Numberscruncher: There Is No Secret Ingredient

ItÁ¢€™s tough being a grandiose financial criminal these days. Lots of people ran scams that took millions from clients; Allan Stanford even collected a title while allegedly fleecing investors with fraudulent CDs. Bernie Madoff confessed to the biggest crime of all, distracting attention from all of the smaller Ponzi schemes, fund misappropriation, and inflated claims cases that are coming to light. The mini-Madoffs involve financial planners, insurance salespeople, and small-time hedge fund managers. Clients trusted them to generate good returns, usually returns that were better than the market. The problem is that financial markets are mostly efficient, so it is bloody hard to beat them.

In his book The Great Crash 1929, John Kenneth Galbraith talks about how thereÁ¢€™s always a Á¢€Å“bezzleÁ¢€ being embezzled, but in good times, no one knows what it is. In fact, happiness increases because the embezzler has the money but the victim doesnÁ¢€™t know that it is gone. He says that embezzlement increases in good times because itÁ¢€™s easier to hide. Á¢€Å“In depression . . . money is watched with a narrow, suspicious eye,Á¢€ he writes. Á¢€Å“The man who handles it is dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.Á¢€ PonziÁ¢€™s own scheme broke well before the Great Crash, when lots of other scams were exposed.

I have met two of the people on the list of suspected Madoff clients, and both are reputable professional investors. YouÁ¢€™d think theyÁ¢€™d know better. Maybe they believed the hype, maybe they thought Madoff was making money but through shady means, or maybe they liked the fictitious tax-statement service allegedly provided to select Madoff clients. ThatÁ¢€™s for the courts to decide; itÁ¢€™s too bad that there are no publicly traded law firms, because I see a lot of lawyers making a lot of money from this case.

The more ordinary clients were probably a mixture of greedy and gullible. When people talk about investing, they never talk about their failures. When they stand around at parties discussing hot stocks, they only discuss winners. That means that people pick up a distorted view of whatÁ¢€™s typical. They assume that everyone else is making a killing, and they want a cut. The entire investment industry promotes the idea that some money managers can beat the market all of the time, which of course lets them market their fees. And everyone wants in on whatever the secret is that lets people beat the market.

There is some research that some money managers do, indeed, beat the market, and these folks charge high fees for their skill. Once the bills are paid, the clients are left with just an ordinary return.

Is an ordinary return so bad? Well, in 2008, it was, but most years, a market return is just fine for people who are saving for retirement or other future goals. A market return is cheap, itÁ¢€™s as much as anyone can reasonably expect, and over the long haul, it beats inflation. Inflation is the real risk that investors face over the long term, even though we have not had a lot of it in recent years. Of course, thatÁ¢€™s also small consolation to investors these days.

The bigger the scam, the easier it is to hide. If a bookkeeper in the accounts payable department is skimming checks here and there for her own account, sheÁ¢€™ll get away with it for a while. And then, someone will have a payment problem, she will be forced to take a sick day, of the firm will let her go in a layoff, and the scam will be uncovered. But if the ringleader is also the top executive, itÁ¢€™s easier to keep two sets of books and charm victims. PharMorÁ¢€™s theft, the biggest scandal out there until Enron came along, was controlled by the CEO and the CFO. EnronÁ¢€™s CEO, Ken Lay, denied any knowledge of that companyÁ¢€™s problems, and he died before he went to trial. Madoff seems to have controlled everything that happened with the money management group, making it easy to lie to those who might ask questions.

When new scam announcements are few and far between, thatÁ¢€™s a sign that the economy is humming along again. The worst offenders will have been caught. Everyone will be optimistic that theyÁ¢€™ll stop asking questions, and new scams will get underway. And no matter what regulators promise, they will be big.