A Country of Madoffs

A Nation of Madoffs…

Yesterday, the Dow rose 58 points. Oil held at $41. The euro at $1.31. And gold fell below $900. The yellow metal still looks good. It is at an all-time high in terms of the euro and the pound. But it still has a long way to go.

Gold is the thing you buy when you suspect that monetary authorities are making a mess of things. The fixers are fixing more than ever before. What are the odds that some of the fixes go bad? We don’t know…but our guess is that gold is looking forward to it.

Meanwhile, consumer confidence in the United States is at an all-time low. Fannie and Freddie say they need another $51 billion. Dow Chemical is considering cutting its dividend for the first time since 1912.

Everybody likes the wages of sin…until the devil calls…

This week began with a squabble. John Thain was sacked as head of Merrill Lynch after giving out $4 billion in bonuses – just before announcing $15 billion in losses for the 4th quarter of ’08. The Bank of America, Merrill’s new owner, said it hadn’t approved the bonuses. Thain said it had been ‘informed.’

Then Citigroup announced that it had bought a new corporate jet for $50 million. Seemed a bit rich for a company that had just lost $8.3 billion.

What sort of devilry is this? Where can you can lose billions…take billions in handouts from taxpayers… and still coddle executives with new planes and million-dollar ‘bonuses?’ Penalties would seem to be more appropriate.

By Tuesday, President Obama was already expressing the outrage of the public; he announced that if banks were going to take money from the public, they would have to limit executive compensations and dividend payouts. He pledged to impose “tough and transparent conditions on firms receiving taxpayers assistance.” Bummer. The party’s over.

But it was fun while it lasted. When animal spirits run high, the animals in the financial industry are able to make a buck. Nothing very surprising about that. But the amounts were startling. At Goldman Sachs, for example, the average compensation in 2006 was $521,000 – including secretaries and cleaning staff. Henry Paulson, then CEO of Goldman, later Secretary of the Treasury, earned $38 million.

But it was not just financial industry workers who were getting rich… In the Bubble Epoque, the entire upper crust was glazed with honey. In 1970, top American CEOs made about 39 times as much as the average employee. Thirty years later, the average pay had risen to $37.5 million… nearly 1,000 times higher than the average worker’s paycheck.

Part of the reason for this explosion of avarice can be traced to the government’s own attempts to limit it. In 1993, Congress limited the tax deductibility of executive salaries to $1 million – except where compensation was tied to performance. This left corporate compensation boards to shift more to the use of stock incentives, based on targets and benchmarks, which were hard to argue with. CEO’s pay increase almost 300% between 1990 to 2005, while production worker’s wages rose only 4.3%. And during that same period CEO’s pay rose twice as fast as the S&P…and three times as fast as corporate profits. Soon, every manager wanted a ‘piece of the upside.’ Investors could have the downside all to themselves!

Like Bernie Madoff, the CEOs put it over on everyone – the capitalists as well as the proles. The poor working stiffs had foreign labor breathing down their necks. If they got out of line, their employers would export their jobs to China. The patsy stockholders had no chance either. They knew perfectly well that the schmuck running the business wasn’t worth what he was being paid, but who could argue with “performance?” Besides they had “compensation committees” and consultants to tell them is was “reasonable” or competitive.

Retired CEO of DuPont, Edgar S. Woolard, Jr., did. In 2005, he was chairman of the NYSE’s executive compensation committee. As to the need to pay such high compensation in order to get good talent, he replied with a single word: “bull.” But did not the super-paid super-CEOs create super wealth? It was a “joke,” said he. He blew the whistle. But no one came a running.

Our own experience in business tells us that the larger the corporation gets the less important the CEO becomes. Many become nothing more than mouthpieces, ambassadors and cheerleaders for businesses they barely understand. They do not ‘run’ the business; the business runs them.

And the evidence of the last few years tells us that the only thing these super CEOs were good at was negotiating their own compensation packages.

Public records tell us that Jimmy Cayne, once CEO of Bear Stearns, once a leading Wall Street investment bank, spent about a third of the month of July, 2007, playing in various bridge tournaments. You might expect that a man who was paid nearly $3 million per month for his services would be on-call 24/7. At least, you might expect him to come into the shop when the firm ran into trouble. But July 2007 was the month Bear Stearns went broke.

Dick Fuld made nearly $4 million a month in his last year at Lehman Bros. At $25,000 an hour, you’d expect him to keep his eye on the ball. Remember too, this was the firm that had survived the Civil War and the Great Depression. But Fuld seemed to have no idea of what was going on. In the end, he blamed short sellers – as if he’d spent a career on Wall Street and learned nothing about how it worked.

Short sellers can’t bring down a large, healthy firm. But when they see a Humpty Dumpty like Lehman on the wall, they give him a push.

*** When there is a financial boom, capital assets throw off capital income – capital gains, dividends, interest and rent. When executives cash in their stock options, for example, they get capital income. From 1979 to 1993, the top one percent of households earned about 40% of all income from capital. But in the bubble years, the amount shot up to nearly 60%.

The envy crowd moaned and complained. But why shouldn’t the capitalists get a bigger share of the pie? And then, when the pie suddenly goes bad…why shouldn’t they be the ones to get indigestion?

*** Harry Markopolos sent a 17-page letter to the SEC on November 7, 2005, write Michael Lewis and David Einhorn in the New York Times. He was blowing the whistle on Bernie Madoff. He explained to the regulators why Madoff’s firm couldn’t be on the level. He wasn’t 100% sure what Madoff was up to, he hadn’t been able to look at the books, but he had been in the investment business long enough to smell a skunk. It was mathematically impossible for Madoff to be doing what he said he was doing. Most likely, he wrote, “Madoff Securities is the world’s largest Ponzi Scheme.”

He was right. But who cared?

Not the customers. According to a Bloomberg article, “Madoff enablers winked at suspect front-running.” Many investors in Madoff’s accounts thought something funny was going on. They believed that Madoff was ripping off his retail clients by front-running their purchases and sales in order to deliver steady, above-market returns to his managed accounts. But nobody is easier to scam than a scammer. His managed account clients were perfectly happy to go along with the scam…as long as they thought they were on the receiving end of it.

The SEC didn’t seem to care either. With Markopolos’s letter in their hands – not to mention many phone calls over a several-year period – SEC regulators saw no evil, heard no evil, nor spoke no evil of Bernie Madoff.

And now the folks at Davos are talking about creating a “super SEC” that will regulate the whole world. What can we say? The bigger the fix…the bigger the fool.

*** Tomorrow…an interview with the man of the hour…Gideon Gono! For the record, here at The Daily Reckoning, we don’t believe in Keynesian or Monetarism or practically any other ism we can think of. But we have confidence in Gonoism. If you really want to destroy an economy…and a currency… yes we can!…Gonoism works.

Until then,

Bill Bonner
The Daily Reckoning