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Stanford Takes Page from Ponzi Playbook

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Texas financier accused of $8 billion fraud.

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It turns about Bernie Madoff wasn't the only one cooking the books: Texas banking icon R. Allen Stanford is the latest to be charged with a massive, multi-billion dollar fraud.

In a story conveniently drowned out by President Obama's signing of the $789 billion economic stimulus package and the auto industry's latest plea for taxpayer money, the Securities and Exchange Commission raided Stanford's Houston headquarters yesterday morning, alleging he perpetrated an $8 billion fraud based on "false promises and fabricated historical data."

According to the Wall Street Journal, Stanford lured in investors by promising steady, safe returns for cash deposited in a bank he owns in Antigua, one of the many Caribbean banking havens. Instead of investing in liquid, low-risk assets as promised, Stanford allegedly funneled the money into high-risk private equity and real estate deals. Oversight was scant, as decisions were reviewed by 2 people: the bank's chief financial officer, James Davis, and Stanford himself.

Much like Madoff's much-publicized Ponzi scheme, consistently high returns that seemed impervious to market gyrations were the hallmark of Stanford's scam.

The SEC claims Stanford International Bank returned between 6-10% from 1992-2006 on its certificates of deposit, or CDs. Yields on comparable investments issued by American banks like JPMorgan (JPM), Bank of America (BAC) and Wells Fargo (WFC) are significantly lower - but carry FDIC insurance to protect depositors from loss.

Strong returns on its investment portfolio, Stanford claimed, allowed the bank to pay out the oversized returns. In 2008, a year that saw the S&P 500 lose 39%, the bank said its portfolio lost just 1.3%.

The SEC says Stanford used these inflated returns to woo investors, many of which hailed from Latin American countries. Shaky banks in South America led many wealthy individuals to invest with Stanford, believing he could earn them strong returns with little risk.

But as their North American counterparts have learned from the ongoing Madoff affair: Where there's return, there's always risk.

This lax attitude towards risk, one that was fostered for decades by the Federal Reserve's overly accommodating monetary policy, was instrumental in sowing the seeds of our current financial crisis. It also helps explain how so many investors around the world were so easily duped by cons that, in retrospect, seem so easy to identify.

"Malinvestments," a term popularized in recent years by Texas Congressman Ron Paul, occur when cash is poured into assets that return a yield that isn't commensurate with their risks.

When times are good, losses remain low and Washington comes to the rescue of the financial industry every time it gets into trouble, investors become accustomed to earning high rates of return without taking much risk. As this belief becomes the status quo, more and more money is funneled towards these seemingly low-risk, high-return opportunities.

Peddlers of financial instruments, from Madoff and Stanford to Goldman Sachs (GS) and Morgan Stanley (MS), dream up increasingly complex places for investors to park their money. Risk, they claimed, was as low as ever, thanks to their financial wizardry.

When real losses did occur, loan defaults began to rise, and the government wasn't deft enough to stem the tide, investors got burned. Badly.

Assets that suddenly become very risky lost value rapidly, since they carried such a low rate of return. Losses beget losses, which beget more losses. We all know how the story ends.

Meanwhile, even as it acted as enabler to Wall Street's (and Main Street's) incessant greed, the federal government now insists on pointing fingers and acting as savior for a system it was complicit in creating.

Where was the SEC to root out Madoff and Stanford before investors lost billions? Where was the Federal Reserve to act on its own findings about the risks of exotic mortgage lending?

Yet, even now, we're counting on these same institutions and politicians to invest nearly $1 trillion of our money to rescue us.

How low-risk is that investment strategy?
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