"A foolish consistency is the hobgoblin of little minds" – Ralph Waldo Emerson

Sometime between 1960, when Bernard L. Madoff Investment Securities was founded, and this past week, Bernie Madoff went a little bit crazy. He says it occurred years ago. He has told his family and now the SEC that his investment business, and his associated hedge fund, have been running losses for years and were bankrupt a long time ago. He admits to running a gigantic Ponzi scheme, in which he has taken new investors’ contributions and paid them out as income to earlier investors. Schemes like this can work a long time if fresh money keeps coming in, and they can even hide actual investment losses for a long time.

But something doesn’t add up here. Madoff manages about $17 billion in assets, but claims to have lost $50 billion over the years. Where has he hidden these losses? Does he owe major market players $33 billion that no one noticed before? A lot of investors have lost big amounts in the market crash of 2008, but pretty much everyone was making money until October of 2007. All you had to do was own stocks. As with any of these financial frauds, we are going to have to wait for the authorities to piece together what happened, which means relying on the SEC, which should have been much more on top of this situation in the first place.

One thing we have learned is that Madoff ran a highly secretive third business for wealthy clients. This business was housed on a floor no one could enter and even his sons say they knew little about it. It is possible this business was run like a Ponzi scheme, and investigators say the losses could well total $50 billion, but they would consist of overstatements of income that Madoff made to clients. These would be mark-to-market gains that were built up over years and suddenly vanished in thin air, a little like the disappearing values in mortgage-backed securities that everyone has experienced who owned them. The difference is in the first case, Madoff just made up values and sent them on to his clients, who felt progressively wealthier with each monthly statement. In the second case, Wall Street assigned values that at least someone thought were real, until they evaporated overnight when it was found nobody wanted to buy the securities anymore. The first is a loss of value caused by fraud, the second is a loss of value caused by ignorance on the part of the people peddling the securities.

To the investor, it matters little whether the loss in value is caused by fraud or ignorance; they are suddenly poorer. For many of them, it may not mean much. It might be no different than seeing housing values go down. As long as your mortgage is still well below the value of the home, you are okay. Others, however, may have borrowed against these fictitious values, and effectively spent them, very much like the homeowners who took “cash” out of their house through a home equity line or through a refinance, and now find they owe more on their house than it is worth. That is a nightmare than can lead to bankruptcy, so there will probably be a few formerly wealthy individuals meeting up with a bankruptcy judge soon.

For every one of Madoff’s investors, though, there will be regret at not having noticed the abundant warning signs, for clearly something has been wrong at his company for years. The major clue was his incredible string of steady, but not spectacular, investment gains. Year after year he would produce 10% – 12% returns for his investors. This occurred for decades. This was somewhat better performance than if you invested over the long term in the S&P 500 stocks, but in many years it was less than what the stock market produced. It was almost like investing in a fixed-rate bond, so steady and predictable was the return.

A fixed rate bond earning 10% a year would be considered high risk and speculative, but Madoff Investments was considered as blue chip an investment fund as you could want. Just to have the acquaintance of “Bernie” was a privilege. He and his wife lived wealthily, with multiple homes and private jets, but they weren’t flashy and they weren’t socialites. They gave prominently to charities. Bernie was an industry stalwart, a member of top advisory councils to the SEC, and a former chairman of NASDAQ. You can’t get more respectable than this, and what made him more respectable still was that he turned people down who wanted to invest with him.

Wealthy Americans clamored to put their money with Bernie, and none of these prominent families ever questioned the risk because they had been receiving the same generous, though not spectacular, return for two decades or longer. Nor were doubts expressed by the many universities which gave Bernie their money, or the “funds of funds”, which are investment advisers who take your money and put it into hedge funds of their own choosing. They were all enamored by the consistency of the returns, not so much their level. Humans generally don’t make good investors in these circumstances because we tend to extrapolate from the past, and assume consistent performance will continue.

There were a few skeptics. In the 1990s several investment firms complained to the SEC about Madoff Investments. They felt such steady returns were impossible for any fund, especially those like Madoff’s which held only a small number of stocks at any one time. They felt Madoff was “front running”, which is the practice of buying a stock just before the firm is about to fill an order for a customer to buy that stock. This is a sure-fire way to make money if the order is big enough to move the market higher in that stock, and it is also illegal. The SEC did investigate Madoff Investments- the first and sadly the only time they ever looked deeply at the firm – and found no evidence of front running. The issue was dropped.

The other thing the skeptics homed in on was the lack of transparency from Madoff Investments. Investors only got very sketchy quarterly reports, with hardly any details on the stocks in the portfolio. The operation was a “black box”, in that no one outside could independently prove that the returns were real. The people who were supposed to do that, the auditors, were a very small East Coast accounting firm that no fund of substance would think of hiring for such critical work.

But the ultimate irritation for these investment professionals were the returns, or more precisely, the steadiness of the returns. It is virtually impossible to simulate by computer any type of investment portfolio in U.S. equities that, over time, would generate 10% – 12% profits like clockwork every year. Statisticians and other quantitative types would point to these returns as proof positive that something fishy was going on at Madoff Investments.

We know now that they were right, and a few of them are speaking up publicly to establish their credentials in avoiding this mess. Good for them in sensing and averting big-time trouble, but let’s pause a moment first to ponder this statistical anomaly. There are more firms than Madoff Investments which achieved the same odd results for long periods of time, and we can start with the most eminent of them all – General Electric.

Here’s a company that throughout the 1980s and 1990s did even better than Madoff Investments- it earned 15% year after year. Its CEO, Jack Welch, became a god-like figure in corporate America, for his apparent brilliance in turning around a stodgy industrial conglomerate into the best performer in the Dow Jones index. His books, his press appearances and speeches, his every utterance, were considered management pearls of wisdom to be emulated by any aspiring CEO.

Jack Welch would talk about the importance of earnings management, but it took a long time for people to figure out how he really managed earnings at GE. For one thing, the company was a huge collection of small manufacturing businesses, and every quarter some would be sold and new ones bought that in combination generated instant earnings for the company. Welch had a famous practice of demanding his companies be in the top three in their business, but in retrospect, this was only an excuse to allow him to sell some of his portfolio every quarter and claim they weren’t really performing to his standards. He also had the habit of firing employees en masse in companies he just bought, theoretically to “cut fat and waste”. He got the name Neutron Jack early in his career for his practice of decimating people while leaving buildings intact.

Second, a growing part of GE was its financial services arm, which was a great business to be in during the 1990s and most of this decade. Welch had the flexibility of bank accounting for loan loss reserves to allow him to adjust reserve levels so that net income for the corporation as a whole always came out to 15%. Jack Welch was basically a trader like Bernie Madoff, only he bought and sold companies rather than stocks of companies, and he had the benefit of a bank to finance these take-overs and help massage earnings.

Jack Welch retired from GE at the top of the market. His successor, Jeffrey Immelt, has been saddled with a stock market that makes it impossible to buy and sell companies at a profit as in the past, and the GE financial operation has imploded along with all the other financial companies. GE’s stock has plummeted as a consequence, but Jack Welch is still living off his reputation as America’s greatest corporate manager. He won’t be going to jail while Bernie Madoff will, but that is because there is a wide gulf between running a Ponzi scheme, and “massaging earnings.” Still, it is odd that the most tell-tale sign of fraud at Madoff Investments – the steady earnings – was also present at GE, yet a lot of people think of GE as respectable still.

One other thing Jack Welch was good at was “beating the estimates”. This meant that his quarterly earnings always came in about one or two pennies a share higher that the estimates of Wall Street analysts. If you averaged the earnings estimates of the 30 or so analysts who followed the stock and reported on their earnings, and if they came say to $1.50/share for the quarter, GE would consistently produce $1.51/share or $1.52/share as actual results.

Statisticians could also prove that this was impossible to achieve so consistently if reported earnings weren’t being manipulated, but no one paid attention. Managing earnings became such an established practice in the 1990s, that even as late as October 2007, nearly three-quarters of all S&P 500 companies generated earnings one or two pennies higher than the analyst estimates.

In other words – not to put too fine a point on it – corporate America’s reported earnings have been dodgy for nearly two decades. They simply can’t possibly reflect actual performance at these companies, and the further proof is that in following quarters most companies announce substantial restatements of previous earnings results. The market ignores this because it is “forward thinking” and obsessed over the next quarter’s earnings only, but there is simply no way around the fact that U.S. corporations have been publishing bogus earnings reports for decades. Bernie Madoff’s version of this game was fraudulent, and Jack Welch’s version was legitimate, or at least tolerated by the SEC. Yet the end result for investors has been exactly the same.

If it is true that Bernie Madoff lost $50 billion in a massive Ponzi scheme, it will dwarf any other financial fraud in history and might well turn out to be a landmark event in this Depression. It will likely mark the demise of the hedge fund industry and any other unregulated financial sector, and now even the wealthy will join everyone else in refusing to hold on to any investment except cash.

Most people, however, will not feel any sorrow for the wealthy who have lost a considerable part of their fortune in the Madoff collapse. Maybe that is because the average middle class person who owns anything in the stock market (like a 401k) has just suffered nearly a 50% collapse in their stock portfolios in the past few months. If they were holding predominantly financial stocks, they lost a lot more, but that is because the financial industry has been running a Ponzi scheme for years, just like Bernie Madoff. Banks and Wall Street investment firms have been delivering to investors astounding returns of 20% to 30% each year for at least ten years, and the only way they could do that is increasing their leverage. That’s the same thing effectively as taking in fresh deposits and investments that will help pay existing customers such handsome returns. If you want to take this analogy one step further, the U.S. government has been doing the exact same thing, especially lately when it has pushed up its debt limit by as much as $1 trillion each quarter.

But beyond this, there is the general deterioration in accounting standards in this country that has made corporate earnings statements a joke. In times of economic trouble, it is remarkable how consistently accounting fraud seems to unveil itself. It is almost always visible to us in advance if we use the right tools, which means looking carefully at the financial reports of the people we hand our money to, questioning who their auditors are, and exercising some simple caution when something seems “too good to be true.” This is especially important when consistency starts to show up in investment performance; it is probably the one most significant red flag available to investors. It is the hobgoblin of little minds, as Emerson said, and it lulls little minds asleep, until one day a tragic, volatile and massive readjustment takes place to wake them up to what really has been going on.