'Tis the season for robbing banks, but for NABBING con guys. The Madoff scandal could have caused a nosedive. The reason it didn't isn't much comfort.

"In David Mamet's movie 'House of Games,' the grifter played by Joe Mantegna explains to a former mark, 'It's called a confidence game. Why? Because you give me your confidence? No. Because I give you mine.' So the bankers gave us their confidence, in the form of mortgages and other forms of credit, and we gave them ours. This culture of credulity did plenty of damage to the economy, but now it has given way to something even more corrosive; namely, endemic mistrust."

"Discovering what the crooks have been up to is disillusioning, but not as disillusioning as coming to terms with what the so-called honest people did."

-- James Surowiecki, in "Cheat, Pray, Love," the "Financial
Page" in this week's (January 12) New Yorker

by Ken

SEC Broadens Its Probe Of Failures in Madoff Case

By Zachary A. Goldfarb
Washington Post Staff Writer
Tuesday, January 6, 2009

The inspector general of the Securities and Exchange Commission said yesterday that he is broadening his investigation into the agency's failure to detect the alleged fraud committed by Bernard L. Madoff, examining whether the regulatory breakdown was isolated.

H. David Kotz, the SEC's inspector general, said he is looking to identify not only the officials who failed to uncover Madoff's activities, but also whether the agency is able to "to respond appropriately and effectively to complaints and detect fraud."

Kotz addressed outraged lawmakers on the House Financial Services Committee, who expressed bipartisan agreement that the Madoff scandal underscores the need to restructure the regulatory system.

And now, warns James Surowiecki (whose "Financial Page" has become one of my favorite things in The New Yorker), may be the time to hunt for more Bernie Madoffs:

Along with slashed payrolls, rising foreclosures, and plummeting stock prices, 2008 brought another unwelcome development: a surge in bank robberies, which were up more than fifty per cent in New York. This wasn't shocking: we typically expect property crimes to rise in hard economic times. There is, though, one crime against property which bucks this trend: defrauding investors. On Wall Street, fraudulent schemes tend to thrive during economic booms, and to blow up when times turn tough. While bank robbers are getting busier, the Bernard Madoffs are starting to get caught.

Madoff, says Surowiecki, "is just the latest in a long line of fraudsters who took advantage of investor euphoria. Time and again, as asset markets have become frothier, fraud has flourished," and he provides examples from "England's South Sea Bubble, in 1720," all the way through the last stock-market bubble and the fun and games of Enron, WorldCom, and their crooked kin.

Fraud is a boom-time crime because it feeds on the faith of investors, and during bubbles that faith is overflowing. So while robbing a bank seems to be a demand-driven crime, robbing bank shareholders is all about supply. . . . The same overconfidence that leads investors and lenders to underestimate the risks of legitimate investments also leads them to underestimate the likelihood of fraud. In Madoff's case, for instance, his propensity for delivering inexplicably consistent returns month after month should have been a warning sign to his investors. But in the past few years besotted investors were willing to believe lots of foolish things -- like the idea that housing prices would just keep going up.

Of course this can't go on forever, and "when the crash comes, and people get more cynical and cautious, the frauds are exposed." Surowiecki quotes Warren Buffett: "You only learn who's been swimming naked when the tide goes out.”

Did the share prices of Enron and WorldCom start plunging after their fraudulent actions came to light? Actually, it was the other way around: the financial mischief was exposed only after their stock prices tanked. In Madoff's case, the steep across-the-board decline in asset prices curbed investors' appetite for risk, so that many started to pull their money out. That effect may very well have forced Madoff to dispense more money than he could keep bringing in, especially since recruiting new investors, which you have to do to keep a Ponzi scheme going, would have become harder after the crash.

There is one small saving grace. With the unmasking of an investor ripoff on the scale of our Bernie's, there is a normal expectation of a sizable jolt to general investor confidence, and that didn't happen.

But the reason why it didn't happen isn't such good news. Surowiecki notes a couple of contributing factors:

* "A stock market that lost seven trillion dollars in value in 2008 knows how to take a fifty-billion-dollar loss in stride."

* "Madoff was running money largely for an élite clientele, which gained access to his services primarily through inside connections, limiting the market-wide impact of his malfeasance."

But the main reason that Madoff didn't destroy investor confidence is that it was already gone, thanks to a year when just about every institution that the market depends on -- rating agencies, accounting firms, regulators, Wall Street C.E.O.s. -- had messed up. The whole web of intermediaries and knowledge brokers that modern asset markets have come to rely on has become frayed. That helps explain the current credit crunch -- bank lending has dropped fifty-five per cent this year -- and the dismal state of the stock market. Discovering what the crooks have been up to is disillusioning, but not as disillusioning as coming to terms with what the so-called honest people did.

"If there's one thing worse than too much confidence," Surowiecki concludes, "it's not enough. Fraud impoverishes a few; fear impoverishes the many. As long as mistrust prevails, people will keeping pulling money out of the system -- sometimes even at gunpoint."

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