respect, maybe Blagoyevich is on to something here. He's gambling that we don't care enough to continually keep following this story and will eventually just forget about it. And he might be right. But I digress. . .

Fortunately, I got a good summary from the Economist:

"Details are still emerging, but Mr. Madoff has himself described it as a giant Ponzi scheme. For years, it seems, the returns paid to investors came, in part at least, not from real investment gains but from inflows from new clients. It might still have been going on, were it not for the global financial crisis. Redemption requests for $7 billion, by investors looking to pull back from turbulent stockmarkets, forced Mr. Madoff to admit that his coffers were empty - bearing out Warren Buffett's adage that only when the tide goes out is it clear who was swimming naked."

Some other details that I found interesting:

"The affair has - like the subprime-mortgage debacle - exposed a stunning lack of due dilligence. Droves of investors who should have known better tossed in billions, preferring to keep their fingers crossed rather than ask awkward questions of a firm whose investment strategy was vague and opaque. Even within his own group, Mr. Madoff's money-management business was a black box; no one but he had full access to the accounts. As a broker-dealer, it was able to clear its own trades, a privilege that should give pause for thought. Worse, questions had been hanging over the operation since the mid-1990s. Some institutional investors have long steered clear of Mr. Madoff, unable to understand how he spun his gold, or uneasy that his books were audited by a tiny, three-person accounting firm."

I bolded the parts I found most interesting. Being able to clear your own trades is just a complete lack of a fundamental control. You can get away with that if your operation is heavily audited, but I think it's pretty obvious that a $50 billion portfolio is way too big for a 3-person accounting firm to handle. Even so, if they had performed their job adequately they would have uncovered this scheme long ago. One of the most basic steps in auditing investments is to pick a sample of securities and observe that they are physically present onsite or in a safety deposit box offsite. I'm sure that this accounting firm will soon be out of business if they are not already. I am quite curious if they have professional liability insurance (as most audit firms do) and if so how much they had and who is on the hook for that.

Two months ago, Christy and I went to see a play called The Voysey Inheritance. Here's a quick summary of the plot:

"Misappropriation of client funds...fraudulent speculation on the Stock Market...deceit...lies ...and an intricate cover up. When young Edward Voysey discovers that the family's wealth has been built on three generations of deceit and theft he must choose between confessing all and ruining the clients that have unwittingly trusted the firm, or continuing the deceit in the hope of righting the wrongs that the firm's clients have unwittingly been subjected to. So the scene is set for an intriguing examination of ethics - and their absence - in the world of high finance."

Hmm, sounds a bit familiar no? The best part is that this play was written in 1905. Technology has grown by leaps and bounds since then, but it seems that financial swindels are often still barely above the sophistication level of 3 Card Monty.

It's also a vivid reminder of the fact that the "con" in "con man" is short for confidence. A good con man doesn't take your money; you give it to him because he's somehow managed to convince you that he's got your best interests in mind, or at least that you both share a common interest. And no matter what the final dollar amount ends up being here, the real damage will be consumers enduring yet another blow to their confidence in the finance industry. As they say about roaches in your house, "by the time you see one, it means you've got 1000." People are likely to start pulling more and more money out of their accounts out of fear and that's going to 1) cause the markets to fall further and 2) expose more criminals who are currently perpetrating similar schemes. The combination is likely to have a postive feedback loop effect, and that can be a very dangerous thing. Whatever the underlying reasons for a financial crisis, nothing gets better until trust is restored. People have to trust that they will still have a job next week before they will make major purchases. Banks have to trust a company's or consumer's income statements before they will lend them money. Right now nobody trusts anybody, and this is actually where greed is the enemy of capitalism. In the capitalist model, a nation of greedy pigs with an unquenchable need for consumption is good for society as a whole, but a nation of greedy misers who horde all they have is not.

It's hard to see the silver lining in all this, but I still believe it's there. There are still a whole lot of well run firms with profitbale, enduring business models and they will end up coming through this fine. I am also hopeful that the exposure of all these systemic problems will let us make some badly needed reforms in a way that is just not possible during the good times. Sometimes you just need to demolish the house and start over again instead of patching up every leak. Of course, that doesn't make it any more pleasant for the owners of the house (i.e. us), particularly when we are still inside the house as it's being demolished around us!