An Example of Ineffectual Competitive Response- Part One

Back in November of last year, I wrote this post shortly after the opening of a local LifeTime Fitness club. I ended the piece by observing,

"I don't follow individual companies for investment purposes, and I don't own any positions in Lifetime Fitness. Looking at the chart, I can't say definitively why the company's stock price began to plummet late last year.

Perhaps it is viewed as a discretionary service which will be hard hit by the likely recession.
If so, the experience of the past few months in New Jersey suggests that they are far better managed than that. Nearly everyone with whom I've spoken at the new facility feels the services are much less expensively priced than what is comparably available. The staff performs in a manner that makes you feel you are watching a well-oiled retail machine at work. It doesn't take much thought to understand that Lifetime's size and growth potential allow its employees to consider career development options which are simply nonexistent in your local, smaller-scale fitness business."

Since then, LifeTime's equity price has bottomed and continued flat through to today. But that's not the point of this post.

Instead, I want to focus on the fitness club to which I still belong (due to an annual membership situation), but no longer actively use. I wrote of it in that linked post,

I've always liked the people who own and operate the fitness club to which I have belonged for nearly a quarter of a century. Were it not for Lifetime, I would have had no reason to sample another competitor, nor plan not to renew my membership when it expires early next year.

However, there's no realistic way in which that business can compete for my fitness dollar now. Due to a mistake made locating on a wetlands parcel, the owners cannot add more fitness services, such as swimming or tennis. The relatively high fixed cost nature of fitness clubs means that just a small loss of customers will have a severe impact on my current club's profitability.

Faced with, by March, two Lifetime fitness facilities bracketing it within a few miles on each side, my old club won't be able to raise prices and retain members. They obviously can't lower prices to retain members and still maintain profitability.

On both financial and service offering bases, it would appear that the club has a relatively short future. Schumpeterian dynamics, in the nature of a large, lower-cost, more service-rich chain of fitness clubs, has irrevocably altered the local competitive landscape for fitness facilities.

And, true to form, it has resulted in more and better fitness services for the customer's dollar."

About a week ago, I received a letter from my old fitness club. I think it's noteworthy, in that it represents the first tangible recognition by the owners and managers that they are in a tough bind. I should note, again, as I mentioned in that quoted passage, that I genuinely like the owners of my old club. Some of the remarks that follow may not be to their, or their managers', liking, should they happen across this post. But I want to illustrate a clear, pure business strategy and competitive response case, so I need to be direct and unvarnished in my observations and comments.

The letter opens,

"You became a member of (name of club) because of our size, programs, and features that could not be found in other clubs. We are small enough to know you, and large enough to serve you."

Well, this is partially true. I became a member of the club twenty-six years ago because it had the only squash courts in the area, while not being a private, country-club-style facility. At that time, the only real fitness club choices were YMCAs and this facility. But twenty-six years is a very long time.

To put it in perspective, when I was a pre-teen, in the mid-1960s, watching old movies on network television, I would sometimes mentally calculate what year would have been as far back from the date of some program or movie as it was from when I was watching it. From that era, the Depression was only thirty years earlier. Technologically, my pre-teen world was entirely different.

That's how I view the current situation. Nearly thirty years ago, socio-economic trends were quite different. So, reminding me why I joined the old fitness club nearly three decades ago simply causes me to remember how much the world has changed. And how little the club has changed with it.

The letter goes on to note the club's history of involvement in squash, with various programs for children, tournament sponsorships, etc.

It then contends,

"We will do everything necessary to continue our position as a premier squash and fitness facility. Our atmosphere, staff and squash professionals together with our facilities cannot be duplicated by other clubs, regardless of their size. Although it is sometimes difficult to balance the competing interests of our programs, we combine 30 years experience serving a challenging and wonderful clientele combined with a staff second to none."

Here, the letter departs into the state of denial.

Until early November, the club was a "premier squash and fitness facility." Then LifeTime Fitness opened its first of two clubs. Now, the old club is no longer "premier" in any sense except its pricing.

LifeTime has four squash courts at each facility. The old club has three older, narrower, hardball squash courts, and two wider, regulation softball squash courts. Softball is now the dominant game of the sport. However, the old club has one feature that is unique and, now, unchangeable. To explain fully, a little history of the club is in order.

In 1978, the owners (I believe just two of the current three) collaborated to build a small, six-court squash club on a piece of land which was bounded by swampland and other structures. Soon thereafter, by 1982, when I joined, they had expanded the original building twice, to add racquetball courts, a small Nautilus circuit room, and aerobics studios.

As time wore on, the wetlands aspect of the property became important, because the owners would have to build into the parking lot, or upward, to expand the club further.

So, now, when the letter states "we will do everything necessary," that isn't quite true. They won't relocate the club.

Several months ago, one of the owners approached me in a weight room and directly asserted that he knew I had joined LifeTime Fitness. I replied that I had, as many other members of the old club, accepted the LifeTime Fitness trial offer to join for a month, at a preferred rate, with the option of leaving for only a $75 administration fee if I didn't like the new club. And that my younger daughter, not I, had been the driver behind this decision.

At the end of a lengthy discussion with this owner, I observed that the club had never really wanted families to belong, because their pricing treated each child as a separate, adult member, and then, only after age fourteen. Also, I suggested that, before he and his partners had pierced the back wall of the club for the first expansion, they should have sat down, considered their long term objectives, and bought land half a mile away, then vacant, to build a member-focused general family fitness facility, rather than private squash club which had been enlarged to attract some expense-sharing members.

His reply was, to paraphrase it closely,

'Yes, but who was thinking that far ahead in 1980? Nobody else was even thinking of a fitness club like ours back then.'

To myself, I thought, in response,

'A surviving fitness club, that's who. You had YMCAs to look to for an example of what the future would hold.'

The key trend that the owners and their managers, through the years, failed to notice was this. Fitness-oriented 20- and 30-somethings marry and have children. Eventually, they want more than a nursery for their children while they exercise. They would want a family fitness club.

YMCAs, YWCAs and their ilk have always offered this, but not so luxuriously as my old fitness club. Had the owners followed my advice, prior to expanding their current facility, they could have bought a sizable tract of land nearby, designed and begun building a YMCA-like facility from scratch, only somewhat more nicely appointed.

The letter continued with a reference to the squash pros. Here, too, they are in denial. The head pro is very qualified, experienced, and likable. However, he doesn't do nearly as much work with youngsters as he used to. Instead, two uncredentialed young squash players, whom I refer to as 'semi-pros,' do that. One is a converted tennis player with no formal squash training. The other, a very nice young woman, played varsity squash in college. Another pro, and arguably the club's best player, is a Jamaican-born, former professional squash player who now teaches squash part-time. Thus, the staff isn't truly any better than LifeTime's pro.

Further, most adult players could care less who the pro is, since they don't take lessons.

The letter goes on to promise,

"We are determined to work even harder so that (club name) is the best place for you to be a member."

Alas, too little, and about eighteen months too late.

From extensive discussions with friends who, like me, joined the LifeTime Fitness club, I gleaned the following information. What would have kept most of us adult squash members from leaving were these steps:

-When the first news of LifeTime's imminent arrival came, offer all squash members a reduction in membership fee from the penalizing $150/month level back down to the general member's $100/'month, or something slightly higher.
-Combine this reduction with a special offer to lock in the rate for, say, two years, with the balance payable upon leaving the club. This would have protected the old club's most profitable membership segment.

-Convert two of the older, narrower courts to a wide court, making a total of three softball courts.

-When repairing, for the fifth time, the front walls of the two existing wide courts, change the composition of or move the front wall so that moisture from the swampland did not continue to corrode the masonry and cause craters and repair-patch dimples for most of the three-four years between wall reconstructions.

-Extend the club's operating hours past 10PM and earlier than 5:30AM.

None of these steps were taken. Instead, the old club now simply has fewer facilities than LifeTime Fitness, at higher prices. They promise to institute a quarterly-meeting 'squash committee,' but, again, it's too late. Most of the adult squash members have already left.

By rough count, some 10% of members of the old club have migrated to LifeTime, including a large number of non-squash players. Why not? You get swimming, basketball courts, a rock climbing wall and more equipment for the same monthly membership fee.

Now, the old club cites its accomplishments and history. But its promises for the future ring hollow.

In my next piece on this example of ineffective competitive response to a new market entrant, I'll provide some financial context to frame my prediction of what will occur over the coming year for the old fitness club.

My Equity Stategy In 2008

I haven't posted about the performance of my equity portfolio strategy since this piece on July 1st of last year. I wrote,

"I am very, very sorry to note that my proprietary equity allocation signal has finally gone to "short" for the first time since 2001.

Believe it or not, even January's rollercoaster ride and March's collapse didn't trigger it. Almost, but the April bounce lifted the S&P just enough to keep us long for a while.

June's S&P return of at best -9%, on first glance using a simple Yahoo-sourced price difference, is the worst in ages, and sends my proprietary market turbulence/allocation signal firmly into short/put territory."

And there it has remained ever since.

The equity strategy racked up a 5% gross loss for the first half. However, by going short with a theoretical 50% of assets for the next six months, it earned 18% in the second half. Netting the two halves resulted in what would have been a +13% gross return for the full year.

I don't even have my own money in the equity strategy now, since the optionized version that my partner and I use is far more profitable. But I still run the underlying equity model to assure the validity of the tool that underpins the options approach derived from it.

Thanks to the risk management tools which I built in the midst of the 2000 equity market crash, the equity portfolio was correctly positioned for this past fall's carnage. While the short portfolio had as much as a 48% return at its peak, it of course gave back some profit as the S&P climbed some 23% from its late November bottom.

For now, my allocation signals still indicate a short position in equities for quite a few more months.

In the worst year for S&P equities on record, it's gratifying to know that, if I had managed just equities with my strategy, it would have not only outperformed the S&P500, but actually had a positive return when many well-known funds lost heavily.

Regulation & Bernie Madoff

Today's Wall Street Journal contained yet another Madoff article. This one described, in detail, the various examinations and investigations of Madoff's investment activities over the past years by the SEC and other agencies.

The tone of the piece was one of shock and disappointment that so many exams had missed the ongoing fraud.

Once again, however, I find myself at odds with the Journal on this topic, as I was in its recent piece by the clueless James Stewart.

Today's piece seems to chide the various Federal agencies for having sniffed so close to the massive fraud, but never have discovered it. Great pains are taken to describe the minor infractions uncovered, the refrain from actually punishing Madoff for various minor trading or record-keeping violations.

What seems to be missing from these pieces, and general expectations of regulation and regulators by Congress, the media and populace, is individual responsibility and prudence.

So long as investment management is a cottage industry, there will be the potential for Madoff-like abuses. People who choose to deal with managers other than those running publicly-followed, large mutual funds should know they are taking excessive risks beyond simply that of the management's investment judgment.

There is simply no way that the SEC will visit and catch every registered, let alone unregistered investment manager.

As an example, the state in which I reside has a law requiring every driver to carry insurance. But this is often honored in the breach. Drivers who can't afford insurance simply void the check, fail to pay the second six-month installment, or never write a good check in the first place. If one of these drivers hits you, you pay for your own damages.

Despite the state's massive regulatory infrastructure, there is simply no way it can identify and remove these scofflaws.

Madoff and his ilk are no different. If we want to allow individual initiative in business, this sort of crime is a certainty. Only individual common sense can really prevent it.

Even now, my business partner and I are reluctant to manage anyone else's money, due to regulatory requirements. But, in reality, we could structure it so that there was no regulatory overhead. Or footprint. And it's likely nobody would ever know otherwise.

We cannot expect large, unwieldy regulatory staffs and agencies to smoke out every single violator. Especially not when people will seek excess returns, heedless of the risks. For a better, longer treatment of this facet of human behavior, see the Journal's excellent weekend story by Stephen Greenspan.

Simply put, though, if the SEC doesn't have evidence that you run a Ponzi scheme across dozens of individual accounts, there's no way they will stumble upon it until it is way, way too late.

Despite what I just heard Jim Cramer allege on CNBC, I doubt anyone would have been in a position early on to learn what was really going on with Madoff, if they were outside the scheme.

As to those who were victims, they did, indeed, consciously throw various cautions to the wind, such as separate custody accounts, too-perfect returns, and an explicit agreement to remain totally ignorant of how such stupendously-invariant returns could be earned.

It's unnerving to see the Madoff affair used to promote more regulation, when what is required is more self-reliance, less denial, and more effective enforcement of existing regulation.

The Coming Economic Mess

Last weekend's Wall Street Journal carried a brief but potent piece by Peter Schiff, President of Euro Pacific Capital, entitled "There's No Pain-Free Cure for Recession."

Schiff, a self-identified member of the Austrian school of economics, casts new doubt on the vaunted coming $1T stimulus package later this month. Reminding us of the common sense of cutting spending and cleaning out weak businesses in the periodic recession that grips all economies, he begins his editorial,

"As recession fears cause the nation to embrace greater state control of the economy and unimaginable federal deficits, one searches in vain for debate worthy of the moment. Where there should be an historic clash of ideas, there is only blind resignation and an amorphous queasiness that we are simply sweeping the slouching beast under the rug.

With faith in the free markets now taking a back seat to fear and expediency, nearly the entire political spectrum agrees that the federal government must spend whatever amount is necessary to stabilize the housing market, bail out financial firms, liquefy the credit markets, create jobs and make the recession as shallow and brief as possible. The few who maintain free-market views have been largely marginalized.

Taking the theories of economist John Maynard Keynes as gospel, our most highly respected contemporary economists imagine a complex world in which economics at the personal, corporate and municipal levels are governed by laws far different from those in effect at the national level.

Individuals, companies or cities with heavy debt and shrinking revenues instinctively know that they must reduce spending, tighten their belts, pay down debt and live within their means. But it is axiomatic in Keynesianism that national governments can create and sustain economic activity by injecting printed money into the financial system. In their view, absent the stimuli of the New Deal and World War II, the Depression would never have ended.

On a gut level, we have a hard time with this concept. There is a vague sense of smoke and mirrors, of something being magically created out of nothing. But economics, we are told, is complicated."

Allowing for Schiff's sarcasm, he has a valid point. It's interesting to see Keynesian economics brought back to reality by exposing its central flaws so directly.

Schiff continues,

"It would be irresponsible in the extreme for an individual to forestall a personal recession by taking out newer, bigger loans when the old loans can't be repaid. However, this is precisely what we are planning on a national level.

I believe these ideas hold sway largely because they promise happy, pain-free solutions. They are the economic equivalent of miracle weight-loss programs that require no dieting or exercise. The theories permit economists to claim mystic wisdom, governments to pretend that they have the power to dispel hardship with the whir of a printing press, and voters to believe that they can have recovery without sacrifice.

Governments cannot create but merely redirect. When the government spends, the money has to come from somewhere. If the government doesn't have a surplus, then it must come from taxes. If taxes don't go up, then it must come from increased borrowing. If lenders won't lend, then it must come from the printing press, which is where all these bailouts are headed. But each additional dollar printed diminishes the value those already in circulation. Something cannot be effortlessly created from nothing."

This is really the crux of the matter in the modern global economy. Individuals must borrow capital they do not have, in order to use it. Nations either borrow, tax, or devalue their currency and create inflation. There is no other 'out.' Congress can't simply create a new way of financing the coming huge spending programs. It must choose one of these three, two of which require national belt-tightening elsewhere, in time or sector, if the spending is to go forward.

Schiff concludes by observing,

"By borrowing more than it can ever pay back, the government will guarantee higher inflation for years to come, thereby diminishing the value of all that Americans have saved and acquired. For now the inflationary tide is being held back by the countervailing pressures of bursting asset bubbles in real estate and stocks, forced liquidations in commodities, and troubled retailers slashing prices to unload excess inventory. But when the dust settles, trillions of new dollars will remain, chasing a diminished supply of goods. We will be left with 1970s-style stagflation, only with a much sharper contraction and significantly higher inflation.

The good news is that economics is not all that complicated. The bad news is that our economy is broken and there is nothing the government can do to fix it. However, the free market does have a cure: it's called a recession, and it's not fun, easy or quick. But if we put our faith in the power of government to make the pain go away, we will live with the consequences for generations."

I agree wholeheartedly with Schiff. As I noted in the linked post above to my last piece on Samuelson's accelerator-multiplier theory, all economies must cycle through recessions. It's a mathematical certainty stemming from the natural consequences of varying economic growth rates.

Instead of letting a normal recession clean out bad business models, reallocate resources to their most efficient usage, and let risk be taken sensibly, we are, instead, embarking on the lunacy of Federal investment by fiat of printed money.

Reading Schiff's piece, I think my experiences with the Nixon-Carter era stagflation is, sadly, going to be useful soon.

Dangerous Advice From The WSJ's James Stewart

The Wall Street Journal employs a particularly inept and whiny investments writer named James B. Stewart, author of its "Common Sense" column.

I last wrote of Stewart's dubious credentials here, in August, in regard to his having fallen victim to the auction rate securities mess. In that post, I observed,

"Which brings me to a hilarious companion piece in the same WSJ edition.
It seems that James B. Stewart, a regular investment columnist who writes "Common Sense," lost his. He spent yesterday's column bitching about his lack of satisfaction as a 'victim' of the ARS mess.

But, back to Mr. Stewart. For someone so lofty as to write a column in the WSJ on investing, wouldn't you think he would know better than to offer an excuse like the above for purchasing ARS notes? Really- something for nothing, James?

Free extra returns, just for 'valuable clients?'

I have to laugh, because I've never bought any structured finance instrument in my life. The market-making assurances on these instruments are simply not to be believed.

Anyone with any experience in securities markets would know this.

Should James B. Stewart even be writing a weekly investing column for the WSJ, if he was taken in by such a simple ruse as the ARS game, and went for the old 'something for nothing' con?"

In yesterday's edition of the Journal, Stewart weighs in on those conned by Bernie Madoff. Here are some priceless gems from Stewart's attempt to excuse all those victims of any personal responsibility in the matter,

"Now that some of the dust is settling around the Bernard Madoff scandal, there has been a growing tendency in some quarters to blame the victims, at least in part. According to these theories, they should have recognized that annual returns of around 10% in both good times and bad were too good to be true. They should have been suspicious of Mr. Madoff's vague explanations of how he arrived at those results. And to the extent he described his strategy, which involved the simultaneous purchase of stock and sale of option contracts, they should have noticed that there wasn't sufficient volume in those options trades to account for the reported gains.

The lesson from such criticisms, I suppose, is that we should all turn ourselves into forensic accountants. I find that preposterous, not to mention distasteful, given that some of these people have lost their life savings. After all, consistent returns in good and bad markets are the selling point for nearly every hedge fund. There are plenty that have reported much larger annual returns without raising eyebrows. Indeed, Mr. Madoff's returns were good, but not so spectacular as to raise undue suspicion. As for his vague explanations, they were no vaguer than those of many other hedge-fund managers and even mutual-fund managers."

For someone writing a column entitled 'Common Sense,' it seems Stewart has decided that investors really shouldn't have to bring any to the table. Madoff's return weren't just consistent- they were practically constant and uniform! Big difference!

It's not forensic accounting to observe that returns are too steady in markets that fluctuate, and you can't get a straight, understandable and believable answer regarding how a manager is able to achieve such unwavering results for years on end.

What Stewart does recommend, later in his piece, are basically four things:

-a well-known manager should have a well-known accountant
-diversify your investments among different managers
-remember that above-average returns have above-average risk
-don't use middlemen to find a manager

The second and third points are basic investment truisms. The first is probably a good idea, but might cause you to avoid a credible manager. Everybody starts somewhere, and every accountant has to have a first client. That doesn't make him/her a criminal.

As to using middlemen, that's a tougher call. Some managers can't really be accessed any other way. Most retail investors don't have the time or knowledge to contact individual managers who will give them the time of day. That's why we have mutual funds. For most investors, either a private bank or pension fund offer a pre-screened selection of managers, i.e., they behave as middlemen.

Stewart's final recommendations are, for the most part, either harmless or obvious.

But his worst offense is in the opening paragraphs of his article, in which he effectively absolves investors from having to take responsibility for using common sense to assess the likelihood that an investment manager is engaging in real, verifiable, extraordinary investment strategies.

The Wall Street Journal shouldn't be publishing this dangerous nonsense, or, in my opinion, anything by James Stewart.

The Coming Cost of Mortgage "Cram-Downs"

Yesterday's Wall Street Journal reported that, thanks to the severe credit crunch, current recession, and imminent control of both Houses of Congress and the Oval Office by Democrats, even mortgage lenders are bracing for some sort of "cram-down" legislation in the coming months.

The TARP bill originally had such a provision, but it was struck on the threat of veto.

In the past, all bankruptcy law modifications have carefully avoided violating residential mortgages on primary residences, since it was understood that introducing such risk into mortgage finance would lead to higher rates and probably downpayments, as well.

Welcome to the new world of mortgage finance. What investor will want to own mortgage-backed securities which are vulnerable to any small-town bankruptcy court judge's whims? It may not be a matter of higher rates or larger downpayments. Much of the mortgage-backed securities market might just vanish if such legislation passes.

Like it or not, the issue boils down to people being responsible for the obligations under contracts into which they freely entered.

Using cram-downs now, of course, rewards those people who engaged in excessive borrowing. And those who can now claim to have been coerced.

But the signal this sends for future contracts is very disturbing. Essentially, we are slowly evolving contract law into a scheme in which, if you don't get your desired result from the contract, somebody in a bankruptcy court will let you void the contract.

How can we, as a society, continue to function economically amidst such a legal vagueness in the most basic of all advanced economic systems?

Dell's Failing Turnaround

Today's Wall Street Journal featured an article about the Dell 'turnaround' in the Marketplace section.

Almost a year ago, in January, I commented on a Journal piece about returning CEOs reviving their companies. I wrote about Dell,

"Why do you suppose that these CEOs, as a group, mostly failed to move their firms to consistently superior total return performance?

In Dell's and Starbuck's cases, I question if they ever will. I believe, for reasons I've discussed in labeled posts on both CEOs and their companies, that competition, growth and simple Schumpeterian dynamics have worked to end their time of consistent outperformance."

It won't matter what sort of shuffling of deck chairs on his personal Titanic that Michael Dell does now. He can change executives, shuffle one to another post, but it won't change the business. Or customer behavior.

As this nearby, one-year price chart for Dell and the S&P500 Index clearly demonstrates, the company still struggles relative to the market.

Dell is down for the count. Nothing Michael Dell does is going to change this Schumpeterian fact.

UPB & Madoff: Custody Again

Today's Wall Street Journal featured an article in the Money & Investing section detailing Union Bancaire Privee's attempts to explain how it became entangled with Bernie Madoff. According to the piece, half of the bank's 22 funds were invested, to varying degrees, with Madoff.

To me, the most revealing passage was this one,

"..UBP said it had reservations about the way Mr. Madoff ran his investment firm, particularly the lack of an outside administrator and custodian (my bold), which would have provided an added degree of certainty that the investments Mr. Madoff claimed to have made were real. But UBP said it overcame those concerns because of Mr. Madoff's firm's status as a "reputable" broker-dealer that was registered with the Securities and Exchange Commission (my bold), as well as Mr. Madoff's longstanding reputation in building Wall Street's financial markets infrastructure."

As I wrote here last week,

"As I reviewed the mechanics of Madoff's scheme of undisclosed numbers of individual accounts, rather than a single, explicitly-spotlighted fund, with my partner, my belief that Madoff had long ago discovered loopholes that I, too, observed earlier this decade grew significantly.

The most important element of his fraud, without question, was the lack of independent custodial inventory reports of financial assets held in accounts for clients. I can't emphasize enough that this alone left every one of Madoff's clients vulnerable."

So, it seems that even a veteran, experienced private bank looked the other way and simply through prudence and common sense to the wind. They let an unrelated aspect of Madoff's investment business- his separate, registered broker-dealer- color their choice of him as an investment manager.

Anyone in the business knows that just because business A is regulated and supervised by the SEC means nothing about a business B, which is not registered.

But, apparently, UBP's staff knew better. Or so it thought.

These are called "con" games for a reason. Short for "confidence," the schemes always work by getting the mark, er, investor, to trust the fraudster, and give him their confidence.

Surprisingly, that's how easy it was for Madoff to accomplish his fraud. Whether he ever had an investment approach that made money is actually immaterial. And always was.

We now see that he managed to dupe the most experienced banks in the business, simply due to gaining their trust on bases other than his investment performance, a thorough review of his methodology, or any other typical object of due diligence.

Leading me, once more, to state that everyone who lost money with Madoff deserved to, because they were motivated by sheer greed. Greed that overwhelmed diversification and common sense investigations that any other investment manager would have had to undergo.

Sheila Bair's Mixed Signals

Friday's Wall Street Journal's Money & Investing Section carried a lead article entitled "Banks Told: Lend More, Save More." With a picture of FDIC's Chairman, Sheila Bair, accompanying it, the piece explored the mixed, opposite signals now being given to US banks- lend what the Federal government has invested in them, but, at the same time, build capital cushions.

As Brian Wesbury pointed out recently, about which I wrote in this post,

"In a related argument, Wesbury noted something genuinely novel and elegant. He opined that, with the Fed pushing rates to nearly zero, there was no way bank lending could expand.

He pointed out that, at a time when risk in the economy, among borrowers, is still so high, and rates are now so low, there is absolutely no way lending can be cost-justified. The risk-adjusted returns to ultra-low interest loans are negative. Wesbury thus observed that the problem isn't a lack of borrowers, but a lack of lenders willing to effectively take a loss on new loans.

He then pointed out how ludicrous was the situation in which banks have been placed by Treasury and the Fed. They are pilloried if they don't lend out the new, unwanted TARP-based 'capital' bestowed upon them by Hank Paulson.

But, if they do make loans at market rates in this environment, those loans will surely go bad, too, resulting in even more balance sheet damage and reprimands from regulators."

It's never fun to have to note a situation of governmental incongruity and wrong-headedness. In this case, Wesbury called this a full two weeks ago.

This is why, in my opinion, if we're going to nationalize the banking sector, we should do it correctly. Lending standards should be articulated from Washington, with clear, quantitative guidelines. If Federal money is going to back the banking system, let's not have loose, prone-to-misinterpretation signals.

If Treasury, the Fed and FDIC all want more bank lending, they should clearly express that in a formal regulatory message, complete with guidelines and a statement of responsibility for subsequent loan performance.

This is why it's not a great idea to mix Federal funding with private funding of banks. Now we have Federal directives to private shareholders that their bank employees should be doing more lending, though, as Wesbury notes, the chances of getting rates to compensate the risks are nil.

Gee, didn't we just spend about a dozen years doing this in the housing sector, via Fannie, Freddie, Barney Frank and two Presidents?

We could be in for a long, long learning period under the new, quasi-nationalized banking system the US now possesses.

FASB Blinks On 'Mark To Market' Methodology At Last

Earlier this week, the Wall Street Journal published an article reporting on FASB's late, halting steps to modify 'mark to market' accounting for financial sector firms- banks and life insurers.

In the piece, the Journal reporters wrote,

"Accounting watchdogs are fast-tracking an effort to provide a small dose of "mark-to-market" relief for financial firms, as banks and life insurers continue grappling with deteriorating investment holdings.

The Financial Accounting Standards Board last week began steps to loosen a rule regarding when financial firms must book losses on a narrowly defined subset of lower-rated mortgage-backed securities, commercial-backed securities and certain other structured securities.

For those financial firms that hold the relatively small group of securities at issue, managements and their auditors would have more leeway to put off a potential write-down that would clip net income. That could help bolster their regulatory capital.

The possible rule revision falls far short of what banking and insurance executives were seeking because they wanted relief that would give them greater leeway in valuing a wider range of securities. But it illustrates how aggressive they have become in trying to stave off paper losses. Analysts are still trying to figure out which companies might own the particular securities at issue."

Unfortunately, the move seems to be coming as far too little, too late. If, some fourteen months ago, FASB had allowed performing securities to be marked at their economic value, rather than the instantaneous trading value, which might be zero, much of the last year's carnage could have been avoided.

However, by waiting too long, intangible losses became tangible writedowns, which restricted credit, investment and, eventually has led to a reduction in real economic activity.

Talk about the tail wagging the dog....

Fraudulent Conveyance In The Madoff Case

In today's earlier post, I referred to the general consensus that many withdrawals by clients from Madoff's accounts in the last six years are subject to seizure, as being fraudulently conveyed by Madoff to those investors.

Apparently, due to recent rulings in the Bayou fund fraud of a few years ago, investors cashing out of a Ponzi-type scheme are not really withdrawing their profits, but, according to a court ruling, taking stolen funds.

Here's what I don't understand. Suppose you invest $5MM with Madoff. And suppose by the time you do, he's totally running a Ponzi scheme. There just isn't really anywhere near the oft-quoted "$50B" in the various accounts.

If you are sent account statements over a period of years stating that you now have, say, $10MM in your account with Madoff, and you choose to take your original stake off the table, and play with 'house' money, how are you fraudulently taking other people's money?

After all, you did give Madoff $5MM. You are certainly entitled to recover your original investment, aren't you?

I can see where withdrawals above the original investment could be seized for pro rata distribution. But not the original investment. That was your money. If you were fortunate enough to take it back, and sufficient funds were available to allow that, how did you take it from anyone else?

Death In The Madoff Case

Wednesday's Wall Street Journal carried the now-widespread news of Thierry Magon de La Villehuchet's suicide.

The French banker was bereft at the losses of his and his clients money in Madoff's scheme.

It's a sad thing, to be sure. But here's what I don't understand.

Villehuchet was said to be working non-stop on 'recovering' funds from the fraudulent investment scheme.

Just how did he plan to do that, when everyone with a brain knows that nobody will be getting any recovery anytime soon. And, if anything, it appears that, due to legal precedent, any investors who withdrew funds in the past six years may be required to return that money as having been fraudulently conveyed.

You could be doing all the work you wanted on trying to get some money returned, but you're not going to be successful.

More likely, the banker was simply overcome with dread at the realization that he had lost $1.5B of blue-chip client, and his own, money in Madoff's fraud.

American Express: That's No Bank!

Now we have yesterday's announcement that the TARP will be unfurled to cover $3.39B of American Express assets. CIT is also in for $2.33B.

According to the Journal article,

"Both CIT and AmEx need stable funding sources to make loans to businesses and consumers, but the credit crunch has made raising funds in public markets expensive."

No kidding!

But neither of these firms are part of the deep, crucial web of bank deposits and monetary system. They are simply standalone credit companies.

We had private sector excess which led to the TARP. Now we have the TARP itself going to excess.

If ever there were two firms which should be shotgun-merged with some other companies, or simply closed, via Chapter 11, these two are them.

Ken Chenault should be fired, on the way to American Express' acquisition by a commercial bank, or the sale of its profitable pieces to other firms.

To some extent, with the decline of the travelers check business, the very raison d'etre of AmEx has evaporated. Its former perfect funding/lending hedge is gone.

So, evidently, should the firm.

The Wisdom Of John Thain's Job Choice

Back in late October of 2007, I wrote this post discussing whether John Thain would take the top job at Merrill Lynch, as Stan O'Neal was being cashiered. I wrote, regarding Thain,

"Why would a senior executive who has run part or all of Goldman Sachs need to prove himself running a less-robust financial services business model with less talented personnel?"

It was inconceivable to me that anyone with a record of accomplishments, as Thain had at Goldman and the NYSE, and a good job, would be remotely interested in being Merrill's CEO. To do so, it seemed to me, would be a triumph of ego over common sense.

After Thain took the Merrill job, I wrote this post, providing more detail for my reasoning that he would eventually dump the retail side and try to recreate Goldman Sachs,

"No, I think it's safe to say Thain will ditch the current form of Merrill, and build a securities sector firm with the best features, in his opinion, of Goldman, Blackstone, and other private equity/hedge fund firms.

Goldman's time is not yet finished as the premier public investment bank. Thain will do well to incorporate large parts of its culture, senior executives, and business mix at Merrill."

Given that Thain had actually jumped from a relatively secure position as NYSE CEO to head troubled Merrill, I figured that, in time, he'd spin the retail side off, realizing that it is a dying business. Instead, he'd probably recreate something with which he was familiar- the Goldman Sachs model.

Finally, in this recent post, about eleven months after the first linked post, I opined,

"Second, I bet John Thain wishes he'd stayed at the NYSE and never been tempted by the wreckage Stan O'Neal left behind. Too much damage, not enough time. Who'd have guessed that Thain would be out of a job before Vikram Pandit at Citigroup?"

Several of my friends think that Thain couldn't lose in taking the Merrill job. That, like I wrote in this post almost exactly one year ago, people like Gerstner, Ryan and Pandit 'can't lose' for taking such CEO billets.

I suppose Thain might be viewed that way, but, personally, I think Thain made a major mistake. So great that, in simply asking to be paid for doing a decent job piloting the wrecked firm into the arms of BofA, rather than go bankrupt or be seized, he drew a huge amount of scorn and derision.

Already, he is seen not as having done yeoman's work at Merrill, but, simply ended by turning greedy when he requested a $10MM bonus for his efforts.

Now he is reportedly out of the running to ever succeed Ken Lewis.

Before Merrill, Thain was viewed as a capable co-head of Goldman, and a very successful CEO at the NYSE, fundamentally changing the firm in the wake of Dick Grasso's ugly exit.

Now, Thain is also remembered for gulling investors in December and the first quarter of 2008 to put money into the disintegrating brokerage firm, then claiming they didn't need to raise any more capital. To me, Thain is tarnished by some of what he did early on at Merrill, and for even leaping into the mess. I think it smacks of too much ego and too little perspective on the unfolding disaster that was in process a year ago.

Maybe I'm alone in this view, but I think Thain's time at Merrill has diminished his reputation and raises questions about his judgment.

More On Bernie Madoff's Fraud & Its Reprecussions

I wrote a prior post concerning the Bernie Madoff investment fraud last week, here.


Since last Tuesday, more stories have circulated detailing the enormity of the losses among many wealthy individuals, charities, trusts, and institutional funds.

Daniel Henninger of the Wall Street Journal offered a comparison between Madoff's spreading scandal and a recent off-broadway play, "The Voysey Inheritance." It's an interesting reflection on the response of people to such large, outright fraud.

However, I wrote in my prior post,

"I guess, for me, the most amazing stories in the Madoff mess are those once-wealthy people who failed to diversify, and basically gave all of their wealth to Madoff to invest. I don't know the details of Madoff's operation, but, from my time as a registered fund manager, I know that there are safeguards required to prevent the easy looting of client assets in cases like this.

For instance, in the case of private accounts, a custodian institution is usually used. It's not clear if such an arrangement was in force for Madoff's clients. Another typical safeguard is a quarterly statement of holdings in individual accounts.

If these were not used, it shows incredible gullibility on the part of so many wealthy people. If they were, it suggests that Madoff had a lot of help, since these would have been fraudulent statements."

We don't yet know the extent of help and complicity that Madoff had with his scheme, with the probable exception of his wife. But as I discussed this matter with friends in the investment business this weekend, we all agreed that, to concoct and maintain such detailed records of fraud for so many individual accounts, Madoff must have had quite a bit of assistance.

It's inconceivable that Madoff's confederates or minions would have thought nothing of hand-entering so much portfolio position data each quarter, rather than it being generated from existing position statements driven by custodian or brokerage account statements.

To me, the key observation, which I read in the Journal last week, was that an outside analyst had done a sort of 'back of the envelope' calculation to determine that Madoff's portfolios, according to estimates of the assets he ran being in the tens of billions of dollars, must have had trading activity exceeding the entire market for various index puts or calls. Additionally, experienced clients seemed to think nothing of the fact that blue chip equities showed no decline in prices earlier this year, although they were key to the alleged strategy.

This smacks of convenient denial of reality by so many clients. The suspension of disbelief, and a desire to simply believe that unbelievably good, and not just consistently, but uniformly constantly good results, were real.

As I reviewed the mechanics of Madoff's scheme of undisclosed numbers of individual accounts, rather than a single, explicitly-spotlighted fund, with my partner, my belief that Madoff had long ago discovered loopholes that I, too, observed earlier this decade grew significantly.

The most important element of his fraud, without question, was the lack of independent custodial inventory reports of financial assets held in accounts for clients. I can't emphasize enough that this alone left every one of Madoff's clients vulnerable.

Coupling this with a curious lack of diversification, a/k/a greed or stupidity, and you have the recipe for disaster among so-called 'sophisticated' investors.

Many years ago, during the WPPSS bond collapse, I read articles in the Wall Street Journal detailing the loss of entire life savings of many very average Americans. People had actually invested entire retirement accounts into just this one instrument, only to see it fail utterly and become worthless.

At the time, I posited a very personal belief that, for most people, simply reaching retirement with their principal intact is probably better than average performance. Never mind the 10% annual S&P average return, or something more like 3-6% if someone invested in a mix of assets and traded heavily.

Just staggering across the financial finish line with what you saved, while avoiding egregious market downturns, frauds, and other widespread investing pitfalls, was probably an exceptionally good performance.

Madoff's clients now add substantial evidence for my viewpoint. How many once-wealthy Americans having millions of dollars of accumulated financial assets are now simply bankrupt? Or nearly so, with almost nothing to show for decades of successful careers?

And all of this....all of it...would have been minimized, if not totally avoided, had each and every investor insisted on receiving a regular asset inventory report from an independent custodian. This would have prohibited false claims of asset ownership, or required an entire custodian's business to be in league with Madoff.

I don't believe any more regulations will prevent a repeat of this type of periodic investment fraud. There are plenty of safeguards required by current regulations. But nobody can prevent a person from simply throwing caution to the winds, trusting in a manager, and his 'special' inner client circle, without any objective, confirming evidence.

As I described to my friends over coffee on Saturday, you can run hundreds of individual investment accounts as an unregistered investment manager. Sure, the legal maximum is between 15 and 30. But so what?

If you choose your clients carefully, and never let on that you actually have hundreds of them, and they don't all meet, who would know? If none complain to the SEC, why would that agency bother you?

If, as in a proper Ponzi scheme, you cash out any disgruntled investors, so they have nothing to take to the SEC by way of losses or evidence of malfeasance, there's simply no way of being discovered.

It's a lot like being shot by an illegal firearm. Sure, we have complicated laws restricting lawful access to these weapons. That only means you are more likely to be shot and/or killed by an unlawfully-obtained weapon, rather than a lawfully-obtained and carried piece. You won't be less wounded, or dead.

And more laws won't actually prevent illegal guns from existing. Nor illegal investment management schemes, either.

The US as The Next Argentina, Not Japan

Earlier this week, on Tuesday, I happened to catch Larry Kudlow's program on CNBC. Among his guests were: Bob McTeer, retired Dallas Fed President, Brian Wesbury, one of my favorite, and a well-regarded economist, and Rick Santelli, the Chicago-based futures and options market reporter for CNBC.

What I heard struck real fear into me.

Kudlow began a debate by relating a sort of 'thought experiment' he had done regarding the Fed's recent actions. He told a story about his days at Bear Stearns, where, every time the Fed cut rates, Larry would joke that he saw palm trees growing on the trading floor- a reference to so-called banana-republic economies. Specifically, Argentina.

McTeer chimed in to agree, as did Brian Wesbury. They all believe that Argentina, not Japan, is the potential role model for what may happen to the US economy and dollar in the years ahead.

This incited a fierce debate with other guests on the segment.

In a related argument, Wesbury noted something genuinely novel and elegant. He opined that, with the Fed pushing rates to nearly zero, there was no way bank lending could expand.

He pointed out that, at a time when risk in the economy, among borrowers, is still so high, and rates are now so low, there is absolutely no way lending can be cost-justified. The risk-adjusted returns to ultra-low interest loans are negative. Wesbury thus observed that the problem isn't a lack of borrowers, but a lack of lenders willing to effectively take a loss on new loans.

He then pointed out how ludicrous was the situation in which banks have been placed by Treasury and the Fed. They are pilloried if they don't lend out the new, unwanted TARP-based 'capital' bestowed upon them by Hank Paulson.

But, if they do make loans at market rates in this environment, those loans will surely go bad, too, resulting in even more balance sheet damage and reprimands from regulators.

Wesbury then reiterated his concern that 'mark-to-market' had not been modified or rescinded, thus causing needless damage to bank and fund balance sheets by overly-severe writedowns of still-performing instruments. McTeer agreed.

Santelli did, as well, picking a fight with a guest, who argued that mark-to-market isn't relevant to the problems at hand. Santelli challenged the guest to buy some of the toxic waste, whereupon the guest said, 'no, because they will eventually be marked down further.'

Santelli then smiled and said that this was exactly his, and Wesbury's and McTeer's point- that because everyone is worried that these structured instruments will ultimately be written down further, nobody will invest in a bank, nor a fund holding such instruments.

Thus, markets are frozen, awaiting the needless writedowns of performing, or even semi-performing assets, due to the self-fulfilling prophesy of a lack of trading markets for said assets.

It was a very informative and densely-packed 15 or so minutes of economic and financial debate. One of the best I've seen in ages.

McTeer continued to back Bernanke's flooding of markets with credit, believing that, at the first sign of inflation, Ben will withdraw said liquidity soon enough to avoid hyper-inflation down the road.

What I took away from the exchanges that evening is that we are, truly, for the first time in ages, in new economic territory. A hideously over-supplied dollar, interest rates too low to be consistent with responsible lending, collapsing asset values now, with a concern over hyper-inflation later.

All very similar to Latin American monetary and economic policies, rather than the Japanese variety. A very chilling prospect for our economic future.

New Evidence On Consumer Choice & Cars From Bankrupt Producers

Yesterday's Wall Street Journal provided new evidence concerning whether American consumers would still buy cars from producers in Chapter 11 bankruptcy.

The answer is, 'yes,' for 90% of those surveyed. As the article notes,

"A pair of new surveys suggest buyers aren't completely unwilling to buy a car from an auto maker in bankruptcy court, as long as the federal government is willing to play a role in helping the company restructure.

This contradicts the conventional view of Detroit auto makers that suggests consumers would shun a bankrupt auto maker over fears related to the resale value of a car, the warranty and the ability to secure service and replacement parts.

Merrill Lynch & Co. recently completed a study showing 90% of car buyers would consider purchasing a vehicle from a car company in bankruptcy court.

Another survey, by CNW Marketing Research, found 48% would consider buying from a bankrupt auto maker if the company were getting help from the government, but that is up from a previous survey conducted by the Bandon, Ore., company."

Of course, this provides refutation of one of the more forceful arguments with which the UAW, GM, Ford and Chrysler have pursued Federal aid. The Journal provided more detail further on in the piece,

"The Merrill Lynch study, conducted for its clients and which included talking to 500 people, concluded that a "large majority of consumers would consider buying or leasing their next vehicle from an auto maker that is backed by U.S. government funding and may emerge as a strong company, following a restructuring through the bankruptcy process."

Merrill has had a banking relationship with domestic auto makers within the past year.

The CNW Marketing Research survey, of 9,700 domestic car owners completed Dec. 14, suggested 48% of buyers would be willing to consider a product sold by an auto maker in bankruptcy court, as long as the government was involved in the process.

CNW had been the source of an earlier study whose conclusions raised concerns about the impact of a bankruptcy filing on a car company. That survey found 80% of buyers would stay away, and the auto maker's revenue would plunge.

But CNW President Art Spinella said in an interview Tuesday that new research suggests people would feel much better about a bankrupt auto maker's chances "as long as there are loan guarantees by the government."

The results contradict much of what executives at U.S. auto makers and the United Auto Workers argue would be the impact of a bankruptcy on one or more of the companies."

Clearly, a Federal loan for debtor in possession financing would meet this criteria, as would some provision in any package for a separate warranty-funding facility.

Thus, once again, we see that the reasons for avoiding Chapter 11 filings for the US auto makers continue to fall by the wayside under closer examination.

Government Intervention's Effects On Risk & Private Capital

Monday's Wall Street Journal featured a very interesting piece in its 'Heard On The Street' column. Entitled "Auto Bailout's Hidden Danger," David Reilly pointed out an insidious aspect of a possible Federal pre-bankruptcy package for the Detroit-based auto makers.

Simply put, Reilly notes that, with Federal involvement causing new uncertainty in the order of creditor seniority for GM and Ford and, in some sense, Cerebrus/Chrysler, such an aid package may further chill any hope of private investment in the sector.

In a manner very similar to that now brought to light by Amity Schlaes concerning FDR's New Deal, such government intervention also brings with it the fear and risk of subsequent Federal legislation which changes the terms of seniority of creditors, or the rights of the Federal government.

For example, it is now recognized that FDR's federalization of power generation, via the TVA, drove investor capital out of that sector for decades.

When the newly-arrived rescuer of a company or sector also has the power to rewrite the laws governing recovery of investment or allocation of loss, it will come as no surprise that private capital may well steer clear of that company or sector permanently.

It's not a trivial matter. Consider what Treasury 'help' did to investors of all the major commercial banks, not to mention AIG. What investor would now be so foolish as to invest in that sector, save for short-term trading gains?

It's a very undesirable, unintended consequence of Federal 'help' for an industrial sector which would, in the end, be so much better-served by joining the rest of American business in using the available Chapter 11 bankruptcy process.

Paul Samuelson's Brilliant Idea

As the US finds itself firmly in a recession, with the potential for this phase of the natural economic cycle to worsen before the economy recovers, I am reminded of one standout economic insight, about which I have written before, here and here.

I am referring, of course, to MIT emeritus/retired Professor of Economics and Nobel Laureate, Paul Samuelson's 'accelerator-multiplier' theory.

Regarding the current recession, I wrote in the second linked post,

"Now, however, as Paul Samuelson's accelerator-multiplier work informs us, the same breakneck growth in housing-related spending and lending which drove prices and 'values' up in the expansion, are at work in reverse, coursing through the sector and depressing values.

The values represented by the peak prices of homes bought and constructed were contextual, and have vanished. The real dollars exchanged for those prices did, for a moment in time, also exist.

But the reverse multiplier effect on all these vendors, assets, etc., have destroyed much of the capital created and borrowed to fund these houses."

As this phenomenon from the housing sector spread through banking and into the general economy, I have ruminated recently, at length, as to what factors can turn a deepening recession into an eventual recovery.

What is it that turns a gloomy consumer outlook, vanishing banking assets, shrinking spending levels and spreading joblessness into subsequent economic growth?

The answer, quite simply, was discovered by Samuelson in the 1950s. Inducing cyclicality into a system is often simply the result of including a 'first difference' term. Samuelson's genius was understanding that businessmen and consumers view the 'first difference' between today and some past period- say, a year ago- to judge whether things have gotten better, worse, or are unchanged.

Right now, a look backward shows that volumes are shrinking, so near-term economic behavior echoes this with more belt-tightening.

But in six-twelve more months, business volumes will probably appear flat. This realization will cause businesses and consumers to conclude that the bottom has been reached in this economic cycle. Sales aren't falling anymore, joblessness isn't growing, and economic activity generally has leveled out.

Since this will be a positive change in the rate of change, planning becomes focused on maintenance or growth, rather than more cutting.

Samuelson quantified natural human behavior for economic purposes in a manner never before articulated.

Of course, there is a huge implication due to Samuelson's work on the accelerator-multiplier theory.

It demonstrates a natural cyclicality to economic conditions that cannot be 'fixed' by any sort or amount of governmental intervention. As I noted in the more recent linked post, this is why one-time fiscal 'stimuli' never work. Only permanent tax cuts can deliver a lasting change in incomes that effectively shock the perceptions of businesses and consumers into seeing the present as better than the recent past, so to trigger expansionary activity.

Further, any promises of governmental program activity, e.g., infrastructure spending, won't do much for widespread business and consumer behavior, either. It is simply impossible to arbitrarily, or determinedly lop off the 'recessionary' phase of economic cycles. The latter exist for a reason, and give society the opportunity to clean out unsustainable, unprofitable businesses, recycling their resources for use in better business opportunities.

Not only does Samuelson's work give us confidence that every recession, in effect, automatically brings about its own consequent expansion, but it confirms that this is a necessary phase in national economic cycles.

Bernie Madoff & The "Sophisticated" Investor

This week's panic over the Bernie Madoff investment fraud points out how much of a cottage industry investment management continues to be. And probably will remain.

As a veteran of the business for over a decade, I can attest to the thoroughness with which some potential investors conduct due diligence.

My initial hedge fund partners required me to replicate my strategy's results using their performance data and software system. It was a very clever approach, since I was forced to cede control over the total return data with which, had I been marketing a fraudulent system, I might have fooled them. As it was, their insistence on my reproduction of the strategy on their system resulted in the elimination of some minor errors and some improvements elsewhere in the approach.

In another case, a potential investor required exact times, dates and tickers of equities which I had bought for my personal account, in order to reconstruct my returns, to the penny.

Never did I have anyone simply accept my return series as prima facie evidence of the strategy's effectiveness. At the least, names of the equities held in each period were required, along with a monthly return series.

So it's incredible to learn that Madoff posited a steady, unchanging 1% per month return, and attracted virtually no in-depth investigation from the bulk of his investors.

However, it's not all that surprising to me that Madoff was able to run his scam for so many years.

The keys, it seems to me, were two-fold.

First, by alleging to manage individual accounts, rather than a fund, he avoided any serious SEC inspection and regulation. The allowable minima for a number of accounts managed individually prevents anyone from every really knowing whether you are in violation, or not.

Madoff's insistence on keeping the activity quiet, ostensibly because of his brokerage operation, resulted in nobody ever asking to see regulatory filings on his activities. Or, if they did, the second key to his success came into play.

By beginning with an attitude of, lets be frank, arrogance, Madoff challenged people's self-confidence. Madoff used what my business partner calls the 'club deal' approach. That is, you are favored by a personal contact with the opportunity to 'get in on' a sweet deal. But you have to just sign up and hand over your money- you can't actually delve into details.

Rather, you are supposed to be so flattered with the chance to participate. And, in fact, we have already heard stories of lucky escapes by wealthy but sceptical investors who did ask too many questions, those questions which were either ignored, or the investors were then declined the opportunity to participate.

The list of those who were bamboozled by Madoff grows daily, and even affected investor confidence yesterday, helping the S&P to drop by 1.3%.

As if the last 18 months of financial markets behavior haven't been sufficient to strike fear into equity investors, the Madoff saga seems to be a fitting bookend on which to close out 2008. If not for Madoff being affected by redemptions, like so many other investment managers, his scheme may have run for years into the future.

Apparently some $50B is gone in a classic Ponzi scheme. Some investors with realized gains may even be approached to return the gains. There's no way, at present, to know if any of the reputed performance Madoff ever had was real, or if it was a scam from the very beginning.

I guess, for me, the most amazing stories in the Madoff mess are those once-wealthy people who failed to diversify, and basically gave all of their wealth to Madoff to invest. I don't know the details of Madoff's operation, but, from my time as a registered fund manager, I know that there are safeguards required to prevent the easy looting of client assets in cases like this.

For instance, in the case of private accounts, a custodian institution is usually used. It's not clear if such an arrangement was in force for Madoff's clients. Another typical safeguard is a quarterly statement of holdings in individual accounts.

If these were not used, it shows incredible gullibility on the part of so many wealthy people. If they were, it suggests that Madoff had a lot of help, since these would have been fraudulent statements.

It's still early innings in the case, so we don't know the extent of complicity of various other people who worked in or with Madoff's investment firm.

But the scope of the fraud is staggering. As is the caliber of the people he bilked.

And, sadly, the one thing we know is that it's not the last time this will occur. Jason Zwieg's article in this weekend's Wall Street Journal pointed out how feelings of inadequacy to even ask questions, on the part of most of Madoff's clients, greatly assisted the ease with which his scheme operated. As well as Madoff's judicious use of initial clients to whom others would look up, and, feeling, again, less confident, simply invest without asking questions.

Human behavior seems to have some enduring components through time, and these certainly qualify. That's why Madoff is just the latest in this saga, not, unfortunately, the final chapter.