Of all the articles covering the scandal, that title from the Financial Times sums it up best. The opening of the piece is pretty good too:

Nothing stupefies like money. Even the savviest investors tend to look the other way when extraordinary returns are being made. This unfortunate human trait is the fuel behind speculative bubbles and the magic behind all financial scams.

No one, it seems, has exploited this as blatantly in recent times as Wall Street bigwig Bernard Madoff, a former Nasdaq chairman arrested this week for allegedly running the biggest dollar Ponzi scheme of all time.

The scale of the fraud is staggering. Tens of billions have been lost – perhaps as much as $50 billion over many years. Wealthy families, numerous charities, and even college trusts have been all but wiped out.

The Palm Beach Country Club, where Madoff recruited many of his victims – er, investors – is said to be in a panic. Perhaps the largest private victim is Carl Shapiro and family, who had known Madoff for 50 years and had $545 million invested.

A number of large players were caught in the scam too. Britain’s HSBC Bank may have lost as much as $1 billion. Banco Santander had more than $3 billion in exposure through its money management arm. Even the State of Massachusetts had skin in the game… the list goes on and on.

The Biggest Red Flag

There were plenty of red flags, but Madoff’s reputation gave him a pass with investigators and regulators alike.

As far back as 1999, forensic whistleblowers had reported Madoff to the SEC as a fraud. Barrons ran an article in 2001 openly wondering how Madoff did it when no one else could. In hindsight there were many small things… skeptics had been asking questions for years, but they were always waved off.

The biggest red flag of all, from a trading point of view, was the silky-smooth consistency of Madoff’s returns.
The steady gains with virtually zero losses were exactly what enthralled Bernie’s clients, when they should have been warned away.

Charles Gradante, founder of hedge fund consulting firm Hennessee Advisors, is one of the skeptics who steered clear.

“He only had five down months since 1996,” Gradante notes. “There’s no strategy in the world that can generate that kind of performance. But when people would come to him and say, ‘How did I make money this month?’ he didn’t like it. He would get upset with people who probed too much.”

In the real world, returns just don’t go up in a nice straight line. Mother nature is messy… markets are messy… and nothing works 100% of the time. But people will pay big bucks to avoid facing up to that truth.

Some of the biggest losers in this mess will prove to be the “funds of funds” – investment pools that allocate money to traders on behalf of their clients. The funds of funds who put billions with Madoff all claimed to be practitioners of deep due diligence. Now they look like useless fools.

On one of my trips to New York two years or so ago, I asked a fund of funds manager what their ideal trader looks like. “The best guys are the ones who deliver that steady 1 to 2 percent a month like clockwork,” he told me.

I thought the idea was dangerous even then, and wrote as much to readers that it would all end in tears. But a clockwork 1 to 2 percent is what the funds of funds wanted… so that’s what Bernie Madoff delivered.

Variations on a Theme

When I first read of Bernie’s loss-defying equity curve, four other exercises in smoothing folly came to mind:

• Ralph Cioffi and Matthew Tannin, managers of the Bear Stearns “High Grade Structured Credit Strategies Fund” and, even more laughably, the “High Grade Structured Credit Strategies Enhanced Leverage Fund.” These guys made money every month for something like 40 months in a row. Then they blew up. Then Bear Stearns blew up.
• Jack Welch, the hero CEO of General Electric whose legacy was later tarnished by the reveal of his “massaged earnings” technique. Under Welch, GE managed to hit growth targets with bull’s eye precision year after year after year. The Street loved it… later it was revealed that Welch had more than a little help from GE Credit (the creative finance arm) of the sort that would be frowned upon today.
• Victor Neiderhoffer, a naked options seller who blew up his clients not once, but twice within a decade. For much of the 1990s, Niederhoffer was rated the top hedge fund manager in the world… until the Asian financial crisis blew him up in 1997. A few years later Vic got back in the game… again posted award winning returns… and blew up in 2007 for a second time, to the tune of 75%.
• Long Term Capital Management, perhaps the most arrogant hedge fund of all time. LTCM had not one but two Nobel laureates on staff. Their strategy was self-described as vacuuming up nickels all over the world that others weren’t smart enough to see. What they were really doing, it turns out, was snatching nickels from the path of bulldozers.

In all these cases, the strategies in question worked smoothly and superbly for quite a long time – until one day they didn’t. It’s like the old trader’s saying… you can take your volatility in small doses, or you can take it all at once. Which one is up to you.

Fraud Prevention is the Easy Part

In keeping with human nature, people will likely draw the wrong lesson from the Madoff fiasco. They’ll focus on the fraud part – the importance of making sure whoever manages their money is not a charlatan.

This is important obviously. But the fraud aspect is actually one of the easiest things to prevent, once one learns to pay attention.

There were many working parts to the setup, but one was absolutely vital. Madoff was only able to pull off the scam because he cleared his own trades. He acted as his own broker-dealer and used a three-person accounting firm holed up in a strip mall to handle the firm’s books. When you’re running $17 billion in assets, that’s insane.

Any normal hedge fund would have been set up with a “prime broker” – a respected third party custodian to handle the assets and book the trades. That would have made it impossible to commit fraud the way Madoff did. When a legit third party holds the assets, there’s no way to falsify the results.

This is probably why Madoff never registered as an outright hedge fund. He knew that doing so would prevent him from carrying out the scam in full.

If Madoff’s returns were real, he could have made hundreds of millions of dollars in “2 and 20″ incentive fees every year, instead of leaving those fees on the table and merely collecting commissions. But as a full-blown hedgie, his books would also have been subject to more scrutiny… so Bernie took a pass on hedge fund status in order to maintain a low profile.

In passing up those huge fees, Madoff’s lack of greed was the dog that didn’t bark. Funny old world innit.

And furthermore in that respect, it’s ironic that hedge funds could get the most political heat from this whole deal. If anyone should be tarred and feathered, it’s the SEC, who had ample reason to check out Madoff through the years and never did.

Know the Risks

The more subtle-yet-vital lesson from this whole Madoff fiasco, in my opinion, is the importance of understanding the strategy.

If you can understand how a trading or investing strategy makes money – the guts of how it really works, good and bad, warts and all – then you can also understand the risks.

The most robust trading and investing strategies are logical. They don’t take rocket science or complicated math or a PhD in physics to understand.

And yet, Madoff’s investors didn’t apply this simple rule of thumb. They took his explanations at face value, even when those explanations didn’t make sense. The strategy was laid out in simple fashion, but the returns literally didn’t add up.

A few savvy investors, knowing the official line had to be bogus, figured Madoff must have been doing something he didn’t talk about… maybe even something illegal… but they figured it was no problem as long as their profits were safe. Call that the most cynical trade of all.

My one hope from all this is that the Wall Street love affair with silky-smooth returns and artificial stability comes to an end (or at least goes into remission for a good long while).

On a larger scale, we run into the same type of “smoothing” problems when our government tries to iron out the natural fluctuations in a free market economy. And what bigger Ponzi scheme exists than social security… but I’d better end here before going too far down that road.

The sooner we realize there’s no free lunch – and no such thing as investing without healthy ups and downs – the better off we’ll be.

Source: Thanks for the Memories (and the $50 Billion)

Or how about this one:

“When the government actually did something about getting our nuclear strategy on track, it got it so utterly wrong that Greenpeace took it to court on a technicality!”

Angry Garry’s been warning about Britain’s dreadful energy strategy for a long time now. As he explains today, he’s worried our energy needs will ultimately be dictated by Moscow.

And something happened last night that has Garry even more worried.

Find out why Garry believes we’re now on the road to an energy nightmare!
Will the lorries force Brown into U-turn?

Why does the Government tax fuel? Is it to raise revenue? Or is it an environmental measure? Either way, it seems the latest little hike in fuel duty — the 2p increase — won’t be going ahead. And quite right too.

British hauliers are feeling the squeeze. Yesterday, many of them converged on London, parked on the A40, and delivered a petition to Downing Street. They want the Government to scrap the 2p increase.

Gordon Brown first proposed this latest 2p hike — due to come into effect this autumn — over a year ago, while still Chancellor. Since then, the price of crude oil has gone through the roof.

This, in turn, has sent prices at the pump soaring. According to petrolprices.com, the average cost of a litre of unleaded petrol is 115p. For diesel it’s 128p.

If the Government’s plan was to price cars off the road to help the environment, it can stop worrying. By going up so much, the oil price has already done more than this extra tax would have done had oil prices stayed the same.

Even in the car-crazy US, the high oil price has finally fed through to a reduction in car usage, as Bill Bonner notes below in today’s Daily Reckoning.

If the purpose of the 2p hike was to raise revenue (as I suspect it was), then things are a bit trickier. Only a bit, mind.

Yes, the Treasury will have budgeted for the extra revenue. But then again, higher fuel prices will have affected consumer behaviour. If Britons drive less, that in itself will impact the Treasury’s fuel duty income.

Not only that, but the higher oil price has boosted the state’s North Sea revenues. And besides, it wouldn’t be the first time this year the Treasury has had to do the sums again.

I’ve had a pop at the Government here before (If I’m honest with myself, that last sentence felt like a bit of a ‘mini-pop’). I’m sure I will again.

But if the Government changes its mind on this one, let’s not just blithely label it a U-turn, in the manner of some newspapers this morning.

Pressing ahead with the 2p increase would be the wrong policy, at the wrong time and hitting the wrong people. As one protester pointed out yesterday, we still need lorries to take goods from place to place.

If domestic hauliers go bust, foreign firms will do the job instead — and the Treasury will receive even less revenue. Not to mention the fact that allowing the industry to wither would be another step on the road to the so-called “backrub economy” — a society in which everyone derives their employment from the service sector.

Much has changed since the 2p hike was first proposed. At the time, crude oil was around $60 a barrel. Now it’s more than double that. In all likelihood, then, the Government will change its policy. And they’ll be right.

It’s just common sense, really.

Brasil! Brasil!

Ever since my days playing capoeira, I’ve liked to spell ‘Brasil’ with an ‘s’. It makes me feel cultural.

“It’s Brazil with a ‘z’,” says my down-to-earth colleague Manraaj Singh. “Now stop it.”

Brazil, you’ll be aware, is one of the hottest economies in the world right now. Manraaj tells me growth this year is expected to be close to 5%. Strong in oil, sugar, and with a buoyant service sector, Brazil is the place to be for many investors.

Leading the Fleet Street charge is our man Manraaj, who today shows us why the stock market there is rapidly outgrowing São Paulo…
Fleet Street Research presents: 3 firms hoping to escape the UK consumer gloom

I don’t know what it’s like where you are, but outside my office window the weather’s pretty grim. I don’t think it’s raining… but it may do soon.

A bit like the economy then (I know! Seamless!)

Tenuous links aside, the UK economy is in wobbly health. The canniest UK firms have protected themselves, and now make a significant amount of their money well away from these shores.

I’ve asked our research department to take a look at some such companies. There’s still work to be done (our boys are thorough, and wouldn’t dream of issuing a recommendation without doing the necessary prodding and poking).

But my colleague Theo has agreed to give you a sneak preview of some of the companies he’s been looking at.

Remember, these are NOT recommendations (happy Theo?). This is just to give you an idea of the kind of opportunities we’re looking at right now.

Until tomorrow

Ben Traynor

Source: How Blair’s Blunders Sold Us to the Russians