all of the expenses associated with the agency’s fulfillment of its statutory duties are paid for by members of the securities industry

TO BE NOTED:

Another View: Unwinding Madoff’s Fraud, Fairly

Irving H. Picard, the trustee overseeing the liquidation of Bernard L. Madoff’s investment firm, and Stephen P. Harbeck, the chief executive officer of the Securities Investor Protection Corporation, address some questions and concerns about how the claims of Mr. Madoff’s defrauded investors are being handled.

Over the last several months, there have been many news reports and articles about the liquidation proceeding under the Securities Investor Protection Act for Bernard L. Madoff Investment Securities, or BLMIS, including the recent opinion piece on DealBook from Helen Davis Chaitman. In the interest of encouraging maximum public understanding, Irving H. Picard, the BLMIS trustee, and the Securities Investor Protection Corporation are making the following statement:

Congress created the S.I.P.C. in 1970 in order to provide “greater protection for customers of registered brokers and dealers and members of the national securities exchanges.” The organization has no regulatory authority over brokers or dealers and only becomes involved when a member fails and must be liquidated under the Securities Investor Protection Act.

“In a very real sense, allowing claims for fictitious profits lets the thief — Mr. Madoff — determine who wins and who loses.”

Although the Securities and Exchange Commission has some oversight authority over it, the S.I.P.C. is not a government agency or establishment. In fact, it is a nonprofit membership corporation whose members are almost all registered securities brokers or dealers. Members of the S.I.P.C. pay an annual assessment to the corporation. The amounts paid become part of the S.I.P.C. Fund, which is used, within limits and as needed, to satisfy customers and to pay administrative expenses in liquidation proceedings.

Only if the S.I.P.C. Fund becomes insufficient may the corporation borrow from the United States Treasury. As such, all of the expenses associated with the agency’s fulfillment of its statutory duties are paid for by members of the securities industry. Only as a last resort would taxpayer monies be used.

As was stated in the S.I.P.C.’s last annual report, since its inception, the organization has commenced more than 300 proceedings. Cash and securities totaling approximately $15.7 billion have been distributed to customers in those proceedings. Of that amount, approximately $15.4 billion came from the debtors’ estates and $322.5 million came from the S.I.P.C. Fund. As these numbers make clear, much of the work done by the S.I.P.A. trustee and his counsel in identifying and gathering the assets of the member and distributing them to all customers of the failed brokerage so that the assets can be shared in a fair and equitable way.

As the largest and most complex securities fraud in history, the Madoff firm presents many unique difficulties rarely encountered in the typical failure of a broker or dealer. Because every customer statement was a fiction, the first task was to reconstruct the books and records of the firm from scratch. This entails reconstructing every customer account from the ground up using BLMIS records, bank statements, e-mail messages, records from third parties as well as documents received from customers through the customer claims process. This has been and continues to be an enormously time-consuming endeavor, complicated by the fact that the trustee and his staff have had to work with law enforcement authorities and therefore access to information has required careful coordination.

Moreover, the claims themselves require thorough analysis given the lengthy nature of the fraud, its complexity and the interrelationships of many of the customers. The database tracking this information is enormous and has taken many highly qualified personnel working intensively to get it to the point where the trustee can now begin acting on claims, secure in the knowledge that the available records are reliable. All of the expenses of this work have been paid for by the S.I.P.C. Customer funds are never used to pay for administrative expenses.

To date, the trustee has received more than 8,500 claims for approximately 3,500 accounts. He has allowed customer protection to 51 claims up to this point. Those customers will receive from S.I.P.C. an advance of up to $500,000 in each, for a total of more than $25 million. With the database now in place and the large number of personnel being devoted to this task, the trustee is hopeful that the claims determination process will accelerate in the coming months.

It should also be noted that the $500,000 advance is not “insurance” as some have described it. The Securities Investor Protection Act provides that the S.I.P.C. Fund will protect a customer up to $500,000, of which up to $100,000 may be cash. Thus, if a customer’s account balance is less than $500,000, that customer would receive only the amount allowed on the claim, not the full $500,000 advance.

In the BLMIS liquidation, it is anticipated that most of the allowed claims will exceed $500,000. As a result, most will receive the full S.I.P.C. advance for securities of $500,000. To the extent that any allowed claim is more than $500,000, the customer will have to await a distribution from the fund of customer property being gathered by the trustee pursuant to his powers under the Bankruptcy Code and the act. Thus far, the trustee has recovered more than $1 billion and has taken many actions to enhance that fund so as to maximize the equitable distribution to all customers.

With regard to the amount of an allowed claim, it has been suggested that the allowed claim should include fictitious profits. This would be inappropriate both legally and factually.

First of all, with regard to the SIPC advance, the trustee has already decided, with concurrence from SIPC, to treat all claims as claims for securities even though no securities were ever purchased. Ordinarily, a valid claim for securities is satisfied by delivering the securities to the customer. If the securities are missing, the trustee may buy them for the customer.

However, in order for the trustee to buy securities, the customer must have paid for them, and there must be a fair and orderly market for the securities. If securities cannot be bought, the customer receives the market value of the securities in cash. In this instance, the trustee will not attempt to buy securities for customers for a few reasons. Because many securities were paid for with “profits” from the “sale” of securities that were never actually bought, in some cases going back decades, it is impossible to identify which securities were actually paid for by the customer and therefore, which securities the customer is entitled to receive.

Moreover, even if securities could be identified and could be shown to have been paid for, including fictitious profits gives the customer the benefit of BLMIS’s unlawful allocation of trades with no relation to reality or the marketplace. In a very real sense, allowing claims for fictitious profits lets the thief — Mr. Madoff — determine who wins and who loses.

Finally, the trustee’s purchase of securities, even if possible, would wreak havoc on the securities markets given the volume of securities involved. Here, given the failure by BLMIS to buy any securities, no orderly market could be maintained.

With regard to the distribution from the customer fund, simple logic suggests that it would not be advantageous to include fictitious profits. In a Ponzi scheme, fictitious profits cannot be part of an equitable plan for distribution to customers. By adding fictitious profits, all that would be achieved is increasing the amount of the claims being divided into the amount of the fund gathered by the trustee, thereby diminishing the percentage of recovery that all customers would receive.

Furthermore, those customers who withdrew more than they put in and withdrew fictitious profits, even unknowingly, actually received someone else’s money. They not only got their money back but, by virtue of the fictitious profits, they have received the actual investment dollars of another customer who will necessarily be out of pocket unless the fictitious profits are returned.

In that regard, allowing fictitious profits in the liquidation proceeding will benefit early investors but penalize later ones. Each customer receives a share of customer property that is proportionate to the size of his or her claim. If fictitious profits are allowed, the money put in to the BLMIS scheme by later investors, whose claims will largely be for real dollars, will be used to pay the earlier investors whose claims will be largely based on fictitious profits. In short, the Ponzi scheme would continue by BLMIS even in liquidation if fictitious profits were recognized.

The trustee and S.I.P.C. are fully aware of the hardship these facts may impose upon a number of the customers, and they will not be unmindful of those hardships in individual cases. However, there are many instances where no hardship exists and the inequitable result of not recovering the fictitious profits would be manifest. The trustee and S.I.P.C. are committed to a fair, equitable and compassionate approach to the allowance of customer claims.

We hope the information contained in this statement is helpful. The trustee maintains a Web site at www.madofftrustee.com that provides current information on the proceedings as well as the customer claims process.

Irving H. Picard is the trustee for the liquidation of Bernard L. Madoff Investment Securities LLC, and Stephen P. Harbeck is president and chief executive of the Securities Investor Protection Corporation."

the Congress needs to find a better way to determine sophistication

From the NY Times:

"Sophisticated?

Joe Nocera’s excellent column on Bernie Madoff and his victims today illustrates one of the great fictions of Amercan regulation — that rich people are automatically sophisticated.

The current securities laws provide one set of rules for pubic investors, with protections and regulations. But a money manager can evade many of those rules if he markets only to so-called qualified investors. To qualify, you don’t need to know the difference between a bond and bondage, or whether revenue and profit refer to different things. You just need to have enough assets.

If you’re into fraud, the rich are obviously more attractive targets. If the revised securities laws do provide exemptions for the supposedly sophisticated, the Congress needs to find a better way to determine sophistication."

Me:

The law just says that you’re rich enough to lose money. That’s it. The reason rich people prove such easy targets for Ponzi Schemes is because they’re rich, there’s a presumption that they’re smart. At least, that’s what they want to believe, and the PS creator reinforces that.

What’s more, no one likes the idea of being left out of an exclusive club when you’re rich. Being a client of a particularly adept manager is a club that many would kill to be in. I’m already sensing the writing of a Law and Order episode about just such a scenario.

What possible test could you give these rich people? They have people to take tests for them.

Finally, to a great extent, these frauds rely on friendship and trust. What’s the test for finding friends that you can trust? I bet that loss of friendship and trust hurts people as much as the money in some cases. You might as well try introducing a test that people are ready to have children or marry. There are no tests for some aspects of life but experience.

— Don the libertarian Democrat

the implicit prediction that we would see a blossoming of enforcement energy in a market bust - after most of the damage has been done

From The Baseline Scenario:

"Bernie Madoff Day

with one comment

As Bernie Madoff goes to his reward today, we should be asking how this could have happened. Not only Madoff and Allen Stanford, but also dozens of “mini-Madoffs” have been unearthed since the market collapse in September and October, which seems to have reminded the SEC that it has an law enforcement function. Not surprisingly, regulators are ramping up their enforcement divisions, and Congressmen are planning legislation to increase enforcement budgets.

A little late to close the barn door.

While Christopher Cox, SEC chairman from 2005 until this January, makes an obvious target, there is a deeper phenomenon at work than just the Bush administration’s hands-off attitude toward corporate fraud (an attitude largely shared by the Clinton administration). That is the general tendency of people - investors and officials alike - to underestimate the risk of fraud during a boom and overestimate the risk of fraud during a bust.

This issue is discussed in a paper by Amitai Aviram published in my own school’s Yale Journal on Regulation (but since you can’t get it from their website, get it from SSRN).

Aviram’s first point is that people tend to ignore fraud risk in good times and worry about it in bad times. There are many reasons for this. Falling asset values and credit crunches make it harder to perpetuate certain types of fraud, such as Ponzi schemes, but there are other factors. In one form of cognitive bias, people ascribe good outcomes to their own investing “skill,” and bad outcomes to exogenous factors they cannot be blamed for, such as fraud. The discovery of a few well-publicized instances of fraud creates an availability bias, where people miscalculate the incidence of fraud.

Typical enforcement patterns only exacerbate this cycle. According to Aviram, the traditional academic model of enforcement is that you set a budget such that, at the margin, the marginal cost of enforcement equals the marginal benefit of enforcement. In practice, however, this model is affected by political pressures. In a boom, when the public underestimates the risk of fraud, there is no percentage in presenting yourself as a crusader against big corporations or Wall Street - especially when they are being portrayed in the media as heroes, as Enron was prior to 2001. But in a bust, the way to score political points is to go after the “crooks and robbers,” which is especially convenient after they have been pointed out to you by the markets (Enron, Madoff). This leads to underenforcement during the boom and overenforcement during the bust. (Or, I might say, severe underenforcement during the boom and maybe sufficient enforcement during the bust.)

Here’s what this looks like:

That’s the annual percent change in the S&P 500 plotted against the annual percent change in the number of SEC enforcement actions. I would have liked to see a regression, or at least a correlation, but this is a law paper, after all.

So, yes, it’s the fault of regulators who are too soft on industry, but they also share the misperceptions of the public at large, which wants to believe that everything is just fine when the market is going up. Of course, regulators are supposed to know more than the public at large.

Aviram has a discussion of the role of conspicuous law enforcement itself in reinforcing or counteracting these misperceptions. This discussion is wishy-washy, because he leaves open the question of whether conspicuous law enforcement increases or decreases risk perceptions. (Again, this is a law paper - no equations and few numbers, just concepts.) But I think it’s pretty clear that it decreases risk perceptions. Let’s put it this way: On the day that you learned about Bernie Madoff, did you feel more secure because you felt like the SEC was doing a good job protecting you? Or did you feel less secure because if Madoff could get away with it for so long, who else could? Let’s assume I’m right and then follow Aviram’s reasoning. In that case, this cyclical enforcement pattern makes things even worse, because the lack of enforcement during good times makes people feel even more secure, and the “over” enforcement in bad times makes them even more paranoid. Therefore, he concludes, enforcement should be expressly counter-cyclical, which requires insulating the regulators from public pressure to be lax during a boom.

Thus, when conspicuous law enforcement increases risk perception [my assumption], implementing the correct long-term policy will cause fear and anger among the public in the short term. Nonetheless, if the goal of anti-fraud laws is to maximize long term efficiency, the public’s immediate sentiments should not be a consideration for abandoning the optimal (long-term) policy. In fact, the law enforcer should be shielded from precisely these short-term pressures.

Aviram cites central banks as an example of an institution that is appropriately counter-cyclical. But let’s not fault him for that. The paper was first written in early 2007, and few people could have foreseen what happened since. Indeed, the implicit prediction that we would see a blossoming of enforcement energy in a market bust - after most of the damage has been done - turns out to have been dead-on.

Written by James Kwak

March 12, 2009 at 2:05 pm"

Me:
Have you ever heard of a Ponzi Scheme being stopped as soon as it began? I doubt it. That’s because it mirrors a particularly lucrative investment for quite a long time. How many people are going to let you close down there investor because you suspect that his returns are too high? They’re more likely to respond that you’re high.

There’s no stopping a Ponzi Scheme until it runs its course. It’s a perfect crime for a fairly long time. Also, notice, Madoff admitted his guilt. Stanford isn’t so stupid it seems. He doesn’t believe that the government can even figure out how a Ponzi Scheme works, let alone convict him of running one. He might turn out to be right.

I suggest reading this post from Scientific American:

http://www.sciam.com/article.cfm?id=limits-on-human-comprehension&print=true

“David H. Wolpert, a physics-trained computer scientist at the NASA Ames Research Center, has chimed in with his version of a knowledge limit. Because of it, he concludes, the universe lies beyond the grasp of any intellect, no matter how powerful, that could exist within the universe. Specifically, during the past two years, he has been refining a proof that no matter what laws of physics govern a universe, there are inevitably facts about the universe that its inhabitants cannot learn by experiment or predict with a computation. Philippe M. Binder, a physicist at the University of Hawaii at Hilo, suggests that the theory implies researchers seeking unified laws cannot hope for anything better than a “theory of almost everything.”

Perhaps with Ponzi Schemes, we’ve simply run up against the limits of human knowledge.

"I'm guilty, guilty, guilty," Bernie Madoff told the court this morning.

From Crunchy Con:

"Thank you, Bernie Madoff
Thursday March 12, 2009

Categories: Economics

"I'm guilty, guilty, guilty," Bernie Madoff told the court this morning. Chadwick Matlin has written the World's Greatest Swindler a sarcastic thank-you note that makes some good points. Excerpt:

I, unlike the rest of our compatriots, will choose to exalt your gifts, not just your sins. Like the way you single-handedly forced Congress to acknowledge just how crappy the SEC is at doing its job. Like when your downfall helped unearth a dozen other Ponzi schemes, proactively saving millions of dollars. And I, for one, do not think you're only the basest kind of American--a man driven by greed, power, and an unchecked case of OCD. No, you, sir, are an American patriot. Your selfless sacrifice is overlooked by the hate-first-think-second mass media. You gave the American people somebody to despise when they needed it most. In our economic era, you may not have been the villain we wanted, but you were the one we needed.

Bernie--may I call you Bernie?--you arrived at just the right time. In December, when you admitted your fraud, we Americans were spewing anger, but it wasn't directed at anyone in particular. President Bush? He was on his way out of office, and we had already vented our frustrations at the polls. The CEOs of subprime lenders? Countrywide was absorbed by Bank of America; Fannie Mae and Freddie Mac belonged to us, the very people they helped ruin. Wall Street? Too many CEOs, all of whom you could call greedy only if you understood what in God's name a credit-default swap was.

But then you descended from the Lipstick Building: a middle-aged, extremely wealthy white guy from New York--exactly the demographic at which Main Street wanted to direct its scorn. (Your Judaism probably didn't hurt.) Instead of conning via derivatives, you conned through deceit. And we can understand deceit. That you had nothing to do with the root cause of our economic crisis didn't matter. You messed with Elie Wiesel, and when you screw with Holocaust survivors, it doesn't matter what kind of financial villain you are. You were evil. Case closed.

But that's all surface-level. I believe your real use came in the kind of scam you were running. If I may put it so baldly, Bernie, you made wealth disappear overnight. Money that your clients thought was there actually wasn't. This is the same thing that happened to homeowners when the housing bubble burst. And it's the same thing that happened to investors when the Dow started its death march. Even though your clients were mostly rich, we could sympathize with their loss, because it was a proxy for our own. We found common ground in our hatred of you.

Bernie, this all sounds awful, I know. But there's a reason I'm dragging you through this painful retelling of your greatest sins. We needed to be united, Bernie, and without you we wouldn't have been. The real cause of our financial meltdown is too nuanced, too impossible to cause total agreement across the country. You, however, were different. You gave us an easy target--a man who was selfish, greedy, and indiscriminate in his destruction. You offered an outlet for our frustration, and now your life sentence gives us a small piece of justice to cling to in these dark, hopeless days of the recession. You were our catharsis."

Me:

Don the libertarian Democrat

March 12, 2009 11:51 AM

http://don-thelibertariandemocrat.blogspot.com/

"and now your life sentence gives us a small piece of justice to cling to in these dark, hopeless days of the recession"

Unfortunately, since he's Jewish, as am I, the sentence doesn't do him much good. Neither does God's forgiveness. In Judaism, God cannot forgive you for crimes against others. You need to individually ask those you harmed for their forgiveness, and, if they are deceased, even go to their graves in some cases. Maybe he can get some kind of cemetery furlough for this purpose.

In any case, he's going to be very busy for a long time. He'll take your forgiveness though, I'm sure. That's one less person on his phone book length list.

"Nationalize them, let them fail, or shut up"

From Paul Kedrosky, a fine list indeed:

"Things I Don't Care About or Believe In

I find myself becoming increasingly irritated at so much of what is going on out there. Here is a quick list of the things I just don't care about:

• Where Bernie Madoff is in NYC on his way to/from hearings. Who cares? Really?( I AGREE )
  
• Apple statements on Steve Jobs' current employment status. Apple is marginally less trustworthy than the Kremlin.( I AGREE )
  
• Conversation about further capital injections in banks. Nationalize them, let them fail, or shut up. And pretending that PE firms can do the deed in the largest banks is tantamount to putting a dunce cap on your head.( I AGREE )
  
• Credit default swaps on the largest sovereigns. Sure, they're tradable, but in default who is on other side?( I AGREE )
  
• Decoupled anything. I have been arguing this point for a year, and I still run into idiots who think, say, China is going to bounce right back because it doesn't need trade. It not only won't bounce right back, it will likely go into outright recession.( I AGREE )
  
• Depression/recession chatter. We're doing that denial thing about a depression the same way we did about about a recession. A credit collapse, trade spiral, disappeared confidence, failing banks, fast-rising unemployment, and loss of confidence worldwide: We are in a depression of some to-be-determined eventual severity. Stop talking and move on.( I AGREE )
  

I find it helpful to keep track of things I don't care about. That way I can stop paying attention when they come. It's liberating, like emptying out the garage.

Feel free to add others."

I've heard enough about:
1) Complexity
2) Never Thought It Could Go Down
3) Incentives Caused It
4) Too Much Money Around
5) Interest Rates Too Low
6) Spenders Becoming Savers, And Savers Becoming Spenders
7) We Need To Replace This Exact Figure
8) Choose Your Theory Has Been Proven Or Shown To Be False
9) We Have A Capitalist System
10) Investors Are Believers In The Free Market
11) Silver Linings

our fear circuitry kicks in and panic ensues, a flight-to-safety leading to a market crash. This is where we are today.

From Freakonomics:

"This Is Your Brain on Prosperity: Andrew Lo on Fear, Greed, and Crisis Management

By Stephen J. Dubner

Andrew Lo

Andrew W. Lo is the Harris & Harris Group Professor at M.I.T. and director of its Laboratory for Financial Engineering. (Here are some of his papers.)

To my mind, he’s one of the most fluent guides to the state of modern finance in that he combines the rigors of a quant with a behavioralist’s appreciation for human intricacy( HUMAN AGENCY EXPLANATION ). He has agreed to write a guest post here (hopefully not his last — please encourage him!), an insightful look at how “extended periods of prosperity act as an anesthetic in the human brain,” lulling everyone involved into “a drug-induced stupor that causes us to take risks that we know we should avoid( WISHFUL THINKING ).”

Fear, Greed, and Crisis Management: A Neuroscientific Perspective
By Andrew W. Lo
A Guest Post

The alleged fraud perpetrated by Bernard Madoff is a timely and powerful microcosm of the current economic crisis, and it underscores the origin of all financial bubbles and busts: fear and greed( TRUE ).

Using techniques such as magnetic resonance imaging, neuroscientists have documented the fact that monetary gain stimulates the same reward circuitry as cocaine — in both cases, dopamine is released into the nucleus accumbens. Similarly, the threat of financial loss activates the same fight-or-flight circuitry as physical attacks, releasing adrenaline and cortisol into the bloodstream, which results in elevated heart rate, blood pressure, and alertness.( OK )

These reactions are hardwired into human physiology, and while some of us are able to overcome our biology through education, experience, or genetic good luck, the vast majority of the human population is driven( INFLUENCED ) by these “animal spirits” that John Maynard Keynes identified over 70 years ago.

From this neuroscientific perspective, it is not surprising that there have been 17 banking-related national crises around the globe since 1974, the majority of which were preceded by periods of rising real-estate and stock prices, large capital inflows, and financial liberalization. Extended periods of prosperity act as an anesthetic in the human brain, lulling investors, business leaders, and policymakers into a state of complacency, a drug-induced stupor that causes us to take risks that we know we should avoid( I AGREE THAT WISHFUL THINKING IS VERY IMPORTANT. HOWEVER, THOSE RISKS TAKEN INCLUDE CRIME, AND THE COMPLACENCY INCLUDES GOVERNMENT GUARANTEES AND EFFECTIVENESS. ).

In the case of Madoff, seasoned investors were apparently sucked into the alleged fraud despite their better judgment because they found his returns too tempting to pass up. In the case of subprime mortgages, homeowners who knew they could not afford certain homes proceeded nonetheless, because the prospects of living large and benefiting from home-price appreciation were too tempting to pass up. And investors in mortgage-backed securities, who knew that the AAA ratings were too optimistic given the riskiness of the underlying collateral, purchased these securities anyway because they found the promised yields and past returns too tempting to pass up.( SOME OF THIS IS CRIMINAL OR NEGLIGENT BEHAVIOR. )

If we add to these temptations a period of financial gain that anesthetizes the general population — including C.E.O.’s, chief risk officers, investors, and regulators — it is easy to see how tulip bulbs, internet stocks, gold, real estate, and fraudulent hedge funds could develop into bubbles. Such gains are unsustainable, and once the losses start mounting, our fear circuitry kicks in and panic ensues( I AGREE ), a flight-to-safety leading to a market crash. This is where we are today.( I AGREE COMPLETELY )

Like hurricanes, financial crises are a force of nature that cannot be legislated away, but we can greatly reduce the damage they do with proper preparation.( I DISAGREE. GOVERNMENT GUARANTEES AND BAGEHOT'S PRINCIPLES CAN RID US OF THIS PESTILENCE. )

Because the most potent form of fear is fear of the unknown, the most effective way to combat the current crisis is with transparency and education. In the short run, one way to achieve transparency is for our president-elect to convene a “crisis summit” once in office, in which all the major stakeholders involved in this crisis, and their most knowledgeable subordinates, are invited to an undisclosed location for an intensive week-long conference( NO ).

During this meeting, detailed information about exposures to “toxic assets,” concentrations of risky counterparty relationships, and other systemic weaknesses will be provided on a confidential basis to regulators and policymakers, and various courses of action can be proposed and debated in real time( NO. COLLUSION CENTRAL. ). Afterward, a redacted( YES. OF MEANING. ) summary of this meeting should be provided to the public by the president, along with a specific plan for addressing the major issues identified during the conference. This process would go a long way toward calming the public’s fears and restoring the trust and confidence that are essential to normal economic activity.( NO. GOVERNMENT GUARANTEES WILL. JAWBONING IS OF LIMITED, ALTHOUGH SOME, USE. )

In the long run, more transparency into the “shadow banking” system; more education for investors, policymakers, and business leaders; and more behaviorally oriented regulation( FINALLY. YES. ) will allow us to weather any type of financial crisis( I AGREE ). Regulation enables us to restrain our behavior during periods when we know we will misbehave; it is most useful during periods of collective fear or greed and should be designed accordingly( YES ). Corporate governance should also be revisited from this perspective; if we truly value naysayers during periods of corporate excess, then we should institute management changes to protect and reward their independence.( HOW ABOUT THEIR EFFECTIVENESS.)

If “crisis is a terrible thing to waste,” as some have argued, then we have a short window of opportunity — before economic recovery begins to weaken our resolve — to reform our regulatory infrastructure for the better. The fact that time heals all wounds may be good for our mental health, but it may not help maintain our economic wealth."

I disagree. Poor regulation and legislation result in a crisis. However hard and counterintuitive it is, we must address these issues in calmer times. This is no harder for a human to do than value investing.

“We had what was for all intents and purposes a systemic bank run for the first time in 70 years,”

Some good points on Bloomberg:

"By James Sterngold

Dec. 31 (Bloomberg) -- It has been a year of record misery: the largest bankruptcy, bank failure and Ponzi scheme in U.S. history; $720 billion in writedowns and losses by financial institutions; $30.1 trillion( AS YET UNEXPLAINED ) in market valuation wiped out.

The biggest loss and the hardest thing to recover, though, may be something that can’t be precisely measured -- confidence in the markets and the firms that rely on them.

“The wholesale funding model lost its credibility,” said David Hendler, senior analyst at New York-based CreditSights Inc. “That started the semi-nationalization( WE SHOULD HAVE ACTUALLY NATIONALIZED SOME OF IT. IT WOULD HAVE BEEN SIMPLER AND MORE EFFECTIVE. ) of funding in the financial markets. It’s a real chink in the armor of capitalism( WE DON'T HAVE THAT. WE HAVE A WELFARE STATE. ) as supposedly the best process for allocating capital. The government( IT HAS BEEN DOING THIS ALL ALONG ) is now deciding who gets access to capital.”

For Paul DeRosa, a principal of Mount Lucas Management Corp., a $1 billion hedge fund in Princeton, New Jersey, most unnerving was that the credit crisis revived something that, like the bubonic plague, was supposed to be a relic of the past.

“We had what was for all intents and purposes a systemic bank run( A CALLING RUN FOLLOWED NOW BY A PROACTIVITY RUN ) for the first time in 70 years,” said DeRosa, whose fund is up 25 percent this year. “This ended our belief that financial panics were a thing of the past( TRUE ). That’s why this is a transcendent event.”

The price tag has been transcendent, too. Global stock markets lost about half of their value in 2008, or $30.1 trillion dollars. In the U.S., $7.2 trillion of shareholder value was wiped off the books, as the Standard & Poor’s 500 Index fell 39 percent through Dec. 30 and the Nasdaq Composite Index dropped 42 percent.

Madoff Swindle

And if market losses weren’t bad enough, as much as $50 billion went up in smoke when New York money manager Bernard L. Madoff confessed to authorities this month to what may be the biggest swindle in history -- an alleged Ponzi scheme that spanned the globe, claiming victims from Alicia Koplowitz, one of Spain’s richest women, to filmmaker Steven Spielberg.

Institutions that seemed as solid as their Manhattan headquarters buildings crumbled. Lehman Brothers Holdings Inc., with assets of $639 billion, filed the largest bankruptcy in U.S. history on Sept. 15. Its creditors may have lost as much $75 billion, the firm’s chief restructuring officer said.

Bear Stearns Cos. was taken over by JPMorgan Chase & Co. in March after a funding crisis triggered by losses from subprime- mortgage investments. Merrill Lynch & Co., facing a crisis of its own, sold itself to Charlotte, North Carolina-based Bank of America Corp. And the last two major investment banks, Goldman Sachs Group Inc. and Morgan Stanley, converted to bank holding companies and got capital injections from the U.S. government.

Bank Failures

In the largest U.S. bank failure, Seattle-based Washington Mutual Inc. collapsed in September with $307 billion in assets.

There were 25 bank failures in 2008, the most in 15 years, according to the Federal Deposit Insurance Corp. The combined assets of lenders that failed in 2008 exceeds the total of those that collapsed in the preceding six years.

New York-based Citigroup Inc., whose shares lost 78 percent of their value this year, needed $20 billion in U.S. bailout funds in November on top of an earlier $25 billion infusion of capital. The government also guaranteed $306 billion of the bank’s troubled assets.

The wave of writedowns and losses that swamped financial institutions around the world reached $720 billion this year. It also eroded employment: 221,360 job cuts in the financial- services industry were announced.

Wall Street bonuses became so rich in recent years that $1 million was referred to as “a buck.” This year, chief executive officers including Lloyd Blankfein of Goldman Sachs and John Mack of Morgan Stanley have said they will get no bonuses at all.

The Amex Securities Brokers/Dealers Index hit a high of 267.69 on June 1, 2007; as of Dec. 30, it stood at 74.26.

AIG, GM

The U.S. government was forced to rescue the world’s largest insurance company, American International Group Inc., with a $152.5 billion package of investments, loans and capital infusions. It had to start purchasing corporate commercial paper to give companies the capital they needed to meet payrolls and conduct routine business.

Overall, the federal government has committed $8.5 trillion( YIKES ) in trying to jumpstart a shrinking economy. General Motors Corp. and Chrysler LLC will get $13.4 billion in federal loans to stay afloat until President-elect Barack Obama’s administration can devise a rescue plan of its own.

The paralysis of credit markets sent ripples through many of the businesses that had flooded Wall Street with profits over the past decade. U.S. corporations raised $4.54 trillion issuing securities in 2008, down from $5.14 trillion in 2007. Global merger activity fell to $2.5 trillion in deals announced from a record $4.1 trillion the previous year.

Loss of Faith

Hedge funds lost 18 percent of their value for the year through November, the worst year since record-keeping began in 1990, according to Chicago-based Hedge Fund Research Inc. Morgan Stanley estimated that, by year end, at least 620 hedge funds will have closed.

At bottom, the debacle amounted to a loss of faith( FEAR AND AVERSION TO RISK ), especially for individual investors. They pulled $215.7 billion from stock mutual funds in the first 11 months of the year, according to Investment Company Institute, a Washington-based association. That compares with a $91 billion inflow of funds for the same period of 2007.

As a result of those withdrawals and market losses, the total net assets in all types of mutual funds fell by $2.67 trillion in the first 11 months of 2008, the institute reported.

While the fear may pass, it will leave permanent changes in its wake. Few believe Wall Street will emerge as anything like the freewheeling industry it was over the past few decades.

“I see this as a Darwinian event,” said Mount Lucas Management’s DeRosa. “You find out which specimens of the species are genetically fit. I’m reasonably sure that things in 2009 will get better, but they’ll get materially worse before( I SAY FOR A FEW MORE MONTHS ) they start to look up.”

To contact the reporter on this story: James Sterngold in Los Angeles at jsterngold2@bloomberg.net"

This post does get the fact that we had a Calling Run, which is similar to a Bank Run. Now we have a proactive shedding of jobs that constitutes a sort of Proactive Firing Run, as well as a proactive decrease in output which is also approaching a run. So, in the wake of a series of bubbles based upon ignoring the fundamentals of investing sense, we now have a simliar downward flight which is also ignoring fundamentals. It doesn't seem to occur to people that the problem of ignoring fundamentals is what got us into this mess, and that ignoring fundamentals could well prolong it.

Somewhere along the line, instead of wailing about the free market, capitalism, nationalization, etc., we are going to need to simply get back to common sense investing basics. That's why I suggest the following:

1) Bagehot's Principles in organizing our financial system.

2) Grant's Graham in organizing our investing system.

3) A Burkean approach to society that realizes that social dislocation is no more inherently impossible than a financial panic.

4) Serious investigation and prosecution of Fraud, Negligence, Fiduciary Mismanagement, and Collusion. The laws necessary to prosecute these crimes are on the books. What is needed now is the funding and will.

5) A return to Political Economy.

6) A focus on Behavioral Economics.

7) A return to Human Agency Explanations as opposed to pseudo-scientific Mechanistic Explantions of Human Societies, Politics, Etc.

The capitalism/socialism blather is just that. We have a Welfare State, which is a Hybrid System. The real threat to our system remains, as always, Totalitarianism, which can only win out through massive social dislocation, which we need to avoid at all cost.

“There are some really extraordinary opportunities in the credit world,”

Were I an investor, I would actually do this:

"By Oliver Staley

Jan. 2 (Bloomberg) -- Yale University, whose endowment dropped $5.9 billion in six months because of the recession, is pursuing a recovery by acquiring distressed debt.

“There are some really extraordinary opportunities in the credit world( I AGREE ),” said David Swensen, the school’s investment chief, in a phone interview from his office at the New Haven, Connecticut, university. “Everything, from bank loans to investment-grade bonds to less-than-investment grade bonds, is priced at really extraordinarily cheap levels( I AGREE ).”

Swensen, 54, increased Yale’s endowment to $22.9 billion on June 30, from $1 billion in 1985 when he assumed the job, making it the second-wealthiest university in the U.S. The school estimated on Dec. 16 that the fund had fallen 25 percent, to $17 billion, because of the global financial crisis. Swensen, who has updated his 2000 book on investing for re-release Jan. 6, said periodic losses are inevitable in a portfolio tilted toward stocks and built to grow over many years.

“There isn’t an investment strategy that can produce the kind of long-term results we’ve generated at Yale that isn’t going to post the occasional negative return,” Swensen said in the Dec. 30 interview. “I don’t think people should disregard the book because of the market trauma of the last few months. We’re not even done with the current fiscal year. Judging a long-term investment strategy based on the results of a five- to six-month period is foolish beyond words( I AGREE ).”

‘Flight To Quality’( OR FLIGHT TO SAFETY )

Among Swensen’s core principles identified in “Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment” (Free Press, 408 pages, $35) is the importance of diversifying holdings while focusing on equities. In a recession, the advantages of diversification get overwhelmed( I AGREE ) by investors’ selling equities in favor of U.S. Treasury bonds in a “flight to quality,” he said.

“When you have a market in which any type of equity exposure is being punished, it’s going to hurt long-term investors,” he said.( TRUE )

In the current environment, distressed corporate securities can produce “equity-like” returns, Swensen said.

“You want to make sure you’re with companies that have the ability to survive in a really tough economic environment” he said, declining to name any of the companies.( I WONDER WHY? )

Yale, one of eight schools in the elite Ivy League in the northeastern U.S., dates from 1701. The school, which has about 13,100 students, trails only Harvard University in wealth. Harvard, in Cambridge, Massachusetts, had an endowment valued at $36.9 billion on June 30 before reporting losses of about $8 billion, or 22 percent.

Ph.D. in Economics

Swensen earned a Ph.D. in economics at Yale before working for Lehman Brothers Holdings Inc. and Salomon Brothers, now a unit of Citigroup Inc. When he took over Yale’s endowment, the fund contributed $45 million, or 10 percent, to the school’s annual budget. In the current fiscal year, which will end on June 30, the endowment is expected to contribute $1.15 billion, or 45 percent of Yale’s revenues, he said in the book.

The distribution from the endowment is based on an average of five years of returns, so the consequences of any loss this fiscal year will be blunted by the gains of previous years, Swensen said.

“We’re projecting no decline in endowment support for the operating budget,” he said.

Since the budget is due to grow in coming years, Yale President Richard Levin has said the school is projecting an operating shortfall of $100 million for fiscal 2010, increasing to more than $300 million four years later. The school estimates no growth in the endowment in fiscal 2010, with increases resuming in 2011.

Slashing Spending

To begin closing the budget gap, the school will slow increases in salaries, and cut budgets for non-faculty staff pay by 5 percent through attrition. Yale said it will reduce other expenses 10 percent over two years by slashing spending on consultants, travel and energy while delaying construction.

Until financial institutions resume lending( FEAR AND AVERSION TO RISK ), the economy will remain stagnant, Swensen said.

“I don’t think the Fed or the administration has figured out how to fix credit markets( BAGEHOT'S PRINCIPLES ),” he said. “We are going to experience economic and financial stress as long as the credit markets are broken and it’s not until we start seeing the credit markets functioning properly will we be able to see a path to economic recovery.”

Swensen advocates federal guarantees for deposits in money- market funds as a way to encourage investment in the vehicles that buy corporate debt( A GOOD IDEA. AS I'VE SAID, YOU'RE GOING TO NEED EXPLICIT GOVERNMENT GUARANTEES TO STOP A CALLING RUN. ).

Swensen’s book is updated to stress the importance of organization and governance for investment firms.

Bernard Madoff

Concerns over governance helped Yale stayed clear of Bernard Madoff, the financier accused of a $50 billion fraud. One reason was an inability to see where investors’ money was going, Swensen said.

“If we can’t sit down with the people making the decisions, and understand what it is they’re doing and how they’re doing it, we’re not going to invest,” he said. “We’re not going to have anything to do with it.”

If Madoff’s victims had read his book, Swensen said, Madoff, who relied on money from so-called funds of funds to feed his operation, “never would have been funded.”

“The reason I don’t like funds of funds is that they facilitate the flow of ignorant capital( SEEMS APT ),” Swensen said.

In general, most investors should stick to passive investments such as index funds that track the market, since attempts to outperform it are often unsuccessful( I AGREE ). For every winner there is a loser, and even the winners pay for much of their gains in fees and commissions, he writes in his book.

Contrarian Investing

“Casual attempts to beat the market provide fodder for organizations willing to devote the resources necessary to win,” he wrote.

Building Yale’s endowment required sticking to a contrarian investing philosophy, a high-performing research team, and the ability to coax “uninstitutional behavior( HUMAN AGENCY EXPLANATION ) from institutions,” Swensen said.

“Nobody said this was easy,” he said. “You’ve go to do an enormous amount of work to get it right.”

To contact the reporter on this story: Oliver Staley in New York at ostaley@bloomberg.net."

He makes some very good points.

"How this one was detected, while the $50 billion Madoff scheme slipped through the cracks is beyond us. "

Bespoke with a bit of humor on a serious topic:

"Stop the Presses: SEC Halts a Ponzi Scheme!

In what could possibly be the biggest 'too little, too late' moment of the century, the SEC announced today that it halted a $23 million Ponzi scheme targeted at Haitian-Americans. How this one was detected, while the $50 billion Madoff scheme slipped through the cracks is beyond us.

To put the two Ponzi schemes into perspective, tomorrow morning a Federal judge is set to approve the disbursement of $28.1 million in funds in order to just facilitate the liquidation of Madoff's assets. In other words, the total cost of the Ponzi scheme the SEC actually caught is $5 million less than the initial amount it will cost to liquidate the firm that ran the Ponzi scheme the SEC missed.

Click here to subscribe to Bespoke Premium today!

December 30, 2008 at 01:12 PM in Politics | Permalink"

Do you list these as Frauds or Lack Of Regulation?

" they will now be contributing their net supply. This will not help the world imbalances"

From Michael Pettis on China Financial Markets:

"Everyone is working hard to increase global trade imbalances December 30th, 2008 by Michael | Filed under Balance of payments, Consumption and production, Exports and imports, Informal banks.

I suspect most of my readers outside China are more interested in enjoying the holiday season than in spending much time following my blog, while most of my readers inside China are focusing on upcoming exams, but anyway my recent writing commitments are so intense that I haven’t been able to post much recently. For what it is worth I have a short piece appearing soon on YaleGlobal Online about why the US-China trade relationship was the “cause” of the recent financial crisis. ( INTERESTING )

I have a much longer piece that will appear in the January issue of the Far Eastern Economic Review that sets out the balance-of-payments framework necessary, in my opinion, for understanding not just how the current crisis came to pass but also how bad it can become if policymakers do not react correctly. The Financial Time’s Martin Wolf has kindly asked me to prepare a shorter version of the piece to appear on the FT blog next month.

Still, for all the writing commitments, there are a few things I wanted to note in my blog entry today. Today’s New York Times has an interesting article on South Korea that I suspect is going to set the tone for a lot of what will happen in the upcoming months:

South Korea posted a current-account surplus for a second consecutive month in November, which may help ease pressure on the won, the region’s worst-performing currency this year. The surplus was $2.06 billion, compared with $1.67 billion in November 2007, the Bank of Korea said…The nation posted a record $4.75 billion excess in October…South Korea has posted current-account shortfalls every month but three this year as higher oil prices and the weaker won drove up the cost of imported goods.

A few days ago the Financial Times had another interesting, related piece.

Vietnam devalued the dong by 3 per cent on Thursday in its latest attempt to keep its export-dependent economy afloat. The government said that 2008 economic growth had shrunk to 6.23 per cent from 8.5 per cent last year and there were signs it was likely to slow further in 2009. Several analysts have warned of the threats of competitive devaluations among Asia’s exporting economies but Hanoi’s move comes after spending most of the year trying to maintain the currency’s strength to slow spiralling inflation.

…Several analysts noted that while governments have resisted pressure for protectionist policies, there are fears they might take the short cut of devaluation. Thailand and Taiwan have recently become net purchasers of dollars, provoking the Asian Development Bank to warn against “unnecessary and excessive interventions in the currency markets, especially to depreciate domestic currencies”.

Vietnam has also cut interest rates several times which, as I have argued before, in an economy whose banking system funnels credit primarily to investment, and not consumption, is as much as an export-enhancing measure as currency depreciation( EXACTLY. A SAVER COUNTRY ).

One consequence of the financial crisis will inevitably be capital outflows from developing countries. The necessary corollary of capital outflows is trade surpluses. Without running a trade surplus no country can consistently support capital outflows, and as obvious as this is, it also seems to be a source of tremendous mystery to many experts and policymakers. Keynes for example pointed this out in his fury at the way Germany was required to post war reparations in the 1920s while its ability to generate export surpluses was all but eliminated by the victorious powers. Capital exports by definition require trade surpluses.

This is just another way of saying that a lot of developing countries that had been running trade deficits will soon be, if they aren’t already, running trade surpluses. Instead of contributing their net demand to the world economy, as they had via their trade deficits, they will now be contributing their net supply( YES ).

This will not help the world imbalances( THEY AREN'T MEANT TO ). The biggest contributors of net demand are the US and non-Germany Europe, and both of these regions are seeing a rapid decline in their net demand contribution (i.e. their trade deficits are expected to shrink). To adjust to this decline the world needs new sources of net demand or else global production must contract sharply via factory closings and rising unemployment. But the largest net supply country, China, is increasing its export of net supply (its trade surplus has been rising) while several trade deficit countries in Asian and elsewhere are switching to trade surplus or otherwise trying to reduce their deficits.

This cannot be sustainable( THE SAVER AND EXPORT COUNTRIES DON'T AGREE ). We cannot expect production to rise while consumption declines except if it comes with a dangerous rise in forced investment (also known as inventory). The crisis cannot even begin to be considered in its final stages until this issue is resolved.

Meanwhile domestically the debate about how to respond to the global crisis is still raging, although it is far from clear that we have anything close to a consensus among policymakers. Today’s South China Morning Post has the following article:

A former mainland central banker has called for a halt to the country’s recent flurry of actions to loosen monetary policy, a view partially echoed by analysts. Wu Xiaoling, who was a deputy governor of the People’s Bank of China before she left a year ago, said deep cuts in interest rates and reserve requirement ratios intended to boost lending could backfire, damaging confidence and adding pressure to bank balance sheets.

“I don’t think we should do more on the monetary policy side,” Ms Wu, now a vice-head of the financial committee of the National People’s Congress, told the Economic Observer newspaper yesterday. “Intensive policy moves will not help stabilise market expectations. Instead, they will cause panic among companies and the public, making the situation worse.”

I am glad to see that there is increasing concern about further interest rate cuts, although not for the reasons cited by most. For me, interest rate cuts in China will have very different effects than they might in the US. In the US, where a great deal of credit goes to consumption, lowering interest rates can be seen as boosting consumption as much as boosting production. At any rate the US, which contributes the largest amount of excess net consumption to the world and must bring it down, has every reason to focus on production-boosting measures as well as consumption-boosting measures.

But China is different. First of all there is little to no consumer credit in China, so cutting interest rates won’t do much to boost consumption. It might do so indirectly by reducing mortgage payments (Chinese mortgages are all floating-rate mortgages) and perhaps by slowing the decline in real estate prices, but it is not clear how big an effect that might have on increasing consumption, especially since even lower interest rates aren’t likely to create much buying interest for real estate. In fact there is some evidence in China that households may actually contract spending when deposit rates are cut since they need to save more to achieve their precautionary savings targets( THAT'S WHAT WILL HAPPEN ).

On the other hand with most credit going to investment, lowering interest rates definitely reduces further the cost of production. I know that the idea of lowering interest rates in an economic contraction is firmly entrenched in economic wisdom, and I am taking what may seem like an extremely opposite viewpoint, but I doubt that cutting interest rates is what China needs to do if it is expecting to adjust to the global payments adjustment. Every domestic policy must be aimed at boosting demand( GOOD LUCK ), and anything that increases China’s “competitiveness” is a dangerous detour since it can only exacerbate global imbalances and increase the likelihood of trade friction.

While still on the subject of banking, there is another very interesting article from the South China Morning Post on pyramid schemes and underground banking. As the financial system in China contracts, in spite of regulatory attempts to force credit expansion, I think the informal banking sector is going to get increasing scrutiny. In addition, and the Bernie Madoff scandal should remind anyone who needs reminding, financial crises always result in the uncovering of financial scandals and fraud on a massive scale, which already seems to be happening here( 2nd CAUSE OF OUR CRISIS ). Rather than comment I will quote extensively from the article:

Beijing will impose severe penalties on people involved in pyramid sales schemes, underground banking or manipulation of government statistics in a move to strengthen financial security, according to draft revisions submitted to the mainland’s top legislative body yesterday.

…Mr Li said the draft was revised to define pyramid selling as “organising, leading sales activities aimed at promoting goods and providing services that require participants to pay for the products or services in order to obtain membership” and “introducing a tiered system to force or prompt participants to attract new members to extract money and property, thereby disturbing public order”. If the changes are passed, people convicted of involvement in such activity could be sentenced to up to five years in jail, while ringleaders could be given even longer sentences in more serious circumstances. A regulation targeting underground banking has also been reviewed, according to Xinhua.

Illegal banks dealing in large financial transactions will be regarded as criminal organisations, the proposed amendments say. Mr Li said his committee added this line after the Legislative Affairs Office and the Public Security Ministry highlighted how underground banking could disturb and harm the financial order. Pyramid sales and underground banking have emerged as two major social problems in the recent weeks( I'M NOT SURPRISED ).

…Illegal banks are targets despite mainland companies of varying sizes relying on them for cash in the credit crisis. Illegal banks on the border help mainland businesspeople invest in the Hong Kong stock exchange."

Happy 2009, everyone. I will spend New Year’s Eve at D22 watching an amazing lineup of some of Beijing’s most brilliant musicians. I hope to see some of you there."

As I've said, the Saver and Export Countries do not want to change the basic arrangement. They will only go so far in the direction Pettis advocates. I've talked about the possibility of forgiving US debt, and I'm sure other options are being considered. It's simply not clear that Saver and Export Countries can change politically or economically.

"But it was the SEC’s decision in the 1990s not to take a stand on the controversial issue of “payment for order flow”

From the FT, another SEC failure. Perhaps James Grant is right:

"SEC inaction that helped fuel scheme

By Greg Farrell in New York

Published: December 23 2008 23:32 | Last updated: December 24 2008 01:44

Stung by claims that it missed discovering a massive fraud, the Securities and Exchange Commission is now poring over Bernard Madoff’s books, trying to unpick an alleged Ponzi-like operation that appears to have lost investors tens of billions of dollars.

But it was the SEC’s decision in the 1990s not to take a stand on the controversial issue of “payment for order flow” that helped fuel the rise of Bernard Madoff Investment Securities, the successful broker-dealer operation two floors above Mr Madoff’s private fund operation in Manhattan."

From the SEC:

"Payment for Order Flow

As a way to attract orders from brokers, some exchanges or market-makers will pay your broker's firm for routing your order to them – perhaps a penny or more per share. This is called "payment for order flow." Payment for order flow is one of the ways your broker's firm can make money from executing your trade. The firm can also make money by internalizing your order.

Upon opening a new account and on an annual basis, firms must inform their customers in writing whether they receive payment for order flow and, if they do, a detailed description of the type of the payments( NOTE WELL ). Firms must also disclose on trade confirmations whether they receive payment for order flow and that customers can make a written request to find out the source and type of the payment as to that particular transaction.

To learn more about the basics of trade execution – including order routing, payment for order flow, and internalization – you should read Trade Execution: What Every Investor Should Know.

http://www.sec.gov/answers/payordf.htm"

Back to the post:

"According to regulators and competitors, Bernard Madoff Investment Securities, enjoyed at least a decade of outsized growth in the 1990s because it paid brokers for business and exploited wide bid-offer spreads in the market.

By paying for order flow, Mr Madoff’s firm siphoned roughly 10 per cent of the volume of trading on the New York Stock Exchange away from the specialist firms that dominated the Big Board’s floor, creating what was known as a “third market”. Then, according to competitors and regulators, Mr Madoff’s firm thrived by trading within the bid-ask spreads, which could be sizeable.

“Mr Madoff was the cleverest and most successful competitor the specialist business ever had,” says Robert Fagenson, former chief executive of the Van der Moolen specialist firm. “When he created the third market his firm was fabulously profitable.”

The SEC had a long-standing rule regarding disclosure of any “remuneration” received in connection with stock transactions. But as the practice of brokers paying for order flow became popular in the 1980s, concerns were raised about whether the brokers doing the paying were buying stocks at the best prices for investors( HOW NICE ).

In 1990, the NASD empanelled a group of experts to study the subject. The committee was headed by former SEC chairman David Ruder, and included Mr Madoff. The so-called “Ruder committee” delivered a report in July 1991 dubbed, “Inducements for Order Flow”.

The report found no legal basis for restricting the practice of payment for order flow, but recommended that the NASD require its members to disclose in advance the “factors that influence their order-routing and execution decisions”( LIKE PROFIT ).

“There was some concern about payment for order flow,” says Mr Ruder, a professor at Northwestern University School of Law. But the report was broadened to include all “inducements for order flow” because, says Mr Ruder, “there’s practically no business done on Wall Street without some exchange of value, promise of future business, custody work or stock loans( YES )”.

In the 1990s, then SEC chairman Arthur Levitt criticised payment for order flow in speeches, but he never restricted the practice. Mr Levitt says he often asked his counsel for market regulation to figure out a way to ban the practice, but those requests went nowhere.

By paying for order flow, Mr Madoff’s firm generated so much traffic that it could act as a market maker, matching buyers and sellers outside of the NYSE. But that kind of traffic cost money, a penny or two per share. The key to the firm’s profitability was that Bernard Madoff Investment Securities did not accept limit orders( ORDERS AT OR BELOW A SPECIFIC PRICE ), according to Mr Fagenson. Without limit orders, the firm was able to buy securities on behalf of one broker for, say, $40.25, and match those same securities to a buy order at $40 per share( IN OTHER WORDS, NOT IN THE CLIENT'S BEST INTEREST BUT THEIRS ). An order for 100 shares of a stock, executed in such a way, generates $25 in profit.

According to Mr Fagenson and other specialists on the NYSE, Mr Madoff paid a penny per share to brokers who routed their transactions through his firm. By exploiting gaps in the bid-ask spreads of, say, eighths of a dollar, Mr Madoff’s firm would make more than 12 cents per share on trades, and give up only 1 cent per share for the order flow. For a firm that represented about 10 per cent of volume on the NYSE during the 1990s, the business model generated big profits.

All that changed in 2000, when the markets shifted from spreads of eighths and sixteenths to decimals. “One thing we can surmise is that when the minimum spread went from a sixteenth to a penny, there was a margin erosion of over 90 per cent( GOOD WORK. I WONDER IF THAT FIGURED INTO TO HIS CASH FLOW PROBLEMS ? ),” said Mr Fagenson."

Just another part of the Fiduciary Mismanagement committed daily and for years legally

"Once you violate such trust it takes years to re-earn it, if you ever can."

I tend to find this kind of post worrisome, but I have to mention it. From the Guardian:

"Richard Silverstein

• 
  
• guardian.co.uk, Tuesday 23 December 2008 13.00 GMT
• Article history

Frankly, I don't know quite what to make of Bernard Madoff, the $50bn man. When you hear the term "Ponzi scheme" you think of words like con artist, financial predator, flim flam artist, trickster. While I don't know Madoff personally or understand the ins and outs of his financial operation, somehow I can't see him in these terms. I don't see him as Michael Milken, Ivan Boesky or Alberto Vilar, a bottom-feeder out to help himself to whatever he can get.

Frankly, while it was a convenient foil for Madoff's work to be a wealthy New York Jewish philanthropist, I don't see him as a poseur in this. While he has destroyed lives and done great harm to American Jewish philanthropy, he has also wiped out the fortunes of his own children and other close relatives, and probably guaranteed himself a prison term. His is a family and tribal tragedy.

I couldn't begin to speculate about what drew him into this fraud – whether it was willful connivance and greed or merely a desire to help friends, family and fellow Jews to improve their investment returns or some combination. It somehow seems more complicated that the typical Wall Street Gekko-like scam. Gershom Gorenberg speculates:

Why did Madoff do it? My guess is that the start he was making profits legally. People admired him for it, and wanted to belong to his country club. When he had a bad month, he got embarrassed, like a smart kid who doesn't want to admit he got a bad report card. So he faked good results, figuring he'd cover the loss later. ... Eventually, faking became his full-time business. I'd feel sorry for him, if I wasn't busy feeling sorry for the rest of us.

Madoff has done incalculable harm to everyone he has touched, from international banking giants to small Jewish foundations to synagogues and Jewish federations. The Jerusalem Post calculates that he has destroyed $600m in Jewish charitable funds (not including personal losses to investors who used these funds for their own Jewish charitable giving) with the possibility it could reach as high as $1.5bn. The Post quotes sources who estimate a possible 20% reduction in funding for Jewish federations around the country.

American Jewish historian, Jonathan Sarna, puts the catastrophe in a broader Jewish philanthropic context:

The Madoff crisis marked an unprecedented loss to the "Jewish economy" – the networks of Jewish institutions, donors and charities that include universities, schools, hospitals and community centers, agreed … Sarna.

"I know of nothing [in history] on this scale"….

Sarna predicted that the wholesale destruction of fortunes and endowments would prove to be a turning point in American Jewish institutional life. … "The reduction of billions ... in the Jewish economy means that there is just not going to be enough money to sustain all the institutions and initiatives that have been created." ...

"We will be a poorer ... for that. What's been wiped out is an infrastructure that was particularly important in sustaining these institutions. The people who were invested with Madoff were the generation that not only supported institutions like Yeshiva University or the Holocaust museums, but that created them," Sarna said.( I HAVE NO IDEA IF THIS IS TRUE. IT SEEMS OVERDONE, BUT HE KNOWS MORE THAN I DO )

The list of specifically Jewish clients reads like a virtual who's who of American Jewry. According to the New York Times and other sources, Hadassah lost $90m, Mortimer Zuckerman's charitable foundation lost $30-40m, Yeshiva University lost $100-125m, Israel's Technion lost $6m, the Jewish Community Foundation of Los Angeles lost $25.5m, Washington DC's Jewish federation lost $10m, Manhattan's Ramaz Jewish day school lost $6m, the American Jewish Congress lost two-thirds of its approximately $17m endowment, Elie Wiesel's charitable foundation lost $37m and one of Steven Spielberg's foundations lost a considerable portion of its $12m in assets.( A LOT OF HIS VICTIMS WERE JEWISH. YES. )

While individually these amounts don't seem like a lot of money in a world in which we're talking about $700bn bail-outs (or Banco Santander's $3bn exposure to Madoff's meltdown), remember that these sums are everything or most everything these charities had. Many will be forced to drastically curtail their services or reduce staff. All of which hurts the deserving beneficiaries of these groups: teachers, students, the elderly, the homeless, cancer victims, etc.

Apparently, Madoff had close personal and financial relationships with Jewish members of the Palm Beach Country Club. One of the members who helped introduce fellow members to Madoff, Carl Shapiro, lost $145m from his own personal foundation. The Lappin Foundation in Boston and the Chais Foundation in Los Angeles have closed their doors, since their entire endowments were invested with Madoff. And these are only the ones we know. Imagine how many other clients we don't yet know about.

The harm done is not just in the financial losses. Think what a devastating blow this will be to organisations that cherished the trust their donors placed in them to invest their gifts wisely. Once you violate such trust it takes years to re-earn it, if you ever can.

I know this because I spent 17-years as a non-profit fundraiser, many of them working for Jewish communal groups, including two federations. Jewish charities pride themselves on the sober, judicious, conservative approach that they take to the funds they raise. These funds are considered a sacred trust, since tzedakah ("justice giving") is one of the highest values in Jewish tradition.

One of the things you learn both as a fundraiser and ordinary investor is to diversify your portfolio( VERY WISE ). Never rely on a single donor, never rely on a single investment vehicle, never rely on a single investment company. Otherwise, you run the risk of destroying your project if there is a financial cataclysm. Financial advisers often tell their clients never to have more than 5% of their assets invested in a single company's stock or with a single broker. It boggles the mind as important an American Jewish organisation as Hadassah would invest $90m with a single trader or that the small Lappin Foundation could invest its entire $7m endowment with Madoff.

What would cause otherwise prudent people, some with sophisticated understanding of finance, to override these concerns and throw caution to the wind? The Los Angeles Times calls it an "affinity scam". In other words, Madoff relied on the Jewish community, in an almost tribal way, to support his financial scheme( THESE HAPPENED TO BE THE PEOPLE HE KNEW ). There does seem to be some sort of almost atavistic instinct at work that led many of these individuals to trust Madoff with all their worldly assets( HOW ABOUT FRIENDSHIP AND TRUST? ). Perhaps they saw Bernie as one of their own, a smart Jewish boy who would take care of them. Some might have felt that in handling their own money, they needed someone who was more than just a distant banker, someone who they could trust as a member of the tribe.( TOO MUCH. HE PREYED ON THE PEOPLE HE WAS CLOSE TO AND WHO TRUSTED HIM. HE HAPPENED TO BE JEWISH AND KNEW A LOT OF OTHER JEWS. )

This is yet another indication of the damage done by Madoff. Perhaps it is wise not to trust someone just because they seem to get good investment returns and share your religious affiliation. But in the days before the Madoff affair, days which seem innocent and faraway though they were just last month, it was a comforting thought that you could do so. Now, it seems a harsher, less trusting, more atomised world in which you can't trust your fellow country club member, your fellow synagogue member, your fellow federation donor, your fellow board member to do the right thing by you or your charity. In the rest of the world, maybe nothing is sacred. But in the Jewish world some things were until Bernie Madoff came along."( THERE STILL IS A BOND BETWEEN MANY JEWS BASED ON A SHARED RELIGION, TRADITIONS, VALUES, ETC. )

Frankly, this article isn't what caught my eye. I read it, but felt no need to post on it. However, as usual, the comments are littered ( my word ) with Jew Haters. That's what caught my attention. An unbelievable number of the comments have been deleted, and, in my opinion, many of the remaining comments are by Jew Haters. I can no longer read Haaretz comments because every Jew hater on the planet who can write a basic English sentence posts on it.

I'd print them, but I don't allow such filth on my blog.

“The purpose of these laws is to balance the losses among the various investors, but how that balance is supposed to be struck is not clear,”

Bloomberg on an odd aspect of the Madoff situation:

"By Carlyn Kolker, Tiffany Kary and Saijel Kishan

Dec. 23 (Bloomberg) -- Like some of Bernard Madoff’s clients, a Florida restaurant owner was lucky enough to withdraw part of his investment before the money manager allegedly confessed to a $50 billion Ponzi scheme. Now he’s worried he might be asked to give it back.( YEP )

The 53-year-old investor, who asked not to be identified to protect his stake, took out about $600,000 this year from his $1.5 million account, using some of it to pay down a mortgage. He and other Madoff clients who withdrew funds as long as six years ago may be sued on behalf of other victims to return profits and even principal, securities and bankruptcy lawyers say( WOW ).

“Right now there are Madoff winners and Madoff losers,” said Lynn LoPucki, who teaches bankruptcy law at Harvard University. “Before this is over there will be nothing but Madoff losers( TOO MUCH ).”

Clients of Madoff had about $36 billion with his firm, according to a Bloomberg tally that may include some double counting. Before his arrest on Dec. 11, Madoff, 70, confessed to employees that his “giant Ponzi scheme” may have cost as much as $50 billion, according to an FBI complaint. His misconduct may have stretched back to at least the 1970s, two people familiar with the government’s inquiry of Madoff said last week.

The Florida investor, who first gave his money to Madoff five years ago, said he had no hint of fraud and would go to jail rather than give up the amount he took out( I UNDERSTAND HOW HE FEELS ).

Irving Picard, the trustee appointed to liquidate Madoff’s brokerage, Bernard L. Madoff Investment Securities LLC, holds the fate of the restaurant owner and other investors in his hands.

Enough Funds Left?

Picard, who didn’t return a call seeking comment on plans to sue victims to recover funds, said in a court filing yesterday that “there has not been any showing or determination that there are sufficient funds” to satisfy victim claims.

A so-called clawback of paid-out funds in the Madoff liquidation could result in lawsuits against investors such as charities, hedge funds and individuals who redeemed profits and took out principal. Nonprofit institutions such as the Carl and Ruth Shapiro Family Foundation, a foundation controlled by Democratic U.S. Senator Frank Lautenberg of New Jersey, and Yeshiva University relied on funding from Madoff investments.

Lawyers and representatives of the Shapiro and Lautenberg foundations didn’t return calls seeking comment. In a statement, Rick Matthews, a Yeshiva University spokesman, said, “Our lawyers and accountants are in the process of an investigation.”

‘Further Risk’

“Charities are looking at their legal options as regarding their right to recoup money,” said Mark Charendoff, president of the New York-based Jewish Funders Network, whose 1,000 members fund Jewish causes and are assessing losses from Madoff investments. “I don’t know that they’ve been focused on or are aware that they may in fact be at further risk of loss.”( COME ON )

Bankruptcy laws authorize a trustee like Picard to recover money that was distributed as part of a fraud and share it among the victims, LoPucki said.

“The purpose of these laws is to balance the losses among the various investors, but how that balance is supposed to be struck is not clear,” LoPucki said.( THIS LAW IS BIZARRE )

Under New York state law, which can be invoked for Madoff recoveries, a trustee can seek redemptions going back six years( TOO LONG ), said Tracy Klestadt, a New York bankruptcy lawyer.

In a similar case, U.S. Bankruptcy Judge Adlai Hardin in White Plains, New York, ordered investors of defunct hedge-fund manager Bayou Group LLC in October to disgorge( FIND ANOTHER TERM PLEASE ) profits they’d taken out. Investors were required to pay back any gains they’d redeemed involving “fictitious profits.” Before the fraud was discovered, Bayou paid out more than $135 million, according to court papers.

‘Good Faith’ Rule

Hardin also ruled some investors would have to hand back their principal. Only investors who acted in “good faith” -- a legal standard that makes investors prove they didn’t have knowledge or suspicion of fraud -- could protect their initial stake, Hardin ruled. He said investors could show they had good faith if they didn’t see any “red flags” when they withdrew the funds( SUPPOSE THEY TAKE THE MONEY OUT AND WARN EVERYBODY ELSE ? ).

That decision could be a guide for Picard, Klestadt said.

The Bayou decision set a high bar for investors who hope to protect their principal, said Carole Neville, a lawyer representing Bayou investors.

“What the Bayou case holds at the moment, is, if you had any reason to feel uncomfortable about your investment and took your money out, you don’t have good faith,” Neville said.( I DON'T LIKE THIS LAW OR DECISION )

“On the surface it seems a standard that’s almost impossible for people to meet( THAT'S ONE REASON THE LAW IS WRONG ),” said Robert Crane, president of New York’s JEHT Foundation, a group dedicated to criminal justice matters that relied on donors who invested with Madoff and said it’s closing in January.

Seeking money from investors who say they were defrauded can result in protracted litigation. In the Bayou case, which is being appealed, $20 million of the $33 million recovered from redeeming investors went to pay legal fees( WHAT A WASTE ), Neville said."

I'll be honest. I don't like this law. I could accept two years and a standard that said you took out your money and had actual evidence of fraud which you didn't pass on to the authorities. Otherwise, it's a needless mess.