• The Securities and Exchange Commission yesterday (Tuesday) charged Texas financier R. Allen Stanford and three of his firms with a “massive” fraud that centered around high-interest-rate certificates of deposit, and raided some of the companies’ offices, MSNBC reported.  In a complaint filed in federal court in Dallas, the Securities and Exchange Commission alleged Stanford conducted a fraudulent investment scheme in an $8 billion CD program that promised “improbable and unsubstantiated high interest rates.”

• Trump Entertainment Resorts Inc. (TRMP), the three Atlantic City casinos once run by Donald Trump filed for Chapter 11 bankruptcy protection yesterday (Tuesday) – for the third time. Trump was frustrated that bondholders and their allies on the board rebuffed his offer to buy the company and take it private. “Other than the fact that it has my name on it – which I’m not thrilled about – I have nothing to do with the company,” Trump told The Associated Press.

• American Express Co. (AXP) and Capital One Financial Corp. (COF) fell in trading yesterday (Tuesday) after they reported overdue loans and payments increased in January.  American Express, the biggest U.S. credit-card company by purchases, said defaults on loans packaged into securities rose to 8.29% from 7%, while payments at least 30 days overdue climbed to 5.28% from 4.86% in December. Capital One said that defaults rose to 7.82% and late payments reached 5.02%, Bloomberg reported.

• Wal-Mart Stores Inc (WMT) posted profits that beat Wall Street forecasts, and said it expects to outperform rivals as the global downturn forces shoppers to seek low prices, Reuters reported. Fueled by sales at its namesake U.S. discount stores, Wal-Mart has been outpacing competitors like Target Corp. (TGT) and Costco Wholesale Corp. (COST), as well as lower-priced department stores like J.C. Penney Company Inc. (JCP), in recent months as consumers stretch limited budgets by shopping its stores for necessities like food and medicine.

• Four executives at Research in Motion Ltd. (RIMM), the maker of the Blackberry phone, agreed to pay more than $2.2 million to settle claims by U.S. regulators that they backdated stock options for eight years, Bloomberg reported. The executives agreed to pay fines totaling $1.4 million and return more than $840,000, which represents the value of the backdated options they had exercised, the Securities and Exchange Commission said. By backdating options, companies retroactively change grant dates to periods when share prices were lower, boosting recipients’ profits while potentially distorting earnings.

• U.S. oil prices fell more than 7% yesterday (Tuesday) below $35 a barrel, as grim economic indicators battered markets and raised concerns about slumping demand, Reuters reported.  U.S. crude for March delivery fell to $34.82 a barrel, down $2.69 from Friday’s close. London Brent crude for April delivery dropped $1.91 to $41.37 a barrel. A report that eastern Europe’s economic slump will further drag down Western banks raised fears that emerging economies will deepen the recession in the U.S.

Source:Global Investment News Briefs Wednesday, February 18th, 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

A U.S. Securities and Exchange Commission investigation into credit-rating companies found the firms improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.

A 10-month review of Moody’s Investors Service, Standard & Poor’s and Fitch Ratings found analysts contributed to fee discussions and weighed losing clients over certain ratings, the Washington-based SEC said in a report released today. Employees also cast doubt on the quality of some ratings, the SEC said, declining to link firms to specific findings.

“We uncovered serious shortcomings at these firms,” SEC Chairman Christopher Cox said today at a news conference. “When there were not enough staff to do the job right, the firms sometimes cut corners.”

Pension and money-market funds bought AAA-rated securities backed by mortgages to the riskiest borrowers because they offered higher returns than government bonds with the same ratings. In many cases, credit raters were paid by investment banks selling the bonds, prompting regulators and lawmakers to question their independence.

The SEC report describes an e-mail in which an analyst refers to the market for collateralized debt obligations as a “monster.”

“Let’s hope we are all wealthy and retired by the time this house of cards falters,” said the e-mail, which was sent Dec. 15, 2006, to another analyst at the same firm.

Mike Burnick at Sovereign Society says,

A look inside one of these [subprime mortgage] bonds tells a frightening tale. A US$80 billion sub-prime asset-backed bond issued by Deutsche Bank in 2005 is still rated AAA by S&P and Moody’s. Yet, 18% of the mortgage loans in the security are in foreclosure.

Additionally, lenders have already seized 15% of the properties underlying the loan values for this security. Another 10% have been delinquent for more than 90-days.

Another Morgan Stanley Capital sub-prime mortgage-backed security has credit support of 64% relative to the number of delinquent mortgages loans in the pool. But the credit should be at least twice the delinquent mortgages to maintain a top rating.

Why This Junk Isn’t Rated As “Junk”

Technically, much of this so-called triple-A rated debt should have been downgraded long ago. So why hasn’t it? The simple answer is: Fear of too much “collateral damage.”

According to Bloomberg, “Financial firms own high-grade collateralized debt obligations, which package securities such as mortgage bonds and slice them into pieces with varying risk. As the underlying mortgage bonds are downgraded, those securities will also lose their ratings and tumble in value.”

There’s a huge potential “contagion” effect that would ripple through the financial system if Moody’s or Standard and Poor’s dared to downgrade these shaky sub-prime credits across the board. For instance, a bank holding US$100 million of AAA-rated sub-prime bonds needs just US$1.6 million in capital backing such a highly rated credit. – that’s a lot of leverage. And such leverage is fine, as long as the bonds remain triple-A rated.

Should the bonds get downgraded to below investment grade however, under global accounting rules, a bank must put up additional capital. In fact, it would take US$16 million in capital to back US$100 million in non-investment grade bonds.

That’s 10 times as much capital required in the event of a credit ratings downgrade. Wall Street just doesn’t have that kind of extra capital lying around. Bear Stearns found this out the hard way over the weekend. That’s why I expect the major ratings agencies, perhaps abetted by the Treasury Department and the Fed, to continue covering-up the true health of US$650 billion in outstanding sub-prime bonds.

Burnick concludes that:

At the risk of sounding like an alarmist, I just have one question. What happens to confidence in the U.S. financial system (not to mention the dollar) when people wake up and realize these fairy tale markets (held up by fantasy ratings) turn into a nightmare?

The Fed is merely monetizing Wall Street’s mistakes yet again, while leaving future generations of taxpayers with an even bigger tab to settle, and higher future inflation to fight.

But there’s just no time for such ponderings now, we’re in the midst of a full-blown financial crisis after all. Damn the financial torpedoes, full speed ahead with the monetary printing press.

–American musicologist Alan Lomax traveled all over the American South in the first part of the 20th century to record the folk music of men like Woody Guthrie, Jelly Roll Morton, and Muddy Waters. He met Huddie Leadbetter (Leadbelly) in Texas and put together an album. In the liner notes to the album, he described Leadbelly as, “the toughest man on the toughest chain gang in the toughest prison in Texas.”

–We read the line in the transcript of radio interview on ABC National Radio with American Anarchist Robert Wolff. It made us think of Dr. Kurt Richebacher, “the toughest economist on the toughest beat during the toughest time in monetary history of the last 50 years.”

–So if yesterday’s Daily Reckoning was a tough slog for you, we’ll take a slightly easier path today. But we’re still going to talk capital, and what Australian assets might be rising in value.

–First, we didn’t have to get far in the headlines this morning to see the issue of just what capital really is come up. “The U.S. Securities and Exchange Commission will require investment banks to disclose their capital and liquidity levels after the agency was criticized for regulatory failings in the wake of the Bear Stearns collapse,” reports Jesse Westbrook at Bloomberg.

–The SEC will require Wall Street firms to report on their capital and liquidity levels in, “terms the market can readily understand and digest.” Aha! So we will now know who has more dodgy assets than real capital. Of course, we already do know quite a bit.

–A new accounting rule last November required banks to report their assets in three categories, from easiest to sell and value (Level 1) to hardest to sell and value (Level 3). We also know that all five major U.S. investment banks (Goldman, Merrill, Bear, Morgan Stanley, and Lehman) have level three assets that are at least double the capital listed on the balance sheet.

–Write-downs in Level three assets directly affect a bank’s capital. It might not seem like such a big deal at first. After all, at Merrill Lynch, Level three assets represent just 8% of the firm’s total assets. The trouble is that in the first quarter of this year, Merrill saw its Level three assets grow to US$82.4 billion-up 70% in just three months.

–It’s not just Merrill, either. Goldman Sachs reported that its Level three assets grew by 39% in the first quarter to over US$78 billion. Those assets are just 8.1% of the firm’s total assets. But again, they exceed by a large margin the firm’s capital base. The same is true of Lehman Brothers. And let us not mention that total liabilities for these firms are many, many times greater than stockholder’s equity.

–In an unrelated development, shares for all five investment banks were down on Wall Street.

–Seriously, with so many assets parked on Level three, with their ability to attract new capital infusions from foreign investors suspect, and with conditions in the American consumer economy so dire…what utterly oblivious investor would consider financial shares “good value”? When your assets are really liabilities waiting to be born, your capital hangs by a slender thread.

–Australia probably has its fair share of balance sheet problems, both at the household and corporate level. We read in today’s Age, via professor Steve Keen, that “At the bottom of the 1990s recession…Australia’s debt was about 78 per cent of GDP. It is now 165 per cent. That’s more than doubled over the past 15 years. In 1892, he says, debt peaked at 104 per cent of GDP and in 1931 it peaked at 77 per cent.”

–Buying assets with borrowed money is a dangerous game.

–What about buying assets that haven’t yet been produced? Yesterday we referred to the structural revaluation in global oil markets. But we probably should have said global energy markets.

–Origin Energy’s Grant King hasn’t responded formally to last week’s unsolicited $12.9 billion bid from British Gas. But he too is suggesting that it’s time to rethink how investors value energy assets.

–King, according to today’s Financial Review, told investors at the Macquarie Securities conference yesterday that his company, “should be valued as a resources stock on a discounted cash flow basis rather than on the typical price-earnings multiple for a utility.” Using discounted cash flow to value resource companies is itself a bit of a challenge. We prefer, at least with gold companies, to use the more common market-cap/ounce of proven reserves.

–This metric tells you clearly whether a share is over or undervalued based on actual gold in the ground. How useful this metric is to something like coal-seam-methane is another question. Some commodities are more capital intensive than others. Some, like oil, begin producing cash flow right away, while others don’t throw off as much cash right away…but have longer, more predictable operating lives.

–There are different ways to value an asset. But the biggest factor is whether the asset is going up in price. Australia has that going for it. Most of its resources are increasing in price, and thus in value. We’ll have more on Australia’s coal-seam-methane projects for you tomorrow.

–How about a question on…yes…capital!

Dear DanLove to read the Daily Reckoning. But you need to explain to me why a factory is the ultimate capital asset . Why not an office that produces services…income for other workers, profits for shareholders and taxes for governments? You seem to suggest that the US needs its factories back. But surely it has a comparative advantage in providing services?Regards

B. M.

–Bob makes an interesting argument, one for which we do not have a full rebuttal. Services can increase productivity, greater output per person. This is one way economies grow without causing inflation. But we’d suggest that an entire economy that trades in services is not possible…or definitely not beneficial for average wages and incomes.

–As Wal-Mart replaced General Motors as the largest employer in America, the average wage for Americans took a historic turn lower. To some extent, this is just a product of the globalisation of labour. Adding China and India to the mix has driven wages down everywhere.

–Our main point, though is that service jobs don’t contribute as much to actually providing the goods that satisfy people’s material wants now and in the future. If you don’t make things people want and trade them for a profit, then someday in the future, what’s on your shelves here in Australia (or America) is going to be determined by the buying preferences of Chinese consumers.

–Obviously there are some global brands which have a great appeal to consumers all over the world. Apple will probably sell a lot of iPhones in China, for example. But where will the profits go? Apple’s profits will go its shareholders and its employees. But you can’t have an economy full of company’s that rely on brand image, styling, and intellectual capital.