DECEMBER 15, 2008

Bernie Madoff

Ponzi squared


Just when Wall Street needs it least, Bernie Madoff’s pyramid scheme takes financial fraud to new lows

FOLLOWERS of the past year and a half’s financial misadventures have become inured to bucketfuls of red ink. Even so, the potential losses from the scam perpetrated by Bernie Madoff, a Wall Street veteran, are jaw-dropping. The $17 billion of investors’ funds that his firm supposedly held earlier this year have all but evaporated and the hole could be as big as $50 billion. That would make it the biggest financial fraud in history.

Details are still emerging, but Mr Madoff has himself described it as a giant Ponzi scheme. For years, it seems, the returns paid to investors came, in part at least, not from real investment gains but from inflows from new clients. It might still have been going on, were it not for the global financial crisis. Redemption requests for $7 billion, by investors looking to pull back from turbulent stockmarkets, forced Mr Madoff to admit that his coffers were empty—bearing out Warren Buffett’s adage that only when the tide goes out is it clear who was swimming naked.

The affair has robbed an embarrassingly long list of supposedly sophisticated investors of their swimwear. Hundreds of banks, hedge funds and wealthy individuals parked money with Mr Madoff, impressed by the steady returns on offer: 10-15% a year, even in rough times, with barely a down month. Global banks such as Banco Santander, BNP Paribas and HSBC, all three of which had until now survived the credit crisis relatively unscathed, are among those reported to be heavily exposed. So too is Bramdean Alternatives, a fund run by Nicola “Superwoman” Horlick, a celebrated British money manager. Others had most or even all of their eggs in the Madoff basket. Several well-heeled Americans have reportedly lost everything but their properties.

Why were they not suspicious of the unnaturally consistent returns? Mr Madoff’s pedigree may have played a part. A former chairman of the NASDAQ stockmarket, he has long been a fixture on Wall Street. He even has an exemption (to the former “uptick rule” for short-selling) named after him. He has served on an advisory committee assembled by the Securities and Exchange Commission (SEC), America’s main market watchdog. Savvy marketing was another factor. Investors had to be invited, lending his operation an air of exclusivity. This went down well in the country clubs of Florida, Minnesota and other states, where the firm’s unofficial agents told of Bernie’s magic touch, explaining that not anyone could get in, yet always somehow finding space for those who fancied a piece.

According to reports, some of those who put their faith in Mr Madoff suspected that he was engaged in wrongdoing, but not the sort that would endanger their money. They thought he might be trading illegally for their benefit on information gleaned by a separate business within his group, which made a market in shares. The firm had been investigated for “front-running”, using information about client orders to trade for its own account before filling those orders.

Even so, the affair has—like the subprime-mortgage debacle—exposed a stunning lack of due diligence. Droves of investors who should have known better tossed in billions, preferring to keep their fingers crossed rather than ask awkward questions of a firm whose investment strategy was vague and opaque. Even within his own group, Mr Madoff’s money-management business was a black box: no one but he had full access to the accounts. As a broker-dealer, it was able to clear its own trades, a privilege that should give pause for thought. Worse, questions had been hanging over the operation since the mid-1990s. Some institutional investors have long steered clear of Mr Madoff, unable to understand how he spun his gold, or uneasy that his books were audited by a tiny, three-person accounting firm.

The SEC, which seems to have been taken aback by the scale of the malfeasance, can hardly hold its head up high either. It did not get round to examining the books of Mr Madoff’s money-management business, even though he registered it with the commission in September 2006—though it did probe the market-making arm and found that it had violated some technical rules.

For an agency that is fighting for its life, that is unfortunate. Even before this scandal the SEC was on the back foot, having stood by as the big Wall Street investment banks it was charged with policing ran amok. In its defence, the commission argued that its primary role was investor protection, not prudential regulation. Now it has been shown wanting in its core competence—though, with 11,000 fund managers to oversee, not to mention the boom in mortgage-related cases, some may think it inevitable. Congress is next year expected to revamp America’s dysfunctional system of financial regulation. One option, already proposed by Hank Paulson, the outgoing treasury secretary, is to fold the SEC’s responsibilities into a new set of agencies.

The sloppy regulators and credulous investors whom Mr Madoff duped must now hope that he has pulled off one last deceit: exaggerating the scale of the losses. Even in these accident-prone times $50 billion sounds like an awful lot for one man to lose. But it is just about possible if he levered up his bets with borrowed money or supercharged them with derivatives (which he is known to have used to reduce volatility). But even if the fraud extends no further than the $17 billion under management, it will go down as a humdinger. Indeed, it makes Charles Ponzi’s promise in 1920 to double investors’ money in three months—which caused losses equivalent to around $160m in today’s money—look like a trifle. Perhaps from now on it should be known as the “Madoff scheme”.

Evidence that the Fed Caused the Housing Boom

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In this forum I have argued that Alan Greenspan’s low-interest-rate policy after the dot-com bust and 9/11 attacks sowed the seeds for our current recession and the housing bubble. I have also criticized the alternate theory that a foreign “savings glut” was the true culprit, rather than the Fed. In the present article, I want to deal with a few empirical objections to the case against Greenspan. That is, several different economic analysts are familiar with the theory that “the Fed did it,” and they claim that the facts just don’t add up. In the space below, I hope to demonstrate that the evidence against Greenspan is indeed damning.

Greenspan’s “Smallish” Injection?

One argument advanced in the attempted exoneration of Greenspan is that he didn’t really pump that much money into the credit markets. For example, popular blogger Megan McArdle writes,

Both right wing Austrians and many liberals have a common theory of how all this happened: Alan Greenspan dunnit. The mechanisms by which he accomplished his foul task are different in the two cases, of course. Austrians, and many other free-market types, believe that by lowering short-term interest rates after 9/11, Alan Greenspan made the housing bubble, and its eventual bust, inevitable… Here’s the problem: if markets are so great, how come the entire system can be brought low by a smallish injection of short-term capital? (emphasis added)

Brad DeLong makes a similar claim in his critique of Larry White, whom DeLong praises as the “best of the Austrians.” (DeLong does not tell us who the best-looking Austrian is, though I hope to at least be nominated.) DeLong writes,

Moreover, I do not think that Larry White has gotten the part of the story that he does cover right…. From the start of 2002 to the start of 2006 the Federal Reserve bought $200 billion in Treasury bills for cash. This $200 billion reduction in outstanding bonds and increase in cash surely did lead to an increase in demand for private bonds. But recall the magnitudes here. We have $2 trillion of losses on $8 trillion in face value of mortgages that ex post should not have been made. Are we supposed to believe that $200 billion of open-market purchases by the Fed drives private agents into making $8 trillion of privately unprofitable loans? Not likely. I can see how monetary contraction can make previously profitable loans unprofitable. But I see no way that this amount of monetary expansion can force private agents to make that amount of unprofitable loans. The magnitudes just do not match.

Similarly, David Henderson and Jeff Hummel[1] write that monetary growth was tamed during the years of the housing boom, and so Greenspan can’t be the culprit:

A better, although now unfashionable, way to judge monetary policy is to look at the monetary measures: MZM, M2, M1, and the monetary base. Since 2001, the annual year-to-year growth rate of MZM fell from over 20 percent to nearly 0 percent by 2006. During that same time, M2 growth fell from over 10 percent to around 2 percent and M1 growth fell from over 10 percent to negative rates. Admittedly the Fed’s control over the broader monetary aggregates has become quite attenuated, for reasons elucidated below. But even the year-to-year annual growth rate of the monetary base since 2001 fell from 10 percent to below 5 percent in 2006 and by June of 2008 was around 1.5 percent, despite Ben S. Bernanke’s alleged reflation. When all of these measures agree, it suggests that monetary policy was not all that expansionary during 2002 and 2003 under Greenspan, despite the low interest rates.

Greenspan Presented in a Less Flattering Light

I realize that these disputes may just further convince some readers that economics is not a science but rather an ideological contest in which each side throws its own set of lying statistics at the other. But even so, I will now use the same underlying data as the writers above, to reach the opposite conclusion: Greenspan allowed the monetary base to grow quite rapidly precisely when the housing boom shifted into high gear, and precisely when interest rates collapsed.

Before proceeding, I want to remind readers that my story is the textbook explanation of how the Fed operates. It is the writers above who are downplaying the Fed’s ability to push down interest rates or to “stimulate” (however temporarily and artificially) the economy. During the boom years, Greenspan and his fans wanted to take credit for his “merciful” low rates which allowed the United States to avoid a painful recession, but now Greenspan and his defenders want to claim that he was an innocent bystander in the face of Asian thrift and shortsighted bankers. In any event, on to the data, this time presented by the “prosecution” as it were.

First, let’s take McArdle and DeLong’s discussion of the injection of base money, and how it was too insignificant to cause the effects we have seen. According to DeLong, there was a $200 billion injection through open-market operations, and yet we have to explain $2 trillion in losses. Well, my first thought is that — as DeLong no doubt teaches his principles-of-macro students — our fractional-reserve system has a built-in multiplier. In particular, if the required reserve ratio is 10 percent, then a given injection of new reserves (through Fed purchases of securities) allows up to a tenfold increase in the quantity of new money. So with that rule of thumb, a $200 billion injection would be expected to have an impact of … $2 trillion.

Now let me anticipate an obvious response from DeLong. He could say, “OK fine, but that still makes no sense. Why would expanding the quantity of money by $2 trillion lead private investors to make so many bad loans?” That’s a good question, but it’s different from the issue of magnitudes. Even if Greenspan flooded the economy with $100 trillion in new money, it doesn’t automatically follow that investors should make dumb lending decisions. My point here is simply that this alleged (by McArdle and DeLong) quantitative mismatch is in fact perfectly adequate; Greenspan injected a lot more than a “smallish” amount of short-term capital, once we recall the nature of our fractional-reserve system.

Now when it comes to Henderson and Hummel, look again at their actual quotation above: they are trying to prove that monetary expansion was nothing unusual in 2002 and 2003, and to do this they quote the starting and ending annual rates of expansion in 2001 and then in 2006. But this is a bit like saying Keanu Reeves in the movie Speed didn’t drive recklessly, because, after all, the bus’s velocity was lower when he got off than when he first got on. To know if Greenspan had a tight or loose monetary policy during 2002 and 2003, it’s not enough to know that the policy in 2006 (when the boom was winding down, after all!) was lower than in 2001.

For the following chart, I have taken the annual averages of the monetary-base series (as compiled by the St. Louis Fed), and plotted the growth rates:

There are a few interesting features of the above graph. First, note that the growth rate in 2002 (8.7%) was higher than in 2001 (5.6%). (Henderson and Hummel may have given the opposite impression, because of the units involved. The base bounced around like crazy because of huge injections and then drainages because of Y2K and 9/11.) Second, note that the base growth in 2002 was about as high as any year from the 1970s, except 1979 (when base growth was 9.2%).[2] Everybody in this debate agrees that the 1970s were characterized by excessively loose monetary policy. It is hard to see then how Greenspan’s behavior during the serious onset of the housing boom can be described as moderate.

Before leaving this section, I should acknowledge that the graph above does seem puzzling in one respect: the growth in the base during the early 2000s is admittedly large by historical standards (even compared to the 1970s), but it is obviously not unprecedented. In particular, there were larger spikes during the 1980s and 1990s.

This is true, but I would remind the reader that there was a massive real-estate bust and stock-market crash in the 1980s as well, and of course the dot-com bubble in the late 1990s. The Austrians would blame those unfortunate events on the Fed (as well as other contributing causes) too.

Mortgage Rates Not Unusual?

The last claim we’ll analyze in this article is made by the excellent Chicago economist Casey Mulligan, who writes,

Another version of the subsidy hypothesis says that public policy encouraged low mortgage rates, which raised housing prices. I believe that housing prices would not have gotten so high if mortgage rates had been higher, but low mortgage rates may not explain why 2006 housing prices were so high relative to housing prices in 2003 or 2008. 30-year fixed-mortgage rates were around six percent per year for most of the boom, and continue to be about six percent.

No one is denying that there must be some endogeneity to the explanation of the housing bubble; after all, the federal-funds rate right now is just as low as under Greenspan, and nobody expects a housing bubble to develop. But again, I think Mulligan’s breezy claims about mortgage rates might give the reader a false impression. He is making it sound as if mortgage rates really have nothing to do with the onset of the boom, because after all they “were around six percent for most of the boom.” But in fact, the fall in mortgage rates fits in very well with the serious onset of the boom.

The following chart plots the 30-year conventional mortgage rate against year-over-year increases in the S&P/Case-Shiller Home Price Index:

Conventional 30-Year Mortgage Rates (Blue, Left)
vs. Year/Year Percentage Growth in Home Prices (Red, Right)
(monthly data)

Thirty-year mortgage rates plummeted from about 8.5% in mid-2000 to below 5.5% three years later. The connection certainly isn’t robotic, but this period also saw a spike in monetary base growth (thus leading us to suspect Greenspan’s influence, not just Asian savers) and the acceleration in the housing boom. On this last point, consider that mortgage rates dropped from about 7% down to about 5.5% from April 2002 to April 2003. Even with perfectly rational neoclassical consumers, that would be expected to raise home prices about 17%.[3] And lo and behold, over this same period the home price index rose about 14.5%.

In a follow-up post in the same Cato Unbound symposium, Mulligan makes an odd claim in his disagreement with White:

Perhaps Professor White would argue that market participants expected short term interest rates to remain low for much longer than a couple of years. If so, he is on shaky ground. First, such a claim is at odds with long-term interest-rate data. As I indicated in my article, long-term mortgage rates were not low during the housing boom. It’s not hard to find commentary from those years recognizing the low short-term rates were not expected to last. (emphasis added)

Again, this is one of those casual claims in the debate over the housing bubble that is liable to mislead some readers. Check out the following chart of 30-year mortgage rates:

As the chart above indicates, mortgage rates during the peak of the housing bubble were the lowest in the entire 37 years for which the St. Louis Fed keeps records. Perhaps Mulligan had in mind inflation-adjusted mortgage rates, but if so we’re stuck, because we don’t yet know what the correct, inflation-adjusted rates on 30-year mortgages were for any mortgages granted after 1978.

I ask the reader to once again look at the chart above. Is it really such a leap to think that perhaps Fed manipulation of interest rates might have something to do with the housing bubble?



Some Austrians are concerned that empirical exercises such as I have performed above will fall into the mainstream habit of aping the physicists, rather than developing a priori theories. However, we all know what the logical, verbal arguments of Mises and Hayek are, regarding the boom-bust cycle caused by central banks. The critics are claiming that this story doesn’t fit the facts. Hence, the only way to respond is to argue that the Misesian theory really does fit the facts.

Despite claims to the contrary, it appears that Alan Greenspan’s ultralow interest rates — which went hand in hand with monetary growth rates comparable to those of the 1970s — were at the very least a large contributing factor to the housing boom. I feel confident in claiming that the housing boom would not have occurred if money and banking had been left in the hands of the private sector, as opposed to the state-organized cartel that we currently “enjoy.”

Iraq rally for Bush shoe attacker

Sadr Protests for Iraqi TV journalist

Thousands of Iraqis have demanded the release of a local TV reporter who threw his shoes at US President George W Bush at a Baghdad news conference.

Crowds gathered in Baghdad’s Sadr City district, calling for “hero” Muntadar al-Zaidi to be freed from custody.

Officials at the Iraqi-owned TV station, al-Baghdadiya, called for the release of their journalist, saying he was exercising freedom of expression.

Iraqi officials have described the incident as shameful.

A statement released by the government said Mr Zaidi’s actions, which also included him shouting insults at President Bush, “harmed the reputation of Iraqi journalists and Iraqi journalism in general”.

Correspondents say the protesters are supporters of Shia cleric Moqtada Sadr – a leading critic of the US presence in Iraq. Smaller protests were reported in Basra and Najaf.


President Bush ducks as the shoes are thrown

The Iraqi government has demanded an on-air apology from his employer.

An Iraqi official was quoted by the Associated Press as saying that the journalist was being interrogated to determine whether anybody paid him to throw his shoes at President Bush.

He was also being tested for alcohol and drugs, and his shoes were being held as evidence, said the official, speaking on condition of anonymity.

The Cairo-based al-Baghdadiya TV channel said Mr Zaidi should be freed because he had been exercising freedom of expression – something which the Americans had promised to Iraqis on the ousting of former Iraqi leader Saddam Hussein.

“Any measures against Muntadar will be considered the acts of a dictatorial regime,” the firm said in a statement.

The programming director for al-Baghdadiya, Muzhir al-Khafaji, described the journalist as a “proud Arab and an open-minded man”.

He said he was afraid for Mr Zaidi’s safety, adding that the reporter had been arrested by US officials twice before.

“We fear that our correspondents in Iraq will be arrested. We have 200 correspondents there,” he added.

‘Proud Arab’

Mr Zaidi leapt from his chair at Sunday’s news conference and hurled first one shoe and then the other at Mr Bush, who was joined at the podium by Iraqi Prime Minister Nouri Maliki.

He [George Bush] deserves to be hit with 100, not just one or two shoes. Who wants him to come here?
A Baghdad resident

The shoes missed as Mr Bush ducked, and Mr Zaidi was immediately wrestled to the ground by security guards and frogmarched from the room.

“This is a farewell kiss, you dog,” he yelled in Arabic as he threw his shoes. “This is from the widows, the orphans and those who were killed in Iraq.”

Arabic TV stations have been repeatedly showing footage of the incident, which was also front-page news in many papers.

Correspondents say the journalist’s tirade was echoed by Arabs across the Middle East who are fed up with US policy in the region.

“He [George Bush] deserves to be hit with 100, not just one or two shoes. Who wants him to come here?” said a man in Baghdad.

But his view was not expressed by everyone.

“I think this incident is unnecessary, to be honest. That was a press conference, not a war. If someone wants to express his opinion he should do so in the proper manner, not this way,” said another Baghdad resident.

Courts criticised

Also on Monday, Human Rights Watch accused Iraq’s main criminal court of failing to meet basic international standards of justice.

The New York-based group said torture and abuse of prisoners before trial appeared common, and legal representation was often ineffectual.

Human Rights Watch said some of the court’s failings showed disturbing similarities to those that existed during the Saddam Hussein era.

The group called on Iraq to take immediate steps to protect detainees from torture, and ensure they had access to proper defence and received a prompt hearing.

Banks hit worldwide by US fraud

Bernard Madoff in 1999 - AP Photo/The New York Times, Ruby Washington

Mr Madoff is the former chairman of the Nasdaq stock exchange

Some of the world’s biggest banks have revealed that they are victims of a fraud which has lost $50bn (£33bn).

Bernard Madoff has been charged with fraud in what is being described as one of the biggest-ever such cases.

Among the banks which have been hit are Britain’s HSBC and RBS, Spain’s Santander and France’s BNP Paribas.

One of the City’s best-known fund managers has criticised US financial regulators for failing to detect the alleged fraud.

Meanwhile the Serious Fraud Office (SFO) has called on workers, former staff and shareholders to come forward with evidence of any corporate wrongdoing in the wake of the credit crunch.

‘Financial scandal’

Nicola Horlick, boss of Bramdean investments, told the BBC: “I think now it is very difficult for people to invest in things that are meant to be regulated in America, because they have fallen down on the job.”


“This is the biggest financial scandal, probably in the history of the markets – $50bn is a huge amount of money,” she said.

Banks and financial institutions across the world had investments with Bernard Madoff, but not all have yet confirmed what their potential losses might be.

Among the largest potential losers so far is Spain’s largest bank, Santander, which also owns the UK High Street banks Abbey, Alliance & Leicester and Bradford & Bingley.

A fraudulent investment scheme paying investors from money paid in by other investors rather than real profits
Named after Charles Ponzi who notoriously used the technique in the United States in 1903
Differs from pyramid selling in that individuals all tend to invest with the same person

One of its funds had $3.1bn invested in the firm run by Bernard Madoff

Britain’s HSBC said it had investments of about $1bn which could be affected.

Royal Bank of Scotland said it could potentially lose about £400m ($601m) if all its investments had to be written off.

The French bank, Natixis, a subsidiary of Caisse d’Epargne and Banque Populaire, said it could potentially lose up to 450m euros (£402m; $605m).

One of the world’s biggest investment groups, Man, said it had invested about $360m through its RMF institutional fund of funds business, representing 0.5% of its total funds

‘Systemic failure’

Meanwhile, some of the biggest private losers seem to have been members of the Palm Beach country club, where many of Mr Madoff’s wealthy clients were recruited.

Santander, Spain – $3.1bn
HSBC, UK – $1bn
Natixis, France – $605m
Royal Bank of Scotland, UK – $601m
BNP Paribas, France – $460m
BBVA, Spain – $400m
Man Group, UK – $360m
Reichmuth & Co, Switzerland – $325m
Nomura, Japan – $303m

According to some reports, the list of prominent victims include a New Jersey Senator, the owners of the New York Mets and the charities run by film director Stephen Spielberg and Nobel Prize winning writer Elie Wiesel.Mrs Horlick said 9% of Bramdean’s own funds were invested with Mr Madoff, but that even if the money was written off, the fund involved would be down just 4%.

“I just want to make it clear to investors that even after this, they they would have done extremely well, relative to anything else they could have invested in,” she said.

In a statement, Bramdean said: “”The allegations made appear to point to a systemic failure of the regulatory and securities markets regime in the US.”

However, some argued that the fund managers should themselves have done more.

“City figures cannot call for light touch regulation yet at the same time complain that regulators missed risks that the industry failed to spot,” said Simon Morris, a partner with City law firm CMS Cameron McKenna.

The collapse of Madoff is likely to accelerate the disappearance of hedge funds
Robert Peston

“It’s the unequivocal job of the fund manager to check out the bona fides of whoever they chose to pass their customers’ money onto,” he said.Correspondents say the case is likely to fuel uncertainty about the entire hedge fund industry.

Meanwhile one of the City’s watchdogs, the Serious Fraud Office (SFO) called on whistleblowers to come forward with evidence of corporate wrongdoing in the wake of the credit crunch.

The Serious Fraud Office said it wanted workers, former staff and shareholders to step up with information over suspected fraud in the current financial turmoil.

Director Richard Alderman said: “Our objective is to ensure that we can bring offenders to justice as quickly as possible.”

High returns promised

US prosecutors say Mr Madoff, a former head of the Nasdaq stock market, masterminded a fraud of massive proportions through his hedge fund and investment advisory business.

Mr Madoff is alleged to have used money from new investors to pay off existing investors in the fund.

A federal judge has appointed a receiver to oversee Mr Madoff firm’s assets and customer accounts, while the 70-year-old banker has been released on $10m bail.

Mr Madoff founded Bernard L Madoff Investment Securities in 1960, but also ran a separate hedge fund business.

According to the US Attorney’s criminal complaint filed in court, Mr Madoff told at least three employees on Wednesday that the hedge fund business – which served up to 25 clients and had $17.1bn under management – was a fraud and had been insolvent for years.

He said he was “finished”, that he had “absolutely nothing” and “it’s all just one big lie”, and that it was “basically, a giant Ponzi scheme”, the complaint said.

If found guilty, US prosecutors say he could face up to 20 years in prison and a fine of up to $5m.

Sunday, December 14, 2008

Internet Attacks Are a Real and Growing Problem

A new report says cyberwar isn’t science fiction.

In the 1960s, the Pentagon looked for a secure way to keep its lines of communication going in the event of all-out war. The interlinked packet networks of computers became the Internet. Fast-forward to today, and that system of open protocols brings the enormous benefits of the Web to civilian life. But the Web has also become an open field for cyber warriors seeking to harm the U.S.

We’re only now realizing that many of these attacks have happened, as evidence mounts that outsiders accessed sensitive government networks and other databases. A report based on closed-door information about cyber attacks reached a sobering conclusion: Foreign governments and terrorist groups are focused on cyber offensives in a “battle we are losing.”

Last week’s Center for Strategic and International Studies report disclosed that the departments of Defense, State, Homeland Security and Commerce all have had intrusions by unknown foreign entities. The Pentagon’s computers are probed “hundreds of thousands of times each day.” An official at the State Department says terabytes of its information have been compromised. The Commerce Department’s Bureau of Industry and Security had to go offline for several months. NASA has stopped using email before shuttle launches. Jihadist hackers are trying to confuse military computers into mistaking the identities of friendly and unfriendly forces in Afghanistan and Iraq.

The quasigovernmental commission revealing these cyber attacks is made up of private-sector information executives, military and intelligence officials, and two members of Congress. The study found that no department knew the extent of damage done to other departments. The extent of the harm is not known.

“The organization of the federal government, which dates to the 1930s or earlier, is part of the reason we are vulnerable,” says the report. “Our industrial-age organization makes a cyber-dependent government vulnerable and inefficient. A collection of hierarchical ‘stovepipes’ is easier to attack and harder to defend because security programs are not of equal strength (the weakest link compromises all) and stovepiped defenders cannot appreciate the scope of, and respond well to, a multiagency attack.”

As the first to build out an Internet grid, the U.S. is more vulnerable than countries that have built their infrastructure later. China, for example, constructed its Internet much later, on a more secure set of protocols. “Many Americans believe that our nation still leads in cyberspace, just as many Americans in 1957 believed that the U.S. led in space until a Soviet satellite appeared over their heads,” the study says.

It’s telling that the U.S. doesn’t have a publicly stated doctrine on cyber defense that warns enemies and commits to taking action in response. Likening today’s issues to the Cold War, the report says there should be clear rules about who will be punished how for what. It’s in the nature of cyber attacks that it’s hard to know exactly who’s responsible, but some response must be made. “These uncertainties limit the value of deterrence for cybersecurity,” the report says. “The deterrent effect of an unknown doctrine is quite limited.”

One problem is that Russia and China are the main suspects, but the U.S. defense establishment hesitates to say so too loudly. It’s true that few cyber attackers are ever clearly identified. No one knows for sure who brought down the Internet in Estonia in 2007, when Moscow was outraged when a Soviet-era war memorial was relocated in Tallinn. Or who was behind the cyber attacks that virtually shut down government communications and financial transactions in the former Soviet republic of Georgia earlier this year. Likewise, many foreign visitors had their PCs and BlackBerrys compromised during the Olympics in Beijing, where cybersnooping equipment is widely available.

Data are lost, communications are compromised, and “denial of service” attacks bring down selected Web sites and national networks. Supposedly confidential corporate information, the report warns, is almost certainly being hacked. As more individuals and companies rely on “cloud computing” — storing information and services such as email remotely on supposedly secure servers — foreign intelligence agencies and commercial snoops may have access.

A former official at Darpa, the Pentagon research agency that launched the Web, testified to Congress last year that a major cyber attack on the U.S. could knock out electricity, banking and digital-based communications. Americans would be left rooting around for food and water, trading with one another for firewood (presumably not on eBay). Even if end-of-the-world visions are overdone, it’s past time to assess risks and justify countermeasures.

The report has recommendations for the Obama administration, including a new government structure for cyber protection and working more closely with the private sector on security research. The broader point is that it’s about time that we knew the extent of the cyberwarring against us. The first step to fighting back is to admit that there’s a fight on.

Madoff and Markets

Shakespeare is a better investor than the SEC.

Capitalism runs on trust, so inevitably there will be men like Bernard Madoff who attempt to steal from the trusting. His alleged $50 billion Ponzi scheme is exceptional mainly for its size, the length of time he was able to run his con, and the affluent and sophisticated circles in which he operated. There is something especially shocking when a man held in high esteem turns out to be a thief.

[Review & Outlook] Splash News

Bernard Madoff.

Among the stranger arguments in the wake of Mr. Madoff’s disclosure is that this proves the case for regulating hedge funds. Huh? Hedge funds were among the main victims here, along with well-heeled individual investors, nonprofit endowment funds and foreign financial companies.

As a broker-dealer, Mr. Madoff’s firm was already heavily regulated, and news reports say the Securities and Exchange Commission investigated him in 1992 without finding anything wrong. The SEC said in a statement Friday that its New York staff also conducted inquiries into Mr. Madoff’s firm in 2005 and 2007. Mr. Madoff’s separate investment company registered with the SEC in 2006, which is all that hedge funds would have had to do under the SEC’s proposed (but failed) hedge-fund rule of a few years back.

In the wake of Enron, Congress also gave the SEC more money and people, as well as new political motivation, to pursue wrongdoers. And Mr. Madoff also operated in New York, under the supposedly watchful and relentless eye of former Attorney General Eliot Spitzer.

Yet Mr. Madoff pulled off his alleged con despite all of this market supervision. We are now supposed to believe that the same SEC lawyers who couldn’t detect a fraud at a firm for which they were directly responsible would somehow have done so if only they had been able to examine other hedge funds that invested in Madoff Securities. Thus does every enforcement failure become an excuse for more enforcement, especially among law-school professors and journalists who specialize in hindsight. Mr. Madoff, by the way, was a big donor to Democrats who favor tougher financial regulation. Perhaps that was also part of his strategy to avoid more scrutiny.

The reality is that it is impossible for the SEC or any regulator to prevent every financial fraud, just as it is impossible for city police to prevent every burglary. If even Mr. Madoff’s two sons claim not to have known about the scheme, despite working at the firm for decades, how can we expect outside regulators to do better?

Mr. Madoff’s investors will in retrospect kick themselves for not asking more questions, especially about the remarkable consistency of his returns over the years, his apparently fly-by-night auditing shop, and his small trading book despite having so much money under management. But the broker’s long record of showing gains and years of rising stock prices no doubt provided reassurance. The 70-year-old Mr. Madoff wasn’t some dot-com upstart but a pillar of the community and philanthropist. The best con men are always those you least suspect.

The real lesson here is about men, not markets. Human nature doesn’t change, and crooks will always be with us. For investors the lessons are the eternal ones of diversification and diligence. Don’t trust your life savings with any single money manager or investment. Don’t assume that passing some new federal law will banish financial fraud, any more than “campaign finance reform” will stop the likes of Rod Blagojevich from trading political favors for money. As Shakespeare understood, the fault is not in our stars, but in ourselves.

Innocents Die in the Drug War

Of all the casualties claimed by the U.S. “war on drugs” in Latin America, perhaps none so fully captures its senselessness and injustice as the 2001 CIA-directed killing of Christian missionary Veronica Bowers and her daughter Charity in Peru.

[The Americas] Reuters

Roni Bowers and her infant daughter Charity (seated second from right).

No one is suggesting that the CIA intentionally killed Mrs. Bowers and her baby. It was an accident. But according to Rep. Pete Hoekstra (R., Mich.), it was an accident waiting to happen because of the way in which the CIA operated the drug interdiction plan in Peru known as the Airbridge Denial Program. Mr. Hoekstra says the goods to prove his charge are in a classified report from the CIA Inspector General that he received in October.

Under the program, initiated by President Clinton, the CIA was charged with identifying small civilian aircraft suspected of carrying cocaine over Peru on a path to Colombia, and directing the Peruvian military to force them down.

Mary Anastasia O’Grady talks to Kelsey Hubbard about the collateral damage caused by the CIA’s fight against drug trafficking.

Strict procedures were put in place to minimize the risks to innocents. But after viewing the IG report, Mr. Hoekstra — the ranking member of the House Intelligence Committee — says that it is clear that those procedures had gone out the window long before the April 20, 2001 tragedy.

On that day the Bowers family was flying in a single-engine plane over the Amazon toward their home in Iquitos. Mrs. Bowers was holding the infant on her lap when a bullet fired by the Peruvian Air Force, under direction of the CIA, hit the aircraft, traveled through her back and into Charity’s skull. The plane crash-landed on the Amazon River. Mr. Bowers, his young son and the pilot survived. Neither the plane nor its passengers were found to be involved in any way in the drug business and initial reports said that the mistaken attack was a tragic one-time error.

The Americas in the News

Get the latest information in Spanish from The Wall Street Journal’s Americas page.

The IG report looked at the Airbridge Denial Program from its inception in 1995 until its termination in 2001 and took seven years to complete. In statements to the press last month Mr. Hoekstra said it demonstrates every one of the 15 “shootdowns” that the CIA participated in over the life of the program had “violations of required procedures.” He also said that the report “found that CIA officers knew of and condoned the violations, fostering an environment of negligence and disregard for the procedures.”

Equally troubling, the congressman says, is the IG finding that after the tragedy there was an attempt to cover up what had been going on in Peru. He has also said that the IG report finds that there were “unauthorized modifications” made to “the presidentially mandated intercept procedures by people who had no authority to do so” and that “there was effectively no legal oversight of the program.” He further charges that “there is evidence that CIA officials made false or misleading statements to Congress,” and that “the CIA denied Congress, the NSC [National Security Council] and the Department of Justice access to key findings of internal reviews that established and documented the sustained and significant violations of the required procedures.”

“It was a rogue operation,” he told me by telephone on Tuesday. “They knew they weren’t following the rules, and they never did anything about it. They were callous about it.” When I asked him to explain further, he said: “My take on this is that they became obsessed with the mission.”

The CIA says that director Michael Hayden has “recognized the seriousness of [the report’s] findings” and “is absolutely committed to a process looking at systemic issues and accountability that is as thorough and fair as possible.” The office of House Intelligence Committee Chairman Silvestre Reyes (D., Texas) won’t comment on the report. But Mr. Hoekstra is calling for more of it to be declassified and for the Justice Department to review “whether further criminal investigation is warranted.”

Yet to honor the memory of Mrs. Bowers and her daughter and spare innocent lives in the future, a broader discussion in Congress about U.S. drug policy in the region is needed.

Consider the fact that Mr. Clinton’s justification for the Airbridge Denial Program was that drug trafficking was a threat to Peruvian national security. Of course it was: Prohibition naturally produces powerful criminal networks that undermine the rule of law. But as a 2001 Senate Intelligence Committee report found, the drug runners learned to avoid detection by altering their routes via Brazil. It also found that while Peru’s coca business shrank, Colombia’s took off.

Since then, U.S. interdiction has put the pressure on Colombia and the problem is now resurging in Peru. The latest reports are that Mexican cartels are teaming up with remnants of the Shining Path terror network to rebuild the business, proving once again the futility of the supply-side attack as a way of minimizing drug use in the U.S.

Bush arrives in Kabul for talks

George Bush addresses US troops at Bagram air base, Afghanistan (15 December 2008)

Hundreds of US troops greeted Mr Bush with cheers at Bagram air base

US President George W Bush has arrived in Afghanistan on a surprise visit, his last before stepping down in January.

Mr Bush addressed US troops at Bagram air base before leaving for talks with his Afghan counterpart, Hamid Karzai.

He said Afghanistan was a “dramatically different country than it was eight years ago”, when US-led forces invaded.

Mr Bush flew to Afghanistan from Iraq, where a news conference was disrupted when an Iraqi TV journalist threw his shoes and shouted insults at him.

The president ducked and just missed the shoes, which hit the wall behind. The journalist was wrestled to the floor by security guards.

During the trip, Mr Bush and Iraqi Prime Minister Nouri Maliki signed a new security agreement between their countries, which paves the way for the withdrawal of US troops from Iraq by 2011.

‘Hopeful gains’

President Bush was met at Bagram air base, north of Kabul, early on Sunday by Gen David McKiernan, the US commander of Nato-led troops in Afghanistan.

He was then led into a giant white tent, where hundreds of US troops greeted him with cheers as he thanked them for serving.

The degree of difficulty is high. It’s hard. Nevertheless the mission is essential
US President George W Bush

“I am confident we will succeed in Afghanistan because our cause is just,” he said in a speech.

“Afghanistan is a dramatically different country than it was eight years ago,” he added. “We are making hopeful gains.”

Mr Bush said he recognised that more troops were needed in the country and that he supported President-elect Barack Obama’s pledge to increase numbers.

He also said it was important to continue working with Pakistan so that pressure was kept on militants based along its border with Afghanistan.

US soldiers in Khost province, Afghanistan (15 November 2008)

Mr Bush said he recognised that more troops were needed in Afghanistan

“If Pakistan is a place from which people feel comfortable attacking infrastructure, citizens, troops, it’s going to make it difficult to succeed in Afghanistan,” he said.

“The more we can get Pakistan and Afghanistan to co-operate, the easier it will be to enforce that part of the border regions.”

Speaking on Air Force One en route to Afghanistan, Mr Bush told reporters that his country’s goal there was similar to the one in Iraq – to let the new democracy develop its institutions so that it could survive on its own.

“The degree of difficulty is high. It’s hard. Nevertheless the mission is essential,” he said.

“We cannot… achieve our objective of removing the safe havens, kicking out the Taleban, and say: ‘OK, now let’s leave’,” he added.

‘Goodbye kiss’

While visiting Baghdad on Saturday, Mr Bush said the war in Iraq was not yet over and that much work still needed to be done there.

If you want the facts, it’s a size 10 shoe that he threw
US President George W Bush

“The work hasn’t been easy but it’s been necessary for American security, Iraqi hope and world peace,” he said during talks with President Jalal Talabani.

The Iraqi leader called Mr Bush “a great friend for the Iraqi people, who helped us liberate our country”.

Later, Mr Bush signed a security pact with Prime Minister Maliki which calls for US troops to be withdrawn from Iraq by the end of 2011. They are first to withdraw from Iraqi cities by June next year.

But in the middle of a news conference with Mr Maliki in the Green Zone, Iraqi television journalist Muntadar al-Zaidi stood up and shouted “this is a goodbye kiss from the Iraqi people, dog,” before hurling a shoe at Mr Bush which narrowly missed him.

With his second shoe, which the president also dodged, Mr Zaidi said: “This is for the widows and orphans and all those killed in Iraq.”


President Bush ducks as the shoes are thrown

Mr Zaidi, a correspondent for Cairo-based al-Baghdadiya TV, was then wrestled to the ground by security personnel and hauled away.

“If you want the facts, it’s a size 10 shoe that he threw,” Mr Bush joked afterwards.

Correspondents say showing the soles of shoes is a sign of contempt in Arab culture. Iraqis threw shoes and used them to beat Saddam Hussein’s statue in Baghdad after he was overthrown in 2003.

Mr Bush’s unannounced visit to Baghdad came a day after Defence Secretary Robert Gates told US troops that the Iraq mission was in its “endgame”.

The BBC’s Sarah Morris in Washington says the presidential trip to Iraq and Afghanistan was planned with meticulous secrecy.

The accompanying journalists were asked to tell no-one other than a superior and their spouse. The White House even published a false schedule of events.

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