In the wake of the largest swindle Wall Street has even known, everyone is questioning how this could have happened. How could anyone run a 50 billion dollar Ponzi scheme right under the SEC’s nose? The SEC, with virtually limitless resources, has the power to do essentially whatever it wants when investigating fraud. So how could they miss this? Is this just a failure of the free market, an example that those hedge funds just have too much freedom, and government regulators need more power and resources? Not at all – in fact, quite the opposite.

This is a wake up call for investors and the public. Where the SEC failed to spot a problem, the free market saw it. Eighteen months ago, a firm named Aksia run by Jim Vos and Jake Waltour, warned clients not to do business with Bernard Madoff’s investment fund. Aksia is what’s called a due-diligence firm, and they’re an example of what regulation would look like in a true free market.

Because of the lack of government regulation in hedge funds, these due-diligence firms emerged. Investors wanted to be assured that their money was going to a reputable fund, so these companies thoroughly investigate hedge funds for a fee.

Since these firms are operating in the free market and competing with one another (as opposed to the SEC, which has a monopoly on the business of regulation), they have incentives to do the best job so that they gain the best reputation in the business, thus increasing their customers and their wealth.

And Aksia was thorough; they found a number of red flags in Madoff’s fund during it’s investigation, including:

1. The Madoff investment strategy, called “split-strike conversion,” is known to be very volatile; it involves trading huge positions around options expirations. Despite that volatility, its returns over the past decade were an amazingly stable 8-10 percent.

2. Aksia discovered a 2005 letter to the Securities and Exchange Commission from a financial advisor who supposedly studied Madoff’s operations. That letter asserted Madoff was running a Ponzi scheme. There was also a Wall Street Journal story at the time about one of the Madoff’s associated “feeder funds” getting shut down in 1992.

3. Madoff’s strategy was bizarre: He said he would move $13 billion in various trades at once, yet Aksia couldn’t find traders who saw his trades. There were also no regulatory filings. And family members were running the firm.

4. The comptroller of the firm was based in Bermuda. Most mainstream hedge fund investment advisers have their comptroller in-house. Madoff’s so-called feeder funds, meanwhile, were audited by respectable auditors. That gave the impression that Madoff had a professional operation. But the central investment action wasn’t with the feeder funds, but in Madoff’s New York City headquarters. And those activities were audited by a smaller, lesser known firm.

5. Madoff sent out accounting statements by mail. Most hedge funds email statements and allowed them to be downloaded via computer for easier analysis by investors.

6. Aksia wasn’t the first firm to check out Madoff’s activities. A two-man shop (not counting the secretary) which operated out of a small office in Muncie, N.Y., was also looking into Madoff’s activities.

So whats the moral of this story? The SEC simply cannot protect investors as well as free market systems can. The SEC failed to protect investors from mortgage-backed securities and credit default swaps and collateralized debt obligations – and now it failed to notice a $50 billion dollar Ponzi scheme masquerading as a hedge fund. Unfortunately, some people will see those facts and come to the conclusion that we just need more regulation and the SEC needs more resources.

The SEC failed because it’s a centralized monopoly, it’s that simple. And Bernie Madoff’s scheme succeeded because investors had a false sense of security in that bad system and it’s regulations. Take away that monopolistic regulatory giant, and a system of due-diligence firms would spring up to take it’s place. That type of decentralized system of competing firms is many orders of magnitude better at finding fraud and protecting investors; and it’s been proven so. It would be less expensive and more efficient than the SEC, and it would lower taxes and place the financial burden on the actual investors instead of the entire US population, including non-investors.

It’s just common sense.

This is a classic sketch from Saturday Night Live with timeless financial advice. Common Sense Investors, take note.

In The Know: Are America’s Rich Falling Behind The Super-Rich?

The internet is a beautiful thing, it creates opportunities to streamline so many things in our lives. It creates a marketplace where people can reach each other so easily. It has the power to decentralize authority and break down barriers. We have information sharing at an insane rate that people just 20 years ago couldn’t imagine, but I think we have yet to see the real power of the internet.

As the financial crisis rages on, a fairly new form of decentralized lending and borrowing is emerging through online sharing of money. According to a study by Grail Research, person-to-person lending (P2P) is a fast emerging trend that could seriously reduce dependence on banks. P2P lending is a form of micro-lending where an individual or a group lends money to a person in need without any intermediary or central authority like a bank.

Many people in third world counties could have their lives changed with less than $100 dollars. They can use that money to buy goods that could allow them to build a business and make more money. For example, someone in Africa could buy a small generator and use it to power a small refrigerator and sell cold drinks. A man in India could buy new carpentry tools to build houses. And those small loans make those things possible.

Borrowers put up a profile online, usually on the site that facilitates this whole process, sites like Kiva.org, dhanaX, or Lending Club, and lenders can browse through the site looking for someone they think is worthy of their loan. The market for these loans is huge. In India, for instance, the size of informal lending market is estimated to be $90-100 billion, with rural areas accounting for bulk of the market. Of this, just 30-35 percent is supposed to be managed through friends and family networks including the emerging new platform of person-to-person lending.

“P2P lending is one of Web 2.0′s less-appreciated applications. By eliminating intermediaries such as banks, it creates better outcomes for both borrowers and lenders. We expect it to be a key threat for traditional lenders such as banks in the long term,” Grail Research Country Head Amit Kumar said.

Groups of the poorest in any given society are the ones that traditional banks won’t help, which is why P2P works so well, it has access to the long tail

Call me an econ-geek, but I’m incredibly excited about the concept of P2P lending. Decentralized solutions to social problems are generally much more elegant and workable. With P2P lending, for example, each individual lender negotiates the interest rate with the borrower, this creates a system where competition increases greatly. Instead of a few banks capable of lending money, the number of lenders is only limited with the number of individuals willing to lend. More competition, of course, means lowered costs and raised quality of the service. It’s a perfect example of how the free market solutions are superior to centrally planned solutions.

Imagine if a government or some other central authority were to take over Kiva.org, or get involved in the micro-lending business. If government were the central authority controlling the microloans, the money would first come from taxes levied on the citizens, whether they want to participate in the program or not. Then, since some members of society may not agree with where the money is going, politicians would propose new legislation requiring borrowers to meet certain qualifications, and setting limits on the amount of money able to be borrowed. Each loan would be controlled by a government employee instead of by the prospective lender, and those government employees need to be paid out of the pool of tax money, lessening the amount that can go to borrowers.

Since everyone is paying, everyone wants a say in how the money is spent. Government officials and special interests, who have more power than individuals, start diverting this pool of money to their own ends. Large corporations start building projects in third world countries under the guise of helping needy so that they can gain access to the pool of micro-loan money, and politicians push that legislation through because they’re getting endorsements and donations from those corporations. All this happens when you move from a decentralized system to a centralized one.

In the decentralized system, since the loans are spread out among thousands of lenders making decisions about their own individual loans, the system is insulated from corruption. There is no need to pay loan counselors or financial consultants because each lender negotiates the rate of interest with the borrower, so less money is used overall and everything is more efficient.

Taking all these things into account, P2P lending is one of the most powerful real world examples of how the free market works better than a regulated system with a central authority. It’s just Common Sense.

Just last year, European private equity company 3i bought high-end UK lingerie brand and retailer, Agent Provocateur, in a reported $120 million deal. AD has been doing well since the company was founded in 1994 by the son of Vivienne Westwood Joseph Corré and his wife Serena Rees, but things have been especially good since 3i’s acquisition. Just recently, the company set up a plan for aggressive worldwide expansion.

The company already 40 boutiques across 14 countries, and their plan is to open more stores in areas directly competing with similar shops in their niche. There are already 8 stores in the United States and AD plans on building at least 2 more: Boston and Chicago. They also have Bahrain, Geneva, Puerto Barres, Madrid, St. Petersburg, and Germany in their crosshairs.

Agent Provocateur is consistently voted one of the UK’s top ten cool brands. In addition to lingerie, the brand has launched a line of very successful fragrances and added shoes to its product range. It’s e-commerce business is one of it’s fastest growing outlets for revenue.

3i’s massive amount of cash will help Agent Provocateur grow in the face of the current economic slowdown. Without that funding, AD probably would have been cutting back instead of expanding right now.

My prediction: It’s a shame AD is in the hands of private equity, because I think it’s going to come out the other side of this economic trouble patch as the worlds leader in high-end luxury lingerie/fragrance/woman’s accessories

(via AdSavvy)

Sometimes companies do things that have no obvious direct benefit but do have an indirect benefit. One example is Amazon.com’s recent frustration-free packaging idea. They’re basically making the world better because of the indirect benefit to the company.

Amazon doesn’t have any obvious reason to make product packaging less frustrating. On the surface, it doesn’t seem that they make any money by doing it, but by making the online shopping experience even more appealing than it already is, customers are more likely to buy online. Plus, Amazon gets the positive press of being the driving force behind a project that makes the world a bit less frustrating. That’s the indirect, intangible benefit.

Another great example is Google. Google gets a huge percentage of the internet’s ad dollars, so it’s willing to do things that make the internet a better place, just for the indirect benefit of having more people shopping online. I’ve talked to people that work at Google, and they can attest that Google has done some pretty large projects with the only goal being “make the internet better”.

We generally think that it’s a bad thing when one company controls most of a market, but as these examples show, there are some advantages. The company has incentive to act on behalf of the interests of consumers. This is one of the unseen factors to the free market.

I wouldn’t say I’m a fan of Bob Murphy, but he certainly hits the nail on the head this time:

Let me say it once again, for the record: Suppose that Ludwig von Mises and Friedrich Hayek were right, and that really low interest rates (caused by the central bank flooding the market with artificial credit) screw up the market’s coordination over time. Then that means we are now sowing the seeds for an even bigger crisis four or five years from now.

It’s true, many people would say, “That’s irrelevant. Right now the pain is so bad, we need to stop the bleeding and deal with future problems down the road.”

However, that’s exactly what people were saying in light of the “unacceptable” pain that would have occurred due to the dot-com crash and 9/11 attacks. It never occurred to people back then, how bad the housing boom would end up being.

On October 3rd, a rumor that Apple CEO Steve Jobs had a heart attack sent Apple’s stock crashing down from $105.04 per share to $94.65 per share, equaling a loss of $9 billion in market value. All that in just 10 minutes. That shows how important Steve Jobs is to Apple. It also shows how fragile the market is at times.

Generally, when a fake news story has a substantial impact on the value of a company’s stock, the SEC gets involved. And that’s just what they did this time. Manipulating the value of a stock for your personal gain is a crime with some hefty penalties, so the SEC tried to trace the story and see if it’s originator had any financial reasons for starting the rumor. It turns out he didn’t.

The story made it’s way to CNN’s iReport.com, which is where it really started to hit the mainstream news, but it’s origin was a tad less respectable: an 18 year-old kid posting on 4Chan as a prank.

Here’s the complete post from CNN’s iReport “Citizen Journalist” Web site:
“Steve Jobs was rushed to the ER just a few hours ago after suffering a major heart attack,” said the false report. “I have an insider who tells me that paramedics were called after Steve claimed to be suffering from severe chest pains and shortness of breath. My source has opted to remain anonymous, but he is quite reliable. I haven’t seen anything about this anywhere else yet, and as of right now, I have no further information, so I thought this would be a good place to start. If anyone else has more information, please share it.”

This past weekend, Editor-in-Chief of Slate, Jacob Weisberg, wrote an error-filled article titled “The End of Libertarianism”. The article is a disturbing look at the misunderstandings of the common media “intellectual”. Fortunately, intermediately after his article was published, an actual intellectual wrote a reply.

Jeffrey Miron, an economist lecturer at Harvard, filled in the missing bits from Weisberg’s bizarre account of history. Enjoy the show:

Whatever one’s views of libertarian policies, the incontrovertible fact is that the U.S. has not pursued such policies. Not in the past 10 years. Not in the past century. Indeed, except for a brief moment before Alexander Hamilton engineered the first U.S. bailout of financial markets, not ever. If the U.S. had truly been the “Libertarian Land” that Weisberg alleges, a huge range of policies that have helped fuel the current situation would have been radically different.

http://www.reason.com/news/show/129580.html

“Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you we won’t do it again.”
-Actual quote from Ben Bernanke

There is an outstanding article over at the Motley Fool. It’s so good I have to re-print it here in it’s entirety. Read it and learn people.

A frightening pattern has emerged in the financial world. It goes something like this: a bad event happens; the government swoops in to help; and then things wind up getting worse. The perpetual optimists among us may wish to believe that the help came just in time to keep a bad situation from getting worse.

Reality spins a different tale. The government has a radically different legal and financial playing field than an ordinary investor. As a result, even when it acts with the best of intentions, Uncle Sam’s assistance often winds up causing far more harm than good.

The road to Hell…
That effect is so strong that there’s even a name for it — “The Law of Unintended Consequences.” It’s what happens when an action designed to do one thing winds up causing something else entirely.

For instance, Federal Reserve Chairman Ben Bernanke has been injecting capital at a furious pace since January in a failing attempt to stave off a financial meltdown. Yet rather than acting as an expensive lender of last resort, the Fed has been aggressively lowering rates and extending borrowing privileges to more companies.

The more aggressive the Fed has gotten, the tighter the credit market has become, especially when it comes to interbank lending. Supporters would have you believe the Fed’s actions were the only thing keeping any liquidity in the market at all. Yet nagging questions remain:

With the government offering an essentially unlimited supply of cash at unbelievably cheap rates, why would any bank borrow anywhere else? Why would any bank with excess capital to loan try to compete by charging less? As long as the Federal taps keep gushing unlimited supplies of cash at such cheap rates, the interbank lending market may never recover.

…is paved with good intentions
Likewise, foreclosures provide three very useful features to the mortgage market:

* They entice people to pay their mortgages even when times are tight, in order to keep their homes.
* They enable banks to loan money to people with less than perfect credit. The home is the bank’s collateral if the borrower defaults.
* When homes are auctioned after foreclosure, the prices they fetch tend to be near or below the low end of what they may really be worth. By establishing a price floor, foreclosures provide a basis by which lenders can feel comfortable making new loans on similar properties.

Yet when the FDIC took over IndyMac, it stopped that bank’s foreclosures. Likewise, Treasury Secretary Henry Paulson is pushing to limit foreclosures as part of his massive investments in the country’s banks. As cruel as it may seem, foreclosures are a necessary part of keeping the mortgage market functional. The tighter the restrictions on foreclosures, the less banks are willing to lend.

For the mortgage market to reopen, banks need to know that their collateral is good. For that to happen, foreclosures need to be a credible threat to keep people paying, and they need to continue to establish the price floor for homes. Without them, the mortgage market may never return.

Reality bites
In fact, mortgage rates have generally been climbing, in spite of all the cash being thrown at the banks as an enticement to loan money. When good intentions get paired with bad policies, we all lose, especially those who play by the rules. 30 year mortgage rates for financially strong borrowers with a 20% down payment haven’t been this high in a long time:

Bank – 30 Year Mortgage Rate
People’s Community Bank (Nasdaq: PCBI) – 7.375%
Bank of America (NYSE: BAC) – 7.125%
US Bank (NYSE: USB) – 7.000%

With all that help causing borrowing costs for strong loan candidates to rise, is there any wonder why property values still haven’t bottomed?

Pick your poison
At this point, unfortunately, there will be more economic pain to come, no matter what happens. If we continue down the path of government “help”, the lending market may never fully recover. On the other hand, if their Federal funding gets shut off, cash-hemorrhaging firms like Ford (NYSE: F) and General Motors (NYSE: GM) may be forced into bankruptcy protection.

Even bankruptcy has its upside, however. It would allow those companies to trim their excess capacity while restructuring their massive legacy costs and debt loads. Once they emerged from their reorganizations, they would be in a far better position to compete against the new automotive titans of Honda (NYSE: HMC) and Toyota (NYSE: TM). If a domestic auto industry is important, in the long run, bankrupting GM and Ford may actually be beneficial.

Bernanke himself once admitted that bad government policies worsened the Great Depression. It’d be a shame for history to repeat itself due to the unintended consequences of all this Federal help.

(via Motley Fool)