This week began with shrieks of joy. First, a federal court came down on Bernie Madoff like a brick on a bald head. Madoff, convicted of lying to investors, drew a sentence that only a sea turtle or a swamp oak could complete. Then, like children playing in the sea, investors were teased by one wave of good news… and tickled by the next.

Bloomberg reported that “Wall Street’s largest bond-trading firms say the worst may be over for investors… ” Then, General Electric’s CEO, Jeffrey Immelt and famous investor George Soros both said that the crisis is “behind us” and that growth will begin again next year. Finally, analyst John Dorfman opined that the stock market would be a safe place for their money at least through the end of the year.

And now comes the big American holiday – July 4th. Investors pack their suntan lotions and head off to the beach for Independence Day. With Jaws in a cage, they had judged it safe to go into the water. But then came Thursday’s news. Instead of going down as predicted, the number of job losses for June went up. Another 467,000 people became unemployed last month. The figure even surprised us; we didn’t think there were that many people who still had jobs.

And so… this weekend, investors walk along the beach deep in thought. Is it safe to go back into the water… or not? They should listen carefully. That gurgling sound they hear is not mermaids singing, it is the world economy, drowning.

As we reported in this space, the feds’ bailouts, boondoggles and bankers’ bonus plans aren’t working. At the end of last year, they predicted unemployment over 8% in 2009 — if the stimulus plan were not enacted. But it was enacted. Unemployment is at 9.5% already and it is still rising. It will be over 10% before the end of the year. Global trade is collapsing; exports from Germany and Japan are down about 40% from a year before.

Prices are going down too – with a report this Wednesday that the entire Eurozone has slipped into negative inflation. And from Britain came data showing a contraction of 2.4% in the first quarter, bringing the year-to-year decline to nearly 5%. “Economy shrinks at 1930s rates,” said the headline in Wednesday’s Telegraph.

When we look at America’s employment numbers, we feel like a school doctor. We would call the authorities, except that it was the authorities who should be arrested. After the feds got finished with them, the numbers told of a better-than-expected drop in May US payrolls.

The key to this uplifting news was not a genuine improvement, but new and improved techniques in torture. Water-boarded with seasonal adjustments and birth/death models, the numbers began to see jobs everywhere. As for “discouraged workers” — those who gave up looking because they couldn’t find a job — they disappeared from the jobless figures altogether.

John William’s Shadow Government Statistics reports that without these twists, the numbers tell the same story they’ve been telling all year – unemployment is still getting worse, at about the same pace as earlier in the year. “The unadjusted annual decline in May payrolls was the worst since May 1958,” says Williams. And if they were allowed to speak freely – as they did in the ‘30s – the figures would show real unemployment at over 20% of the workforce… or about 30 million people. That approaches Great Depression levels… .and we’re still only in 1930, not 1932. As for those still working, an additional 1.5 million US workers have been “forced into part time work” according to the Financial Times.

Analysts compare these sharp drops in trade, prices and employment to what happened after WWII. Come 1946 and the world had little use for so many soldiers, machine guns and artillery shells. Millions of young men were ‘de-mobed’ and joined the unemployed. And smokestacks suddenly stopped smoking.

But that was at the very beginning of 62-year period of credit expansion. Consumers had pent up demand for houses, cars, and other goods and services… and they had the wartime savings to buy them with. Even so, it took three years of adjustment after the war before the stock market began to turn up.

Now, we are at the other end of the cycle – the beginning of a major credit contraction, with no pent-up demand, no savings, and too much capacity to turn out too much stuff that too many people don’t have the money to buy.

Meanwhile, housing prices are still going down in America… and with housing goes the lenders’ collateral. US residential property prices have fallen 33 months in a row. So many houses are “underwater” that the US is beginning to look like the lost continent of Atlantis. More foreclosures are coming. US mortgage loans typically call for “down the road modifications” that lead homeowners into a kind of financial cul de sac with no way out except foreclosure. According to a study by T2 Partners, there are three more big waves of foreclosures still ahead – including those in ‘prime” loans, home equity lines of credit, and in commercial real estate.

“When [these mortgage loans] start adjusting upward it will turn millions of homeowners into over-levered, underwater renters, and ensure housing is a dead asset class for years to come,” says Mark Hanson of the Field Check Group.

With incomes falling and house prices weak, consumers will miss payments, default, and cut back spending. Business earnings will decline; bankruptcies will increase. This economic undertow is treacherous. Investors should stay out of the water.

Source: Stay Out of the Water

Let the punishment fit the crime!

Poor Bernie. The man has been ordered to spend 150 years in the hoosegow. What for? Who did he kill? A century-and-a-half seems a little excessive for a financial crime. You could hold up three liquor stores and rape a whole convent and still not get 150 years. With a little good lawyering, a history of child abuse in the family and good behavior in the big house, you’d be back on the street in 18 months.

But all the papers seem delighted. “Locked up for Life!” says one of today’s headlines. The judge “threw the book at him,” says another. His victims wanted him to get no mercy. The judge gave him none, imposing the maximum sentence. He is “extraordinarily evil,” said the man on the bench.

Justice has been done. Right?

Here in the building with the gold balls, we’re not so sure. We stand up for lost causes, die hards and scalawags. Besides, we’re not convinced that Bernie is extraordinarily evil at all. He seems much more like an ordinary evil to us.

They say he defrauded investors out of $65 billion. The amount is unusual, but the crime is as common as income tax evasion. Who gets 150 years for evading income taxes? Heck, in civilized countries it’s not a crime at all – but a civil misdemeanor, subject to fine and retribution, not punishment.

But didn’t he lie to investors? Well, yes… he exaggerated the returns investors were likely to get from his fund. But if you put every fellow on Wall Street who does that in jail, you wouldn’t have any room for stick-up men and wife beaters.

Isn’t he the biggest financial scammer of all time? Well… he’s the title holder now. But he has a lot of competition close on his heels. Bernie’s crime was taking money from people under false pretenses… and then being unable to give it back to them. How is that different from the financing activities of the US government?

This year alone, the feds will borrow 50 times as much money has Bernie managed to take in during his whole 20-year career. They can only pay it back by borrowing even more money from more lenders. This is not very different from the typical “Ponzi” scheme, except that it’s the government doing it. Eventually, the suckers are going to lose a lot of money.

And when you balance Bernie’s sins against his virtues, we’re not sure the man doesn’t come out at least as well as many of his accusers. While Bernie was pretending to make his investors rich, the SEC was pretending to protect them from Bernie. In fact, neither were really doing what they claimed. Which is to say, both are guilty of ordinary evil.

As we pointed out yesterday, nothing is as dangerous as good luck. Madoff was not extraordinarily evil; he was just extraordinarily lucky. He was plying his trade when the feds were pumping up the biggest financial bubble in history. No wonder so much hot gas came his way. His luck ran out when the bubble popped. And now a court has found him guilty of fraud and a judge has ordered him locked up for a period equal to roughly the time between the end of the US War Between the States and the resignation of Richard Nixon.

While Bernie is behind bars, the SEC and FED officials are still at large. Both are clearly guilty of dereliction and negligence.

But, what is the point of keeping Madoff in prison? He represents no threat. Rather than pay $30,000 per year to keep him locked up, we suggest that he be forced to do community service work. He should be pressed into service as the next head of the Federal Reserve after Ben Bernanke’s term expires in December. With Madoff in the big office, there would be no longer any illusions about what sort of bank the Fed is running.

And more views on the news:

*** Illusions there are aplenty. In the popular mind, the slump of ’07-’09 is coming to an end by Christmas. Practically everyone says so – including Ben Bernanke himself. All the bailouts and stimuli are paying off, they think. Soon, it will be business as usual.

Yesterday, the Dow rose 90 points. Oil rose a bit too – to $71. The 10-year T-note rose too… with a yield falling below 3.5%. And gold held steady at $940. If the markets know what happens next, they’re keeping mum.

We have already told you, dear reader, why we do not expect business as usual ever again in our lifetimes. From WWII to 2007, the world economy had a single important driver – the US consumer. At the beginning of that period, he consumed because he earned. By the end of it, he earned because he consumed. That is, the more he was willing to borrow and spend, the more the whole world economy seemed to bubble up.

But now, that era is over. As Jeff Immelt, head of GE says, “you’re going to have a world where the US consumer won’t be the main driver.”

Or, as En Yu Faz put it, “there are only two forces in the world: life and death, positive and negative, up and down, yes and no, love and fear… ”

Yu Faz, as he is popularly called, was a mysterious Mongolian philosopher, believed to have lived in the 13th century, when he was an advisor to the Great Khan.

“I am a slave to my master,” Yu Faz said, “but my master is slave to me too.”

We were wondering what the hell he meant by that when we recalled that we were writing a financial commentary. So let us turn back to the financial news…

*** “Where was the SEC?” asked a sign outside of the courtroom where Bernie Madoff was sentenced.

Good question. And guess what. We have the answer. While Madoff was taking in his billions… and the biggest financial bubble was preparing to explode… the SEC was asking questions – of your editor!

Yes, dear… dear reader. All over the world, responsible authorities are demanding a more muscled approach to financial regulation. “Bernie Madoff’s life sentence should galvanize regulators everywhere,” says today’s Times of London editorial, speaking for the majority.

But it was not muscle that kept the SEC off Madoff’s case. At the very moment when a free-lance informant was tipping off the SEC about Madoff… the agency’s goons were beating up innocent victims… and grilling innocent publishers:

The New York Times reports:

“The Boston office of the Securities and Exchange Commission began the investigation around 2001. Three years later, formal charges were brought against Mr. [Richard] Kwak and seven others. By the time the case went to trial, in 2007, only three defendants were left; the others had settled with the S.E.C.

“In that 2007 trial, Mr. Kwak and another defendant, Stephen J. Wilson, were cleared of one charge, with a hung jury on the remaining charges. (The third defendant, who foolishly acted as his own lawyer, was found liable and fined $10,000.) “The S.E.C. retried Mr. Wilson in 2008. He was cleared. Finally, in March 2009, the S.E.C. retried Mr. Kwak, with the same result. The jury took less than four hours to exonerate him.

Mr. Kwak’s life is now in tatters. He is around $1 million in debt and suffers from emotional problems. He has struggled to stay out of bankruptcy. Although he is still a broker — he certainly can’t afford to retire — he long ago lost his job with Morgan Stanley, where he had spent several decades without so much as a hint of impropriety. Needless to say, his business is a small fraction of what it once was.

“It pretty well wiped me out,” he said a few days ago. He is extremely bitter.”

The story of our own brush with the SEC will have to wait for another day. It is still subject to a gag order imposed by our own lawyers. The case is still undecided – four years later. We can’t tell the whole story yet… but we can pass along the moral of it now: anyone who believes government regulators will stop investors from losing money to fraudsters is dreaming…

Stay tuned.

*** The election results were counted up last night. The Kirchners – the husband and wife team that governed Argentina – lost. The winner was the man accused of drug dealing… Francisco Narvaez.

As we remarked above, we’re suckers for underdogs, die hards and scalawags. That is probably one of the reasons we like Argentina; it is all those things and more. It is a measure of the lost cause status of the pampas that news of the election was hard to find. We looked through the TIMES and found no mention of it. The International Herald Tribune did pass along the news – on page 4.

Something went wrong in Argentina. The country was once a rival of the United States of America – with nearly the same income per capita… and about the same prospects. Now, it has less income per person than Chile and exports less beef than its tiny neighbor, Uruguay.

What went wrong?

We turn to Yu Faz for an answer:

“Tribes… empires… are just big people,” says the philosopher. “They must all obey the stars.”

We’re not exactly sure what he meant by that either. But we take it to mean that life is not exactly under our control. We doubt that a group of Argentines ever got together and decided to become a second rate country. Things happen.

And here at the Daily Reckoning we watch… and wonder what will happen next.

Source: The Ordinary Evil of Bernie Madoff

• Goldman Sachs Group Inc. (GS) created a $5.5 billion fund to purchase private-equity assets on the secondary market, Bloomberg reported. The GS Vintage Fund V – Goldman’s fifth private-equity-targeting fund – will acquire portfolios ranging from $1 million to $1 billion.

• Citing “current market conditions,” Current Media Inc., owner of youth-focused network Current TV, has withdrawn its plans for a $100 million initial public offering. “It’s still early for a young company in this sector to be coming to market with a new issue at this point,” David Joyce, an analyst at Miller Tabak & Co., told Reuters.

• India’s Tech Mahindra Ltd. emerged as the highest bidder for scandal-plagued Satyam Computer Services Ltd. (ADR:SAY). Tech Manhindra, which is 31% owned by Britian’s BT Group plc (ADR:BT), will pay $550 million for up to a 51% stake in Satyam, Reuters reported, giving the troubled IT company the chance to restore its profitability and reputation.

• Five investors filed an involuntary bankruptcy petition against Bernard Madoff to ensure that all of his assets are used to pay victims of his $65 billion Ponzi scheme. The petition against the convicted money manager was filed by five victims of the largest Ponzi scheme in U.S. history seeking to push Madoff into Chapter 7 bankruptcy. They hold $64 million in claims against Madoff, who pleaded guilty last month, Bloomberg reported.

• Express Scripts Inc. (ESRX), gained about 25 million new members yesterday (Monday) when it agreed to buy WellPoint Inc.’s (WLP), NetRx pharmacy-benefit management unit for $4.7 billion, Bloomberg reported. St. Louis-based Express Scripts, the third- largest manager of U.S. drug benefits, will pay with cash and as much as $1.4 billion in stock, the company said in a regulatory filing. The acquisition may add “slightly” to earnings this year, Express Scripts said.

• Citigroup Inc. (C), may be willing to sell its investment banking and asset management operations in Japan, in addition to retail operations previously put up for sale, Reuters reported, citing sources familiar with the matter. The retail brokerage, Nikko Cordial Securities, was put up for sale in February, drawing interest from Japan’s top three banks.

• The International Energy Agency slashed its forecast for oil demand, knocking crude oil futures down $1.24 to below $51 a barrel on Monday.  The prediction offset the impact of data showing Chinese crude imports rose to their second highest ever. The IEA said on Friday world oil demand would fall by 2.4 million barrels per day (bpd) this year compared with 2008 as fuel consumption dropped to levels last seen in the early 1980s.

Source: Global Investment News Briefs Tuesday, April 14th, 2009

• Shares of C.H. Robinson Worldwide, Inc. (CHRW) climbed as high as 4.8% in trading yesterday (Monday) before closing at $44.03 a share. For the past five days, the company’s stock jumped nearly 16%. Money Morning Contributing Editor Horacio Marquez recommended investors buy C.H. Robinson’s stock yesterday in his popular Buy/Sell/Hold series.

• A team of economists at Morgan Stanley (MS) believes Latin America’s economy may contract 4% this year, which would be the biggest decline since 1980. Leading the region’s decline is South America’s largest economy, Brazil, whose gross domestic product could fall as much as 4.5%, Morgan Stanley said.

• Foreign investing in China fell by 15.8%, or $5.83 billion, in February, from the year earlier. The decline marks the fifth straight month that companies and government tightened their spending on Chinese assets, Bloomberg reported.

• The 146-year-old Seattle Post-Intelligencer will publish its final print issue today, becoming an online-only news portal. The paper’s owner, The Hearst Corp., made the decision after failing to find a buyer for the newspaper, Reuters reported.

• The government said Sunday that it intends to seize real estate, cash, bonds, art, autos, boats and other property worth more than $100 million from Bernard Madoff and his wife, including the Madoffs’ $7 million Upper East Side apartment in Manhattan and homes in Montauk, New York, Palm Beach, Florida, and France. Prosecutors will seek $17 million in cash and $45 million in bonds in accounts in Ruth Madoff’s name, acting Manhattan U.S. Attorney Lev Dassin told Bloomberg. Madoff, 70, pleaded guilty March 12 to defrauding investors of as much as $65 billion in the biggest Ponzi scheme in history.

• The U.S. Treasury said yesterday (Monday) that foreigners were net sellers of U.S. securities in January, a worrying development at a time when the government is rolling out a massive spending plan to mitigate the 14-month recession. Adding to the economy’s problems, the U.S. Federal Reserve said industrial production fell to its lowest level in almost seven years in February. U.S. industrial output fell 1.4% in February, following a 1.9% drop in January, according to government data, Reuters reported.

• MGM Mirage (MGM) is in talks with banks to pledge casinos as loan collateral, as it seeks to modify lending terms and avoid default on a $7 billion senior credit facility. The company agreed in December to sell the its Treasure Island casino and canceled a condominium development at CityCenter, MGM’s joint venture Strip development with Dubai World. The Las Vegas-based casino company said it is also open to selling more assets, Bloomberg reported, citing a person with knowledge of the discussions.

Source: Global Investment News Briefs Tuesday, March 17, 2009

Madoff had provided investors with modest, steady returns, claiming to be making money by trading in Standard & Poor’s 500 Index options, and closing all positions prior to mandatory reporting dates so that investors had no window into the fund’s holdings.

Apart from individuals, charities and numerous “funds of funds” investing in hedge funds, such as HSBC Holdings PLC (ADR: HBC) and Banco Santander SA (ADR: STD), lent billions to investors participating in the Madoff fund, secured only by holdings in a fund that is now insolvent.  The debacle is likely to strengthen criticism of the U.S. Securities and Exchange Commission, for its failure to protect investors, and to cast doubt on the hedge fund sector and on “alternative investments” in general.

It is not surprising that the recent unpleasantness on Wall Street has exposed a gigantic Ponzi scheme. It wasn’t even really even surprising that the Ponzi-scheme losses were an enormous $50 billion: After all, 13 years of excessive money creation have allowed bad Wall Street behavior to grow like weeds, so you’d expect the inevitable Ponzi scheme to be huge, like an out-of-control, possibly radioactive bindweed.

However, it is surprising that the major investors in Madoff’s scheme were not a bunch of suckers he met at a country club, nor a set of unworldly charities seduced by a smooth sales pitch (though both of those were involved), but instead were actually hedge funds, the most obnoxiously professional of professional investors. This raises a hugely heretical question: Is it possible that hedge fund managers aren’t the “best and the brightest” after all?

The Life and Times of Charles Ponzi

The original Ponzi scheme was a much smaller-scale operation, with losses of only few million. In the disturbed years after World War I, Charles Ponzi got the idea that postal reply coupons could be purchased in Italy and exchanged for U.S. stamps at a substantial profit – essentially an early form of arbitrage.

The anomaly existed because the international postal agreements had been designed in a pre-1914 Gold Standard world, which had disappeared, with different currencies having devalued by different amounts.  The kernel of Ponzi’s scheme was thus a genuine moneymaker, albeit on a tiny scale (at its peak, 160 million postal coupons should have been shipped from Italy to the United States, compared with 27,000 actually outstanding worldwide).  However, using this moneymaker as incentive, Ponzi attracted millions of dollars in deposits, paying profits on the early deposits from the proceeds of later ones.

This is the essence of a Ponzi scheme; if there is a genuine moneymaking operation at its center, it is swamped by the amount of money invested, which can only appear to make profits through later investments being used to pay out earlier ones. Even in 1920, the authorities realized this was a no-no. Ponzi was convicted of mail fraud and sentenced to five years in prison on federal charges. Released after three and a half years, Ponzi then faced state charges in Massachusetts. He fled and remained at large for a time, but was eventually captured, tried and sentenced to nine years imprisonment in Massachusetts, where the bulk of his schemes took place.

Modern-Day Schemes Abound

Ponzi schemes are a well-known hazard in the banking world, and the SEC and other regulatory authorities have great experience unraveling them. They are fairly easy to detect by any reasonably suspicious professional: when offered an investment opportunity you simply keep asking questions of the promoter until you are absolutely confident of the mechanism by which money is made.

If you can’t figure it out, you don’t invest – you are, after all, a financial professional and finance is an area in which there should be no impenetrable mysteries to the experienced and competent. In the emerging capitalism of 1990s Eastern Europe, Ponzi schemes were a well-known hazard, because the populace didn’t understand how capitalism worked and regulation was weak. The MMM scheme in Russia collected $1.5 billion, the Caritas scheme in Romania collected $1 billion, and in Albania in 1997, the entire banking system and the government collapsed under a $1.2 billion scheme.

In the West, successful Ponzi schemes rest on the gullibility of simple folk. Two groups in particular stand out. Some rich country club types tend to believe far too much in “connections” – to the exclusion of everything else – and neither understands nor cares about the details of how investment returns are generated.

Thus, rather than invest through well-qualified specialist investment managers, they buy rubbish investment products from people whose “connections” are believed to provide an “inside track” to extra returns. Madoff, a former chairman of NASDAQ with a charming personality, was naturally well qualified to appeal to these gullible amateur investors. Charitable organizations and state funds often have substantial endowments that are run by under-qualified people, because the charities and states don’t pay enough; these people can also be seduced by the well-connected, and are not necessarily competent to assess the details of how investment returns are generated.

Ponzi schemes were given an enormous boost by the advent of derivatives and trading desks in the 1980s. Whereas the doziest country club member or charitable trustee has some idea of how bonds or stocks make money, even many financial professionals are a bit hazy about derivatives and trading profits. Hence, Madoff was able to maintain a plausible smokescreen over his activities. Since private partnerships do not have the same disclosure rules as public investment funds, he had no need to disclose the precise trades by which profits were made, nor any details about his methodology.

The increased complexity of modern investment does not however excuse the gullibility of professionals such as those who manage hedge funds and “funds of funds,” both of which invested in Madoff’s schemes. These people are paid inordinate amounts of money to provide superior investment returns to individuals and institutions that – perhaps naively – believe that by paying excessive management fees, one can obtain truly superior investment management. They should not be able to claim inexperience, a lack of an understanding of complex investment products, or even a lack of intelligence, since most of these people have degrees from top schools.

Warning Signs to Watch For

In reality, professional investors were infected with the “get-rich-quick” fever that reached epidemic proportions during the 13 years of easy money and lax regulation. As a result, these “professional” investors failed to exercise their “due diligence” in investigating how Madoff’s investment operation made money before investing in it. To the extent they were investing other people’s money, they deserve to be sued for failing in their fiduciary duty. To the extent they were investing their own money, they deserve to have their fancy degrees removed at some suitably ignominious ceremony, for crass stupidity and incompetence.

As for the lessons the rest of us should take away from this event, allow me to say that there are several:

• First and foremost, don’t invest in something you don’t understand, just because the promoter has good connections. If he can’t explain to you in terms you can understand how he makes money, there’s probably something fishy involved.

• Second, don’t believe the hype about “alternative asset classes” – most of it is just jargon designed to remove extra fees from you.

• And third, if you obey the three cardinal rules of investing – diversify, buy over an extended period, and research well what you intend to buy – you will probably do as well as most professionals, and far better than that substantial minority of professionals who are in reality utter incompetents.

• One great consolation about this recession: Ponzi schemes do much less well in recessions, because people are more suspicious. Ponzi flourished in the modest hot-money boom after World War I and Madoff made hugely more money in the correspondingly larger bubble from 1995-2008. Recessions, unlike bubbles, are relatively safe times to buy investments, because the investments themselves are cheaper and there are fewer crooks around.

Source: How to Avoid Madoff Mayhem