Friday, December 12, 2008

Greed is Good, Trust is Bad

The first rule for arms control agreements and personal investing is inspect and verify. You may trust you friends and family, but don't trust your broker. Ponzi schemes need greed, but they only succeed because of trust. Bernard Madoff was the founder and former chairman of Nasdaq and an esteemed member of prominent country clubs. the Palm Beach Country Club and Boca Rio Golf Club. Who wouldn't trust a man like this? He was such a nice guy. He even tried to pay his employees their Christmas bonuses. As reported, "he wanted to pay certain employees portions of the $200 million to $300 million dollars that was left." Wait a second! Weren't those Christmas bonuses other peoples wrongfully taken money?

Trust is an expensive virtue that will likely cost investors over $50 billion. In the days ahead we will hear from investors who say that Madoff never fully explained how he was able to generate a steady stream of profits in these uncertain time. Everyone said he was a financial genius and others had profited. Given trust, there was no need to inspect and verify.

The second rule of investing is don't invest in something you don't understand. Madoff's investors probably received fancy looking reports on expensive paper with ambiguous explanations for past returns. But did any of these financial gurus that channeled clients funds to Madoff really inspect the books? Could any of them explain just how those returns were generated? Madoff would get upset with people that probed too much. They were probably told that they didn't have the financial skills to understand the advanced trading strategies that Madoff was engaging, such as the sideways arabesk or the perambulated put. Brokers closed their eyes, earned their commissions and put their trust in the man. His employees say he was "cryptic" about his business investments. According to one news report, financial consultants "couldn't figure out how he managed to produce steady returns, month after month, even when everyone else was losing money -- and leave almost no footprint while moving billions of dollars in and out of the markets."

Fraudulent schemes flourish in good times. If there is any benefit from a recession, it is that bad times expose fraud. If Madoff's investors didn't need to withdraw funds to cover other losses he could have continued his sham for many more years racking up even more losses. Recessions purge the system, exposing cancerous frauds and driving out failing firms and dying industries. They leave the body weak but intact. Joseph Schumpeter labeled this "creative destruction." You can't have creation without some destruction and if you are not willing to put up with the destruction then you must forgo the creation. It is the necessary preparation for future growth and recovery.

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