Who are these four people?  Brother Peter Madoff and his daughter Shana, both lawyers, who were chief compliance officer and compliance director, respectively, in a business that was in blatant non-compliance with all kinds of securities trading laws and sons Mark and Andrew Madoff, co-directors of trading for a business that never really executed the trades it claimed.

Does the trustee allege they were co-conspirators with Bernard Madoff?  No, just stupid.  His legal theory in not-so-legalese: These people shouldn’t be allowed to profit as a result of being dumber than a box of rocks, if that truly was the case – recognizing, of course, that willful ignorance is not ignorance at all.

If only it were always true that people were not allowed to profit from being dumb ….

But as the schools, one by one, disclose their numbers, the managers of these endowments are indicating their continued support for a diversified portfolio chock full of alternative investments like hedge funds, private equity and real estate — the very things that have caused so much trouble.

None of these managers would want me on their Boards of Trustees.  In my humble opinion, the goals of non-profit investing should be to ensure that the corpus is maintained, while making a conservative return.  Why?  Well, Harvard University and Yale University, as well as West Virginia University and Marshall University, are just too important to have their endowments (our donations!) frittered away on high-risk, high-reward options, even if the returns generally will be higher over the long term.  Non-profit higher education institutions also need consistent revenue, not obscene profits.  These high-risk strategies should be considered breaches of fiduciary duty.

After reading the report, you will not want to put government officials in charge of anything – even though there’s really no choice if we’re going to try to protect innocent investors from crimes like Mr. Madoff’s.  Had Madoff investigators done the most basic thing – verifying that allegedly profitable trades actually occurred – the Ponzi scheme would have unraveled years earlier.  But none of the SEC investigators – except one who just ignored the results – did this most basic thing.

I did not have a lot of confidence in the SEC before this report; now I have virtually none.  This country’s financial regulatory system needs a serious overhaul.

No big deal, right?  An eighth or sixteenth of a penny here or there couldn’t add up to much?  Just $8 BILLION across the industry, estimates one market research firm.  And from whom was the $8 BILLION taken?  Average investors like you and me.

Is the criminal arm of justice going after Mr. Aleynikov to protect you and me?  No, it’s going after him to protect Goldman Sachs.

By the way, look for a new report from the CFTC this month that REVERSES a finding that the gas price hikes were caused by supply and demand issues, not speculators.

Chairman Gensler’s telephone number is 202.418.5050, and his fax number is 202.418.5533 if you want to weigh in on this important issue.

The New York Times reported last week that our machines are becoming smarter than we, and scientists are debating whether there should be limits on research that might lead to loss of human control over computer-based systems.  A threat?  Not for a while, I would hope.

The New York Times also reported last week that traders like Goldman Sachs – the bad guys in case you don’t know about the internet bubble, housing bubble and oil bubble – are beginning to make a lot of money by subtly manipulating share prices with high-speed, high-frequency trading.  The issue came to light when a former Goldman Sachs computer programmer left with secret computer codes, which a federal prosecutor now claims could be used to “manipulate markets in unfair ways.”  Hhhmmm?!?  If the programmer could use them to manipulate markets in unfair ways, how was Goldman Sachs using them?  A threat?  Yes, and now.

Matt Taibbi, Journalist: This is the world we live in now. And in this world, some of us have to play by the rules, while others get a note from the principal excusing them from homework till the end of time, plus 10 billion free dollars in a paper bag to buy lunch. It’s a gangster state, running on gangster economics, and even prices can’t be trusted anymore; there are hidden taxes in every buck you pay. And maybe we can’t stop it, but we should at least know where it’s all going.

We must pay closer attention to our financial services industry or else we will find ourselves in economic crisis after economic crisis.  I know: The terms are difficult to understand … collateralized debt obligations, commodity futures, initial public offerings, junk bonds … but we must begin to grapple with them.

Franklin D. Roosevelt, Fireside Chat 6: “The second step we have taken in the restoration of normal business enterprise has been to clean up thoroughly unwholesome conditions in the field of investment. In this we have had assistance from many bankers and businessmen, most of whom recognize the past evils in the banking system, in the sale of securities, in the deliberate encouragement of stock gambling, in the sale of unsound mortgages and in many other ways in which the public lost billions of dollars. They saw that without changes in the policies and methods of investment there could be no recovery of public confidence in the security of savings. The country now enjoys the safety of bank savings under the new banking laws, the careful checking of new securities under the Securities Act and the curtailment of rank stock speculation through the Securities Exchange Act. I sincerely hope that as a result people will be discouraged in unhappy efforts to get rich quick by speculating in securities. The average person almost always loses.”

There is nothing new under the sun.  Our banking and securities laws and regulations desperately need an overhaul, just as they needed one in the 1934. But we must be very careful in doing so because there are some very smart financial services people out there who face the loss of significant income, aim to sabotage every meaningful regulatory effort and who will take advantage of any loophole left open for them.

Edward Liddy, AIG chairman: “We cannot attract and retain the best and the brightest talent to lead and staff the AIG businesses — which are now being operated principally on behalf of American taxpayers — if employees believe their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury.”

Do we really want our best and brightest going into the financial services field?  I think not.  We all need to support strongly all efforts to reign in their salaries.  Wouldn’t it be wonderful if our best and brightest chose education, public service (e.g., financial services regulation) or something remotely beneficial to society as careers?  While I appreciate the need for a financial services sector to ensure that capital is available to support economic growth, that’s not what far too many of these people are doing.  These people are destroyers, not builders.

For President Bill Clinton, it was Robert Rubin, Treasury Secretary, who had spent 26 years working at Goldman Sachs.  For the record, Robert Rubin is the person who stopped the CFTC from regulating derivatives in the late 1990s, which might have prevented the housing bubble.

For President George W. Bush, it was Henry Paulson, Treasury Secretary and financial bailout architect, who formerly was Chairman and Chief Executive Officer of Goldman Sachs, and Josh Bolten, the President’s Chief of Staff, who formerly was director of legal affairs for the company in London.  For the record, Mr. Paulson is the person who decided to let Goldman Sach’s competitor Lehman Brothers go out of business while bailing out AIG with $85 billion, $13 billion of which went directly to Goldman Sachs.

How about President Barack Obama, who received over $1 million in campaign contributions from Goldman Sachs employees?  To date, his biggest Goldman Sachs hire is Robert Hormats, the State Department’s Undersecretary for Economic, Energy and Agricultural Affairs.  A close second is Mark Patterson, former Goldman lobbyist turned Chief of Staff for Treasury Secretary Timothy Geithner, who worked against executive compensation caps before going to work for Mr. Geithner.

For those who think meaningful health care reform will be difficult, try meaningful financial services reform.  The foxes are guarding the henhouse.

Goldman did it by persuading pension funds and other large institutional investors to invest in oil futures — agreeing to buy oil at a certain price on a fixed date. The push transformed oil from a physical commodity, rigidly subject to supply and demand, into something to bet on, like a stock.

- Matt Taibbi

How was this bubble created?  Remember the four elements:

• An Intangible Market.  Goldman Sachs peddled oil futures, not oil in the here and now.
• A Broken Rule.  In 1936, the CFTC was given authority to regulate speculative trades in commodities.  In 1991 a Goldman-owned subsidiary was given an exemption from the speculative trades limit, and 14 other companies eventually obtained similar exemptions.
• An Insider.  While Goldman’s “oracle of oil” was predicting a “super spike” in oil prices in the future …
• A Hedge.  … Goldman was heavily invested in oil and profiting from the rapid increase in price in the here and now.

The effects of the housing bubble are well known — it led more or less directly to the collapse of Bear Stearns, Lehman Brothers and AIG, whose toxic portfolio of credit swaps was in significant part composed of the insurance that banks like Goldman bought against their own housing portfolios.

- Matt Taibbi

How was this bubble created?  Remember the four elements:

• An Intangible Market.  Goldman Sachs bundled good and bad mortgages into Collateralized Debt Obligations (CDOs) so that buyers couldn’t figure out what was good and what was bad … and sold them over and over and over again.
• A Broken Rule.  In the only days, mortgage dealers required 10% plus down payments, a steady income and a good credit rating.  These underwriting standards were discarded creating a lot more bad mortgages.
• An Insider.  Robert Rubin, a 26-year alum of Goldman, fought back an effort to regulate derivatives like these CDOs when the head of the Commodity Futures Trading Commission (CFTC) tried to do so.  The CFTC was ultimately stripped of regulatory authority and banks were “free to trade default swaps with impunity.”
• A Hedge.  ”To hedge its own bets, Goldman got companies like AIG to provide insurance – known as credit default swaps – on the CDOs.”  In other words, Goldman Sachs was betting against the CDOs it was selling.

Importantly, please realize that Goldman Sachs was not alone in creating this bubble.

The basic scam in the Internet Age is pretty easy even for the financially illiterate to grasp. Companies that weren’t much more than potfueled ideas scrawled on napkins by uptoolate bongsmokers were taken public via [Initial Public Offerings (IPOs)], hyped in the media and sold to the public for mega-millions. It was as if banks like Goldman were wrapping ribbons around watermelons, tossing them out 50-story windows and opening the phones for bids. In this game you were a winner only if you took your money out before the melon hit the pavement.

- Matt Taibbi

How was this bubble created?  Remember the four elements from yesterday’s post:

• An Intangible Market.  The internet, which really is just a bunch of interconnected electronic circuits whose use might somehow produce money for the user, was the ultimate intangible market.
• A Broken Rule.  Prior to the internet bubble, there was a long-standing rule concerning which companies were appropriate for IPOs.  The company had to have been in existence for five years and produced a profit for three consecutive years.  Near the end of the internet bubble, tech IPOs were being initiated for companies that had never made a profit and would not make a profit into the foreseeable future.
• An Insider.  The investment bank offered executives sweetheart deals for IPO shares resulting in money being diverted from the company’s bank account to the CEO’s and CFO’s bank accounts.  In return the investment bank was promised additional business.
• A Hedge.  As the facilitator of an IPO, an investment bank earned a commission on the amount of money it raised.  The big risk for the investment bank was that it wouldn’t be able to dupe people into investing enough in a shaky IPO.

While some of Mr. Taibbi’s language is a bit risqué and he singles out Goldman Sachs when other financial services firms are guilty of the same or similar practices, I encourage you to set aside all prudish compunctions and read Taibbi’s article from beginning to end.  Indeed I predict that many of you will be spouting his colorful expletives freely by the time you finish.

Before doing so, however, reflect on the news from Wall Street last week.  One after another, banks and investment houses announced large profits in the midst of the largest financial meltdown since the Great Depression.  Leading the way was Goldman Sachs, which reported a $3.44 billion (that’s “billion” with a “b”) profit in the second quarter, followed closely by JPMorgan Chase with a $2.7 billion profit.  ”One theme here,” said former Clinton Administration Labor Secretary Robert Reich in The New York Times, “is that Goldman Sachs and JPMorgan really emerged as the winners, as the last of the survivors.”

What is the recipe for Goldman Sach’s success, according to Mr. Taibbi?  Consistent with all illicit money-making schemes, there are four elements:

• An Intangible Market.  It’s difficult to defraud someone when he or she is paying you cash for a widget.  Either you have the widget or you don’t.  Either the widget works or it doesn’t.  Not so with markets for intangibles, which can come and go like a magician’s rabbit.
• A Broken Rule.  Contrary to popular belief, there is no new money-making scheme under the sun.  Every scheme has been tried in one form or another before.  As a result, there generally are rules in place to prevent the most significant abuses from occurring.  These rules must be broken.
• An Insider.  It helps to have someone who gets a better deal than everyone else or has a special relationship with you.  Every money-making scheme needs champions.  This is why Ponzi schemes are so successful.
• A Hedge.  The savvy investment house always positions itself so that does not get harmed when the bubble bursts.

The lessons to be learned from the internet, housing and oil bubbles are so important that they need to be examined in detail.  But first a tantalizing trinket: How much did Goldman Sachs pay to this nation in taxes last year?  $14 million (that’s “million” with an “m”), or about 1/3 of what the company’s CEO made.

The take-away: Free markets are only “free” for companies like Goldman Sachs who are “too big to fail.”

Despite what you might hear in the hallowed halls of academe, there is a reasonably good argument for having students pay for their own higher education, even if they have to take out student loans to do so.  In 2006 the average male with a high school diploma earned $37,030, while the average male with a bachelor’s degree earned $60,910. A rather substantial loan payment could be made with that $23,880 in extra income.  If the average college graduate is going to see that kind of benefit, why shouldn’t he or she pay for it?  Furthermore, why should that high school graduate earning $23,880 less than the college graduate subsidize the college graduate’s education with his or her taxes?

There are two reasonably good responses to these points.  The first relates to fairness and equity.  Research tells us that students from poorer families, particularly with no history of college attendance, too often make the wrong decision from a purely economic perspective not to attend college.  Do we really want the rich to get richer and the poor to get poorer?  The second relates to the larger public benefits that accrue to an educated society – stronger economic development, greater civic engagement, etc.  The rising tide of education lifts all boats.

“Investing in Lawsuits, for a Share of the Awards”

Instead of investing in stocks or bonds or even mortgage-backed securities, Juridica Capital Management invests in lawsuits.  Juridica, says the New York Times, “invests in one side of a lawsuit in exchange for a share of the winnings.”  To the legally unitiated, this may seem bizarre.  But lawyers who take cases on a contingent fee basis and who enter into co-counsel arrangements in order to finance high-cost litigation, such as class-action lawsuits, do much the same thing.

Juridica seems to be going down a road that is very similar to the one previously taken by bankrupt and near-bankrupt financial services companies, which never seemed to run out of new investment ideas.  Will we soon have a new financial market for lawsuits?  Will we soon pool together legal risks and sell and resell them so that no one can determine their true value?