Continuing Erosion of Music Label Power: The Case of Erin McCarley

This past Thursday's Wall Street Journal contained a review of a new artist named Erin McCarley.

I'm not interested in reviewing Ms. McCarley's music here. But what did catch my attention was the manner in which she has risen to some measure of popularity prior to having a recording contract with any major label.

As I have written elsewhere on this blog in prior years, including this post, it's only a matter of time before record labels are nearly useless. In that post, from October, 2006, I noted,

"The second one ran in yesterday's edition, and dealt with, ironically, how easy it now is for independent bands to become successful with little or no money, no traditional record label and, thus, no old media agent. Some indie bands do retain what one might call eagents, such as NetWerk Records, a combination indie label and artist management firm. This seems to support my contention that agents, as we have known them, will also be unnecessary for the coming era of online digital video content production, found here.

What's interesting is that established bands are also exploiting digital downloads, in order to capture immediate interest by fans. Rather than expect, or let, prospective buyers go to iTunes to buy and download music, they are embedding a MySpace MP3 player on their MySpace sites."

This is exactly what Ms. McCarley had done. The Journal article details her being paired with another musician to complete her own song-writing and singing efforts for a first album of work,

"As they cut the record without any outside funding- Mr. Kenney pulled together a band for the sessions- Ms. McCarley understood she could have a level of control over her career.

They sent out a six-song sampler to industry insiders and posted some songs on Ms. McCarley's MySpace page. A showcase performance at last year's South by Southwest Festival resulted in a bidding war for her disc.

Having a finished album they could distribute without a major-label marketing push, Ms. McCarley and Mr. Kenney negotiated from a position of strength."

I found and listened to her music on the MySpace page, just as the article described. They are full-length, high-quality tracks. The article also mentions her being featured on iTunes, with the opening track of her album available there for free.

It's wonderful to see such a seamless combination of technological and marketing/promotional channels occur to give small business people, i.e., a musical artist, the ability to start her career without the suffocating 'help' of a major recording label.

Instead, today's mix of free internet social sites, layered applications like embedded music and video, and iTunes have resulted in a talented artist building her own business and career her way, with minimal need for outside funding or technology.

Along with others, I foresaw this several years ago. But, with each passing year, it's evidently becoming easier to execute.

Cable Television's Problems Hit Home At Time Warner

Last October, in this post, and earlier, in 2006, in this post, I have voiced my belief that, in the not too distant future, half of cable companies' revenues will be shorn, as their television packages begin to be disconnected.

In 2006, I wrote,

"I now wonder whether half of cable's revenues will go away as more consumers find and buy/view content directly on urls via their hi speed data facilities. With destination sites like Youtube, who will need a pre-packaged suite of programming content like Comcast currently has for TV, or is attempting for the internet? And then, we'll probably see cable and telephone company DSL-based content offerings compete each other's prices downward to retain some measure of revenue from these antiquated, pre-packaged content services.

Instead, we'llprobably buy a wireless box which takes the hi speed online signal, directs it with a handheld wireless controller, and displays url-based video on your in-home TV display."

And, in October, I added, in that post,

"It won't be surprising to me at all if we unplug from Comcast's television services within two years. I'll save about $600/year, which means the most expensive of the new wireless internet-to-television boxes will have a 6 month payback. Schumpeterian dynamics are quickly moving internet-based video content, that is not business news, into a competitively-advantaged position relative to packaged video content services offered by cable operators."

Well, two things have occurred to speed my prediction along.

First, Time Warner took a $35B charge yesterday for impairment of value in its cable properties. The company's new CEO, Jeff Bewkes, explained that, due to the company's equity price having been mercilessly hammered, it was forced to recognize the reduction of the economic value of its cable system assets.

The Wall Street Journal article reporting this pointedly noted that disintermediation via services like Hulu and iTunes were causing viewers to find alternative, cheaper, or even free sources of programming which used to be accessible only via paid cable television packages.

On a personal note, I can vouch for this. My daughters and I took a giant leap forward in this direction with the holiday season purchase of a TiVo HD DVR. With a wireless adapter, we now can stream Netflix on demand program content directly to our television.

Further, it's already affected my cable television subscription. Rather than consider upgrading to a more expensive package to receive Disney channels, I now have next-day access, for free, via Netflix. Netflix also offers a huge number of recent television programming, plus several thousand movie titles for on-demand streaming.

Because TiVo upgrades its boxes with software downloads, how long will it be before the service begins to offer direct streaming from various other internet-bases sites, including Hulu or individual cable channel-related sites?

Today, it's Disney that I'm not buying from Comcast. Tomorrow, who knows which channels will have also become redundant?

The second linked post, from last October, detailed how some younger video content consumers are dropping their cable television subscriptions, substituting them with set-top boxes streaming Netflix and/or other content to their televisions.

Time Warner's write down was an unexpected piece of additional evidence that this vision of the future disintermediation of cable content by internet-based content sites is approaching much faster than anyone believed even a year or two ago.

Chances are, it will accelerate from here.

An Example of Ineffectual Competitive Response- Part Two

Earlier this week, I wrote about a local example of ineffective competitive response to a new market entrant.

Throughout the past few years, I've written many pieces on the inevitable demise of GM, but that's a global- and national-scale story. In the case of the local fitness club, I am fascinated by the operation of similar principles, but on a much smaller, totally observable scale.

In the prior post, I detailed some of the history of my old fitness club. How it began, what crucial decisions the owners made which cast their future options in stone.

The current attitude of the owners is summed up in the notion expressed in their recent letter to members,

"We are small enough to know you and large enough to serve you."

Unfortunately, that's only the demand side. What about the supply situation? That is, the financial realities of operating such a facility?

Fitness clubs have a fairly high proportion of fixed to variable costs. The building must be opened, heated/cooled, lit, towels washed and water provided, the facility cleaned. A few people are needed for administrative purposes, and to conduct various classes. But for the most part, the daily costs of running such a club are pretty constant, whether 20 or 200 people use it that day.

Based upon the known membership size as of the middle of last year, the pricing plans, and the number of higher fee-paying squash members, the revenue for the club in a recent full year of operation was probably something in the neighborhood of $3-3.3MM, including some estimate for personal training revenues, which vary by membership size.

From various sources, including a rough count of the number of former members of the old club appearing at the newly-opened LifeTime Fitness club, it has been estimated that about 10% of the members of the old club have switched to the new one. Most of those who switched play squash, thus representing the highest-margin members at the old club. Since LifeTime Fitness has a single fee per person, rather than charging extra for using various parts of their club, this was one of the attractions of the new club to many squash players from the old fitness club.

If one assumed a fairly standard profit rate of 10% on sales, the old fitness club probably earned a pre-tax income for its owners of something in the range of $300-330K annually. But with so many of its higher-paying members gone, some of my more financially-savvy friends and myself have estimated that this has now dropped to near breakeven.

We may be off by a few percentage points, but, from the standpoint of an external consultant, the direction of the changes, and their relative magnitudes, are fairly clear. If you were given the job of managing my old fitness club, you'd have a considerable challenge on your hands.

For instance, you've probably lost almost 10% of your revenues, but your costs are still pretty constant. Furthermore, in less than a month, a second LifeTime Fitness club will open a few miles away, taking perhaps another 50-100 members, or another 3-6% of the original member base.

Because the club's membership loss comes from a new entrant, it's unlikely that many new members will be joining the old club. Those that do will probably fit a rather narrow profile: 30+, single or married, living very near to the facility. Otherwise, those with families or more distant will find one of the two LifeTime Fitness clubs a better economic value while being no further away.

If the old club attracted as many as 50 new members per year, it's reasonable to assume that would fall to no more than perhaps 10-20 now. And those are unlikely to be the higher-priced squash members.

Thus, revenue and profit growth for the old club are now limited. A manager's next move would be to cut expenses. Since desk and other low-paid, part-time workers are necessary and provide little in the way of profitability improvement, the only reasonable alternative is to either cut the higher-paid activities staff, or move them to the same basis of compensation as LifeTime Fitness employees, i.e., a heavy incentive component based upon member involvement.

The owners of my old club are very successful, accomplished, likable older men. Having owned and operated the club since 1978, they are not looking toward additional decades of involvement in the facility.

So, if you were a consultant hired to advise them on alternatives, you'd know that, whatever money they were making prior to the entry of LifeTime Fitness into the local market, they will probably never make that much profit again. New member growth is unlikely. Raising prices even higher above LifeTime's levels will probably drive even more members away. Cutting prices will, of course, only result in member retention with less profit. Moving some of the program-related employees, such as the aerobics program director and various class leaders to variable compensation, will only result in a one-time drop in expenses.

Thus, from the supply side of the fitness club's financial equation, it's unclear whether it can prosper by fulfilling its stated objective.

In more graphic terms, it's unclear that a collection of aerobics class-using housewives, older, retired couples and some locally-residing members, all of whom value the club's proximity and friendly, small environment, can ever provide the prior level of profitability, or even a breakeven level of profit.

I would wonder how long the current owners can afford to fund the lower level of profitability. If there were a competitive environment in which the owners of the old club could add programs, facilities, or cut prices, they might hope for a return to the prior level of profitability. But this isn't really feasible anymore.

Like GM, though on a much smaller scale, one wonders how long managers and/or owners of an enterprise can afford to be in denial about financial realities facing them in the future?

I guess, for my old fitness club, it's a function of how long the owners choose to fund a less-profitable, and perhaps even losing enterprise, than they had in the past. Unfortunately, good intentions and prior accomplishments don't necessarily count for much when a more economical, fully-featured competitive facility enters the market.

Thirty years is a very long time for a relatively static business enterprise to have survived and prospered. Ceasing operations under these circumstances wouldn't mean a failure of the business, so much as a change in the competitive environment, and market, which the older club is simply unable to profitably address any longer.

The Next Union Victims: US States

Last November, amidst the dust up regarding the US auto maker's, and UAW's plea for a Federal bailout, I wrote this post discussing that union's chief's surreal press conference.

I closed that post with this thought,

"This, sadly, is a fact. It's clear that Gettelfinger's UAW is salivating at the prospect of raiding the Federal Treasury, courtesy of the Illinois rookie, Frisco Nan and Harry Reid, without taking any wage or benefit cuts whatsoever. So desperate are they that Gettelfinger is trying to mau-mau President Bush to cough up the funding in advance. The greed and lack of a sense of reality on the part of the UAW's senior officials is just mind boggling."

In discussing this whole mess with my partner recently, I noted that, thankfully, the entire range of Federal bailouts of late 2008- banks, insurance firms, auto companies- don't seem to involve any of America's highest-growth, innovative and/or superior value-adding companies or sectors.

For this, we should give tremendous thanks.

In truth, as is often the case, the economy's laggards and commodity providers are seeking relief. So, aside from wasting our society's scarce resources on these inefficient, dying or low value-added producers, the bailouts don't seem to be hampering the creation of new value on the cutting edge of our economy. It's not like Washington is getting into bed with Google, Intel, HP or Gilead via financial investments and coercion.

Unfortunately, we have seen substantial evidence that the stream of entities heading to Washington for relief has not yet ended.

Rather than companies, it seems the next beggars will be profligate US states, brought low, economically, by their own spending and, of course, promises to unions.

It's become widely understood recently, including being a subject of a Wall Street Journal piece, that California, Illinois and New Jersey- blue states all- are on the brink of bankruptcy.

California has its own myriad reasons for financial distress, from what I read. However, regarding Illinois and New Jersey, I have, sadly, more personal acquaintance with and knowledge of their travails.

In both cases, lush benefits promised to AFSCME are proving to be unaffordable.

Speaking personally, I noticed this trend as far back as when I was a VP at Chase Manhattan Bank in the 1980s, during the radical transformation of the steel industry. What occurred to me then was what I expressed in this first post on this blog in 2005. Specifically,

"What I find ironic is that, while so much of this week’s, and many prior years’ focus, is on union leaders squaring off against company managements, nobody has bothered to ask how it is that the unions got themselves in this mess in the first place?

Why did unions ever begin taking future pension contributions from the companies for which their members worked, instead of cash compensation?

In hindsight, “defined benefit” plans of any type or name, public or private, are a clever way for a public corporation or a government to fund operations with implicit loans. For big steel, autos and airlines, as well as other labor-intensive sectors in the ‘50s, ‘60s and later, this amounted to labor union members lending, via unsecured future compensation and fringe benefit promises from their employers, sums of money for which they had no collateral. Financial engineering which puts modern investment bankers to shame."

The same goes for public workers and their union. They foolishly accepted inflated promises of future benefits from various governmental entities, beginning in lavish style in the 1960s.

However, what has befallen private sector unions such as the steel and airline workers since then is surely coming soon to the AFSCME chapter near you.

How many voters will actually accept much higher taxes to pay for retirements they don't, themselves, enjoy? That's the crux of the lack of support by most Americans for the UAW in the recent Detroit bailout.

But, as my partner and I noted, there is a major problem looming for states such as California, Illinois, New Jersey, and their ilk, and their AFSCME locals. We've already begun to see it in the worst-off state, California.

People can leave states which have overwhelming financial obligations. They can choose to walk away from a financially bankrupt state entity, leaving fewer residents to shoulder the fixed pension obligations promised so many decades ago.

What will happen when a state like Illinois watches younger, more productive and higher-earning citizens depart, along with the companies that employ them, for lower-taxing states with better financial health?

Don't think it can't or won't happen. Look at the diaspora of industry and residents from California over the past decade. Washington, Oregon, New Mexico and Nevada have all grown due to emigration from the Golden State.

As an economic dilemma, this one will rank up with the great ones for the US. We've seen school boards like Chicago's taken over, and even New York City endured a form of Chapter 11 reorganization under 'Big Mac' for several years.

But we have yet to see an entire state seek the governmental equivalent of Chapter 11 bankruptcy. California seems close, in that, last month, it began to issue paper script IOUs to vendors, in lieu of cash, so it could husband funds to pay its bondholders, thus avoiding defaults, and severe credit rating consequences.

To me, it just makes sense that each group of parties in our society which promised, and accepted, unrealistically lavish financial benefits decades ago, at the height of the post-WWII American prosperity, will have to eventually reduce the magnitude of those promised benefits.

Whether through private corporations and their unions, or governmental entities and their unions, our society has to face the fact that a lot of unwise, irredeemable financial guarantees were foolishly given and accepted years ago by people who should have known better.

As we saw in the steel sector collapse of the 1970s and '80s, then the airline reorganizations and, now, the auto sector, economic realities typically, if painfully, trump unrealizable contractual obligations.

I don't think the case of states and AFSCME demands will be any different, in the end. But the process of our society, on a state-by-state basis, acknowledging the reduction of pension and benefit promises from decades-old pacts between governments, as agents of their populations, and employees of those governments, will likely create watershed economic events heretofore unimagined in our society.

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.