Thursday, March 5, 2009

A Lesson From Bernie

Mark Pittman from Bloomberg on Fed Refusing to Release Bank Lending Data:

"Bloomberg sued Nov. 7 under the U.S. Freedom of
Information Act requesting details about the terms of 11 Fed lending programs.
--- In response to Bloomberg’s request, the Fed said the U.S. is facing
“an unprecedented crisis” in which “loss in confidence in and between financial
institutions can occur with lightning speed and devastating

The question ultimately comes down to, what is confidence based on? Confidence stems from certainty. If you are certain about a particular outcome then your confidence regarding that outcome is high. If uncertainty of an outcome is increased, confidence in that outcome drops. Increase in uncertainty, therefore, increases risk. The less certain you are about a particular outcome, the greater risk you take on.

Therefore, confidence, or lack thereof, ought to be a reflection of perceived risk.

As Bernie Madoff turned his hedge fund into a Ponzi Scheme, he closed off transparency into his fund. Inquisitive managers conducting due dilligince on Madoff's fund were turned away with their concerns marginalized and their questions left unanswered. This decrease in transparency of business operations inherently increased risk to investors, yet for those that invested significant amounts of their wealth with Madoff, their confidence, as judged by their actions, was as high as ever.

What, then, was that confidence based on? As transparency decreased, confidence should have decreased as well. But that's not what happened. Instead, for those that invested with Madoff, confidence became a criterion for investment rather than a byproduct of other factors, like his investment strategy and risk profile of that strategy.

Friends encouraged friends to join, and their confidence, detached from reality as it was, bred confidence in others. This is why Madoff's scheme worked for as long as it did. As long as new investors had confidence -- more aptly, blind faith -- in Madoff, then the cogs could continue going for longer than they fundamentally should have. The added duration of Madoff's ponzi scheme only served to compound the problem to $50 billion.

Those that had their money with Madoff were confident, but that confidence was illusory. When baseless confidence becomes a criterion for action, then risk is no longer being considered when decisions are made.

And therein lies the problem -- our government treats confidence as the underlying source of our woes, when it is really a symptom. Instead of dealing with reality for fear of 'devastating effects' our government continues its 'ponzi scheme' policies and uses faux confidence to continue their destructive actions. This, as with the Madoff debacle, will only serve to compound our problems -- not solve them.

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