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)

I said out loud to the family, “This is interesting news! Bloomberg.com says, ‘The U.S. government’s borrowing needs will almost double to $2 trillion this fiscal year, prompting the Treasury to revive three-year notes and hold more frequent sales of 10- and 30-year debt, according to Goldman Sachs Group Inc. (NYSE:GS)’”

I forced a wooden smile onto my face as I stood up and slowly – so as not to draw attention to myself – started walking towards the kitchen so as to run out of the back door, bolting like a scared little coward to the Mogambo Secret Bunker Of Security (MSBOS) so that I could frantically lock myself in, throw a couple of security systems to the “Fully Armed” position, and clutch my teddy bear tightly to my chest until I finally settled down.

Normally, this would be catastrophic, as that much money added to the money supply would send inflation raging to the moon. But these days, so much money is being lost that even this $2 trillion is not enough to make bond investors wake up out of their fearful trance and demand higher yields in the face of impending inflation, and these bond buyer guys are real idiots, accepting about 4% as a yield on a 30-year bond! Hahahaha! Morons!

In fact, I assume that bond buyers are all drug addicts who are not aware of what they are doing, morons who are not aware of what they are doing, or grubby slicksters who are buying them on behalf of drug addicts and morons! Hahaha!

Bill Bonner here at The Daily Reckoning is apparently not ready to ascribe to my new Mogambo Drug Addicts And Moron Bond Theory (MDAAMBT), but seems more horrified by how much money has been lost, as “Stock markets around the world have deflated by about $10 trillion. U.S. housing has deflated by about $5 trillion”, and I seem to recall that the director of the Congressional Budget Office, Peter Orszag, testified that some $2 trillion in retirement savings has been lost over the past year or so.

And as insane as all that seems, it is destined to get a lot more insane, as we can infer from a Wall Street Journal article titled “Two-Year Yield (If You Can Call It That) Tilts Lower”, which refers to the ludicrously low yield on government bonds these days with a humorous degree of surprised disbelief.

The article notes, “Last week, the Fed cuts its fed-funds target rate to 1%. Then, the two-year yield touched a historical low of 1.06%”, which is so low that I cannot stop myself from laughing at any moron buying a government bond and paying such a high price for it that the imputed yield is one lousy percent!

Hell, the government’s new and “official” GDP deflator (the amount of inflation in prices that must be wrung from raw GDP data to produce “real” GDP) just jumped to an annual rate of 4.2%! Just how stupid do you have to be to lock up your money for two years in order to get $1.08 per hundred dollars, while you lost $4.20 per hundred in buying power? Hahaha! Morons!

Well, as bizarre as that is, it is going to get even MORE bizarre, as the WSJ article went on to say that rate cuts by the Fed are just getting started, and that “HSBC (NYSE:HBC) economists expect the Fed to trim the target rate to zero by the end of June”! What? An interest rate of literally zero? Zero! Hahahaha! The mark of the truly, truly desperate!

And, even more startling, “Credit Suisse predicts the two-year yield will drop to 1% by the end of the year and dive to 0.5% by the first quarter of 2009″, which is such insanely low yield in light of the sheer amounts of money that the central banks of the world are suddenly creating, and promise to keep creating, that you involuntarily leap atop your desk and howl like a wounded wolf out on the lone prairie, going “OwwwooOOOOoooo!”, pausing only to scratch a few fleas while everyone around you is yelling at you to shut up, and then you snarl at them.

In short, I’m insane, and everybody is insane for ever believing that the morons at the Federal Reserve and their childishly-simplistic, brain-dead ilk that infest the majority of the nation’s universities know what they are talking about, when their stupid neo-Keynesian, equation-driven “econometric” stupidities have failed so miserably!

Perhaps Sam Mathid in his essay at 321Gold.com says it best when he notes that “Nowhere is there reference to prior criminality and stupidity on such a grand scale. There is no historical precedent.”

This would usually lead me to a long harangue about how you should be buying gold, silver and oil at these low, low prices in response to such monetary and fiscal outrages, but it is late, I am tired, I already have plenty of each.

And if you, too, have plenty of each, then relax, as you have nothing to worry about, and you should go to bed and get a good night’s sleep, too.

And if you do not likewise have plenty of each, then while I am not in the mood to call you a halfwit lowlife ignorant moron who deserves economic death for not having plenty of each, consider yourself enlightened as to your true status, and tremble.

Source: Wounded Wolves on the Financial Prairie

And that’s precisely the wrong decision to make at the wrong time. No matter how poorly the financial markets are performing, saving for retirement has to remain a top priority.

“It’s not a time for people to stop contributing,” Diane Young, director of retirement and goal planning at TD Ameritrade Holding Corp. (AMTD), the Omaha, Neb.-based brokerage firm that conducted the retirement study, said in an interview with Bloomberg News. “Because time is money, it’s important to stay on track.”

According to the Ameritrade study – released yesterday (Tuesday) – 63% of Americans have completely stopped contributing to their retirement plan. Financial strain due to the economic downturn was cited by half (50%) of those who say they have reduced or stopped contributing to their retirement plan. Unemployment (32%) and healthcare costs (25%) also were cited as key factors affecting their ability to contribute to their retirement plan.

Only 54% of survey respondents, which included senior citizens, indicated they had a retirement account. Of that number, one out of three had less than $50,000 in investment assets.

But slacking off on retirement savings now is only going to hurt you more down the road.
Chipping Away at Retirement Assets

Giving up the power of compounding can be the most costly mistake an investor can make when it comes to investing for retirement, but unfortunately that’s just what many are doing in light of the dismal market performance.

And those dismal returns aren’t the only factor hammering the bottom line of retirement accounts these days. Retirees and those close to retirement are feeling as if they are under attack from all sides due to the factors that threaten a comfortable retirement.

The main source of income for many retirees continues to be the Social Security Administration. But the Social Security program has been at risk for years as life expectancies continue to grow and the number of retirees advances in kind. The program will only come under more pressure as the baby boomer generation edges closer to retirement.

“Social Security’s current annual surpluses of tax income over expenditures will begin to decline in 2011 and then turn into rapidly growing deficits as the baby boom generation retires,” the most recent trustees’ report said.

Many retirees depend on dividend payments from investments to supplement income. But with a growing number of companies reducing or eliminating dividend payments in the face of poor earnings or a changing business landscape, that income stream is dwindling.

Even companies with long track records of dividend growth, such as General Electric Co. (GE) and Bank of America Corp. (BAC), have been paring back.

Given the current market conditions, selling a stock that has eliminated its dividend is no longer as likely to make up for that lost income.

“If I’m down 25% in dividend income, but the stock is down 35%, if I sell the stock, can I afford to lose another 10 to 15% by selling?” Howard Silverblatt, a senior index analyst with Standard & Poor’s, told The Associated Press. “Younger investors can wait the market out and sell the stock when it bounces back. But older people are really stuck in a bad spot.”

Companies with poor earnings are also cutting back on company contributions to 401(k) plans, which can downright wreck your expected retirement calculations. General Motors Corp. (GM) recently announced that it would discontinue company-matching contributions for non-union employees until economic conditions improve.

According to a recent survey by Watson Wyatt Worldwide Inc. (WW), 2% of companies surveyed have already decreased 401(k) contributions, while another 4% are planning to do so in the 2009.

Retirees with defined benefit or pension plans aren’t in much better shape.

According to Adrian Hartshorn, an actuary with Mercer, a business consultant subsidiary of Marsh & McLennan Companies Inc. (MMC), the pension account assets of companies in the S&P 1500 are shrinking. At the end of 2007, the companies Hartshorn tracks had a collective surplus of $60 billion. But stock-market losses have transformed that $60 billion surplus into a $35 billion deficit.
Protecting Your Retirement

If you find yourself the victim of a cutback in company contributions or a loss of dividend income, make sure you take the initiative to safeguard your retirement.

“Redo your financial planning and figure out if you need to save more now,” Robyn Credico, Watson Wyatt’s national director of defined-benefit consulting, told The Washington Post.

Here are some more steps you can take to help protect your retirement account, even during difficult market conditions:

* Be Aware: AARP’s website has a number of interactive financial calculators that will help you estimate everything from how much you need to save for retirement to how much income you can expect during retirement. While you want a long and healthy life, you don’t want to outlive your money, so be sure you don’t underestimate your time horizon.

* Be Proactive: If you think you’re going to come up short when it’s time for retirement, reconsider your options. Some workers are delaying retirement to give their assets more time to grow. Other retirees are supplementing their income with part-time work or curbing expenses by cutting back on unnecessary expenditures.

* Be Thrifty: Save as much as you can. Make sure you’re getting the most out of your company 401(k) plan by maximizing the company match. And try to save the maximum annual limit for your company’s 410(k) plan or your traditional IRA. Contributions to your retirement account often reduce your taxable income, so it might not be as much of a sacrifice as you think. Indeed, some investors do double damage to themselves by ending their retirement plan contributions, but forgetting to also adjust their tax withholding. That can make for an ugly surprise at tax time – either with a smaller-than-expected tax refund or a bigger-than-expected tax bill.

* Be Investment Savvy: Align your retirement investments with your time horizon and risk tolerance. Generally, younger investors can tolerate more risk, while those closer to retirement need to choose more stable options. Money Morning Investment Director Keith Fitz-Gerald recently recommended American Century Capital Preservation Fund (CPFXX) as a “safety-first” investment choice for investors close to retirement. And don’t be overly dependent on dividend income or a company pension fund, both of which could be affected by overall poor market conditions or weak company earnings.

Source: Four Ways to Protect Your Retirement From the Ongoing Financial Crisis

— Here’s a cheery way to start your week: More than two-thirds of American Gen Xers — those aged 27-42 — don’t think they will ever be able to stop working. And don’t think they’ll ever see a dime from Social Security or Medicare.

“The Gen X group is the most anxious about their finances,” Chris Moloney of Scottrade told Reuters last week.

Of the 1,000 people they talked to who were 18 and older, nearly 40% percent said they had saved less than $25,000 for retirement. Conventional wisdom suggests if you want to live for 20 years on about $50,000 per year — whatever that will be worth at that the time — you’ll need to have $1 million stashed away.

“Gen X is in the middle of a ‘retirement perfect storm’ of very high expectations, low retirement savings and massive concern about the future of Social Security,” Moloney says.

Thirty seven percent said they would like to have between $1-5 million saved for retirement — even if their ability to save this money leaves such sums in the realm of wishful thinking.

Not that we want to reignite the debate among readers about which generation is “to blame” for the state of things, but we also note that 64% of baby boomers say they’re ready to retire — and aren’t worried.

Take that.

Worth the paper it’s printed on…

— Retail sales were up in March…but mostly because gasoline keeps costing more.

The Commerce Department says retail sales rose 0.2% in March, a tad more than the flat reading analysts were expecting. But throw gasoline out of the equation, and they were ruler flat, indeed.

If the figures took inflation into account, which they don’t, the outlook for retailers would be even more discouraging. Still, a 0.2% increase in March looks better than, say, the revised 0.4% decline in February…

— U.S. stock markets began the week moving sideways, taking a breather after GE’s earnings disappointment Friday and before Citi and Merrill reveal whatever they’re going to reveal later this week.

But Goldman Sachs isn’t waiting to make its call: Earnings season has had an “awful” start and stocks will head downward this spring.

“Early signs are awful,” says a Goldman report out today. “We expect generally disappointing results and a swath of lowered profit guidance that will drive the Standard & Poor’s 500 Index lower in coming weeks,” perhaps as low as 1,160, before a rebound by year’s end to around 1,380 — which would put the S&P down 6% for the year.

That’s a remarkably gloomy call for David Kostin, Goldman’s new chief forecaster — at least compared to his predecessor, the ever-optimistic Abby Joseph Cohen.

— Wachovia needs cash, and quickly. Ho-hum. The bank plans to float $7 billion in new shares and slash its dividend by 41%. It’s the second time Wachovia’s had to scramble for capital just this year.

Wachovia jumped into the adjustable-rate mortgage pool with both feet at the most frothy stage of the bubble in 2006 by purchasing Golden West — whose business was focused on one of the most airheaded states, California.

— But that’s just the beginning of the financials’ pain this week, as many of the top firms reveal first-quarter earnings… and probably more write-downs, too. Citigroup will likely write down $10 billion in debt this week…which would add up to a first-quarter loss of $3 billion. Merrill Lynch will likely write down another $5 billion, for a loss of $2.7 billion.

That’s still a drop in the bucket given that write-downs industrywide total $250 billion to date…and that everyone from George Soros to the International Monetary Fund is forecasting $1 trillion, give or take, by the time all is said and done.

— Citi’s announcement last week that it will unload about $12 billion in debt onto private equity at 90 cents on the dollar highlights another problem — one that’s “entirely separate from subprime mortgage lending,” writes Strategic Short Report’s Dan Amoss. “It’s another symptom of the credit bubble disease.”

The $12 billion is money Citi hoped to raise in the credit markets to finance leveraged buyouts. But when the credit markets seized up last summer, Citi had to take the deals onto its own books.

“Investment banks are stuck with an estimated $250 billion worth of this buyout debt on their balance sheets,” says Dan, “or in off-balance sheet entities for which they’ve made guarantees. Until they get rid of it, credit will remain fairly tight.

“Financial stock bulls point to this $12 billion sale as evidence that the leveraged loan sector of the credit markets is thawing. But I remain a financial stock bear, because this sale is only a tiny part of the market and only one of the many other credit-related problems plaguing investment banks.” For ways to play Dan’s skepticism, see the Strategic Short Report.

— Asian stock markets tanked overnight, fearing the worst from U.S. financials this week. Shanghai was down 5.6%, Hong Kong 3.5%, the Nikkei 3%.