We are all Kerviel Madoff

And so it goes. From the FT.

Investors around the world were rushing on Friday to assess potential losses from what could be Wall Street’s biggest fraud – a multi-billion-dollar scheme allegedly perpetrated by investment manager Bernard Madoff.

The case threatens to stoke fears among investors and encourage withdrawals from hedge funds struggling to raise cash to meet redemptions. …

“These people went to sleep Wednesday night thinking they had a comfortable retirement and now they are thrown into a spiral of horror,” said Stephen Weiss, a lawyer representing people who had invested a combined $1bn with Mr Madoff. “Some of these people don’t know how they are going to pay their mortgage.”

The number being bandied around is $50 billion.

Scroll back 10 months. At that point, the world was horrified that fraud by a young French trader, Jerome Kerviel, had cost one of Europe’s biggest banks $7 billion. How could this happen? As I wrote then

Kerviel — speculating wildly, way beyond his limits, hiding his speculation from everyone with a series of offsetting paper trades — is a near perfect metaphor for our entire economy. Everyone is in on it and nobody wants to look too closely at how rotten the whole scheme is.

With Madoff’s fraud, the trend becomes ever more evident. Multiple giant hedge funds were happy pad their portfolio’s with his easy, steady returns: borrow at 5% and get a guaranteed 10% return year-in and year-out? Why not do a couple billion of that trade? The SEC, which got multiple tipoffs that Madoff’s business was giga-Ponzi scheme, failed to follow through. The old idiot had to turn himself in.

There’s a pattern here people. Kerviel loses $7 billion in February; Madoff loses $50 billion in December. Citigroup asks for $25 billion in government aid; then 6 weeks later needs $300 billion. The government asks for $700 billion to bailout banks, then lends them $2 trillion behind the scenes.

The rule of thumb is add a zero every 6 to 12 months. Where does the next zero take us?

As I mentioned a few weeks back, it’s $65 trillion. That’s the size of the credit default swap market, the hidden metastatic cancer that oozes through every pore of our financial system. At some point soon, that sinkhole is going to swallow all the girders we’ve bolted together around its borders, all the concrete we’ve tried to pour to stabilize the inexorable earthward sucking.

We’re engaged in a game of mutual self-deception — things can’t be that bad. Can they?

Can they?

Yes.

We’re living a giant Ponzi scheme.

House buyers knowingly and eagerly borrowed more than they could afford, believing that some new sucker would come to bail them out of their houses.

Banks knowingly lent money to uncredit-worthy borrowers in the pursuit of next quarter’s bonus.

Insurance companies and other premium hungry miscreants wrote insurance promises against the failure of other businesses, called Credit Default Swaps (CDS), creating liabilities that far exceed their assets. These liabilities don’t offset each other, they are lined up like dominoes and will tumble quickly when the right wind blows. The hand of God would not be powerful enough to turn back the tsunami of defaults that a few large defaults will set off. (In total, CDS liabilities are $65 trillion, five times bigger than the entire US GDP.)

Now, governments give “temporary” aid to banks that are known to have irreparable (unless there’s a violent paroxysm of inflation) holes in their balance sheets. Free market Republicans grab money intended to shore up housing prices to bailout automakers. Bernanke says, in almost as many words, that we’ll just have inflate our way out of housing defaults.

Prudent folks will head for the hills or prepare for hyperinflation.

Others will just keep grinning like Madoff’s investors when they went to bed last Thursday night.