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Making Off Like Madoff

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Right after Barack Obama was elected president, I followed his lead and began reading books on Franklin D. Roosevelt and the Great Depression. Like the president-elect, I wanted to know what lessons history had for dealing with our dire economic crisis.

Much of our current crisis stems from the financial sector: risky derivatives, corrupted credit ratings agencies, and worthless mortgage-backed securities. I just read a terrific book that reminded me that history has important lessons to teach us here too. Time has come to heed them.

The Match King: Ivar Kreuger, The Financial Genius Behind a Century of Wall Street Scandals, by Frank Partnoy, tells the story behind one of the greatest scam artists the country has ever known. Ivar Kreuger was a financial whiz who, in the 1920s and 30s ran the largest match company in the world. Before lighters were commonplace, little wooden matches were one of life's essentials. From these small bits of wood, Kreuger built an empire.

The only problem was that the financial foundation of that empire was as ephemeral as the smoke from one of those matches.

Modern day "credit default swap" traders have nothing on Kreuger. The Swede was able to raise tons of money from Wall Street investors with little more than a prestigious investment bank's endorsement. For years, he refused to reveal any substantive information about his companies' assets and liabilities. And yet Wall Street investors, even the most sophisticated among them, bought more and more of his stock. The less he told, the more he sold.

That's one of the amazing things about Wall Street: investors don't seem to care that they can't understand the value of an asset. The fact that it can't be accurately valued seems to be the reason people buy it. Check out the dictionary under "Enron" or "Derivatives."

Part of the reason Kreuger was able to woo the best and the brightest was that they thought he was even smarter then them. And in many ways, he was. Partnoy shows how Kreuger developed new financial instruments that no one had ever seen before -- off-balance sheet entities and off-shore liabilities -- which made investors swoon, even though they didn't know what they were buying. These "innovations" made it appear that investors had nothing to lose and riches to gain.

The Match King, as Kreuger was known at the time, owed much of his success to guaranteed money. Like Bernie Madoff decades later, he promised investors double digit returns annually. And just like Bernie Madoff, he delivered year after year.

That it was too good to be true didn't really matter -- until the day of reckoning came.

Like a Palm Beach Ponzi scheme, Kreuger used newly raised money to pay off older investors. That works fine unless the market crashes and there is no more new money coming in. Then you have to turn yourself in to authorities.

One of the most important lessons the Match King's story teaches us is that we can't wait for market crashes to reveal the frauds and the abusers of our financial system. Wall Street in the 1920s and Wall Street in the 1990s both had one major problem: remarkably deficient regulatory oversight. There was no one to stop the madness of the markets.

We're now faced with rebuilding our financial system. A good place to start would be Partnoy's engrossing book on Ivar Kreuger. Let's hope President Obama learns the lessons of the Match King before completing his reforms.

Maybe I'll send him a copy.