Associated Press, 01.28.10, 01:06 PM EST

The merger puts one of the credit crisis's good guys under pressure.

For years there were whispers on Wall Street about Bernard Madoff’s hedge fund. The cynics said the returns were too good, too steady and Madoff’s operation always looked too slim for the tens of billions of dollars it was managing. But given Madoff’s more than four-decades of experience as trader and past service as chairman of the Nasdaq Stock Market the wealthy kept giving him their money.

Well, it looks like those concerns were right all along now that federal prosecutors have charged the 70-year-old Madoff with securities fraud, in what could amount to one of the biggest Wall Street scams ever. Securities regulators, in a civil complaint, say Madoff’s scheme may have cost investors up to $50 billion—although that figure appears to be based on Madoff’s own bravado. At a minimum, it appears the $17 billion Madoff was managing earlier this year may be gone.

The allegations against Madoff describe a classic Ponzi scheme, in which money is taken in from new investors to pay out money to earlier investors. Madoff, authorities allege, even told his sons earlier this week that the hedge fund was nothing more than “a giant Ponzi scheme.’’

It didn’t take long for investors in Madoff’s fund to begin crying foul. Hours after the news of Madoff’s arrest broke, investors were contacting lawyers to determine how they can get their money back—assuming there is any money left over. The Securities and Exchange Commission is moving to appoint a receiver to take control of the Madoff fund to protect whatever assets remain. Scott Berman, a lawyer who represents a number of Madoff investors, says the fear in a case like this is that the investors will be left “fighting over the crumbs.”

It’s way to soon to know how long the alleged scheme had been going on, although authorities allege it began years ago, after Madoff tried to cover up for past losses. But it appears Madoff ultimately was unmasked by the worst financial crisis since the Great Depression. Just like many hedge fund operators, Madoff received a wave of redemption notices in recent months, from investors looking to preserve cash. Authorities say investors sought to pull-out some $7 billion from the fund—money Madoff apparently did not have.

In the end, most Ponzi schemes collapse when too many investors seek to pull their money out at the same time, and the operator doesn’t have the cash on hand. Many a scheme has failed when the markets turn south. One potential red flag that investors failed to notice along the way is that the hedge fund was being audited by a small outfit in Rockland County, NY—not one of the large accounting firms.

But the financial crisis appears to be hastening the unwinding process of potential scams, as it has dried-up all sources of liquidity. Banks are unwilling to lend and investors are fleeing hedge funds, stocks, bonds, commodities and other asset classes for the safety of cash.

In September, another alleged Ponzi scheme collapsed, when federal prosecutors arrested Minnesota businessman Tom Petters. Federal prosecutors allege that much of Petters’ empire, which consisted of buying up distressed businesses, was based on a series of lies. He’s been charged with bilking some six-dozen hedge funds out of $3 billion. Petters’ alleged scheme came undone when some of the hedge funds that lent him money had gotten redemption requests from their investors and began asking Petters to pay-off his debt. Just like Madoff, Petters apparently couldn’t come up with the cash. Several of the hedge funds that lent money to Petters are in tatters, and some are shutting down.

A lack of liquidity may have been behind the bizarre scheme involving New York attorney Marc Dreier. Earlier this week, federal prosecutors charged the high-profile attorney with allegedly scamming several hedge funds into giving him up to $100 million by selling shares in what appears to be a fraudulent real estate venture. It appears Dreier’s 250-lawyer firm was running low on cash and had failed to make payments on a bank loan.

As the financial crisis deepens, don’t be surprised if other scams get flushed out in the coming weeks and months.

Michael Austin

Over risotto at Ca' Brea, former Sony (SNE) Pictures Chairman Peter Guber is lamenting the state of his industry. A movie he's trying to get made is in limbo, held up by a bank that wants him to put up more money before making a deal. "No one wants to lend money these days for an asset that will take months to create," Guber says, before rushing off to plead with his banker.
Over risotto at Ca' Brea, former Sony (SNE) Pictures Chairman Peter Guber is lamenting the state of his industry. A movie he's trying to get made is in limbo, held up by a bank that wants him to put up more money before making a deal. "No one wants to lend money these days for an asset that will take months to create," Guber says, before rushing off to plead with his banker.

Like the rest of Hollywood, Guber is discovering that Los Angeles' Dream Factory is not immune when the rest of the country slips into recession. Cinemas around the U.S. are selling fewer tickets. DVD sales, a major profit engine, are tanking. And within weeks, the Screen Actors Guild may authorize a strike that could throw Hollywood into its second work stoppage in a year.

It's hard to spot the worry lines when half the town is botoxed. But the angst is there. Yes, television production is booming. But a lot of that activity is the networks and studios playing catch-up after losing 14 weeks to the writers' strike that shut down Hollywood earlier this year. And while some wonder whether SAG would actually strike at a moment of such economic vulnerability, the studios are quietly pulling back. They are slower to green-light pricey films, and the networks are ordering shows without expensive pilots.

Even before the economy went off the rails, studios were making fewer movies. Box office tracker Media by Numbers says they will release about 450 films this year, 67 fewer than in 2007. Next year there will be even fewer. Paramount (VIA) has said it will make 20 films each year, not 25. Time Warner (TWX) shut its New Line Cinema unit. Meanwhile, even leviathans are having trouble funding movies. Steven Spielberg's DreamWorks SKG has been talking to banks for weeks about how to structure a $750 million line of credit.

COMPETING LOCATIONS
To make matters worse for the Los Angeles economy, cash-strapped states are using hefty tax incentives to lure away films and TV shows. In late November, Illinois passed a 30% tax credit to woo productions (Michigan already has a 40% credit), and earlier this year New York upped its credit to 35%. Los Angeles has since lost two TV shows to New York: HBO's (TWX) In Treatment and ABC's (DIS) Ugly Betty. "L.A. needs to do more, or this will keep happening," says Ugly Betty creator Silvio Horta. "Sooner or later, Hollywood will just be a state of mind, not an actual location for productions."

Back in California, an alarmed Governor Arnold Schwarzenegger is urging the state legislature to pass its own sweeteners. His plea comes as some studios are starting to lay off people. NBC Universal is whacking its budget by $500 million, and staff there are bracing for pink slips. Lions Gate Entertainment (LGF), which produces AMC's (AC) Mad Men, laid off 41. And just before Thanksgiving, The Weinstein Co. let go 24 people, or 11% of its staff.

The economic situation in Hollywood is hardly as dire as it is in, say, the Midwest. But then, Tinseltown has long prided itself as being recession-proof. "This is nuts," says an actor-turned-waiter named Justin. "It's like we're in the auto industry."

Credit card defaults could rise to 10% in the next quarter, as borrowers throw in the towel and stop chasing lifestyles they can't afford.

This is likely just a preamble for 2009, when default rates could spike much higher, according to Innovest Strategic Value Advisors. But even the 10% figure is much higher than previously anticipated, and credit cards could follow mortgages as the next great calamity.

The surprise is that the credit card industry's own belated attempts to whip itself into shape are causing the damage, according to Laura Nishikawa, an analyst at Innovest. She noted that credit card issuers are helping drive debtors into default by reducing credit lines, limiting access to home credit lines and, as mentioned, killing roll-overs. Nishikawa said these measures have had unintended consequences and are driving customers away from paying their bills.

Partly to blame for the upcoming correction, of course, is the credit card lifestyle. According to Innovest, since 1999, as wages have stagnated credit card debt outstanding has risen by almost 80%. It's only gotten worse as access to home equity lines have been shut down. Rather than stop shopping people have simply put their purchases on plastic.

Walter Todd, a portfolio manager at Greenwood Capital Associates was quoted by the Calgary Herald in late November, noting that there has never been this much consumer debt with unemployment nearing 8%: "It's hard to run a model because it's never happened before."

The worst is yet to come, Innovest says, because 2006's bankruptcy reforms have caused a delayed reaction in defaults. The firm expects the full tide of defaults to roll in early in 2009. Happy inauguration, President Obama.

Give Sun Microsystems credit: The roof may be on fire, but the beleaguered server vendor seems just as focused on putting out innovative products as putting out the flames.

On Nov. 3, Sun (nasdaq: JAVA - news - people ) announced a new series of data center storage systems designed to use NAND flash memory, a storage technology borrowed from the world of consumer products like iPods, thumb drives and laptops and designed to perform faster and use less energy than traditional spinning hard drives. Sun is touting its new storage system, which it calls Amber Road, as not only simpler and easier to use than its older storage products, but up to four times faster and more efficient than an equivalent spinning drives

Unlike traditional hard drives, so-called "solid state" drives (SSDs) have no moving parts, so don't waste time and energy physically turning a disk to look for data. Until recently, they've also been far pricier. But as flash makers have boosted production to meet demand for iPods, iPhones and other small flash-based gadgets, Sun Executive Vice President John Fowler says flash memory prices have been dropping at a rate of 50% to 70% a year. (See Sun Jumps Into Flash)

The new flash-based devices, labeled the 7000 series, cost between $11,000 and $35,000 for anywhere from two to 11 terabytes of capacity. Although that's far cheaper than they used to be, it's still pricier than conventional hard drive systems that could be as low as $2,000 a terabyte.

Sun isn't the only storage vendor to see the opportunity that flash's falling prices have created. Storage giant EMC (nyse: EMC - news - people ) has released its own SSDs. Hard-drive maker Seagate (nyse: STX - news - people ) is currently embroiled in a patent lawsuit with flash memory maker STEC (nasdaq: STEC - news - people ), possibly, some analysts believe, with the intention of acquiring the company.

But Sun may have a leg up. Gene Ruth, an analyst with research firm Burton Group says that Sun has trumped its competitors by optimizing storage arrays to automatically hold the most frequently accessed files in faster flash memory while less-used information is moved to slower disk drives. That algorithm, which Sun calls its ZFS file system, has the potential to make Sun's system far cheaper and more effective than the competitors', Ruth says.

"The competitors' systems are a novelty, but they don't realize the full potential for flash," he argues. "Sun's big idea is integration of the storage systems’ hardware and software, with a file system that's intelligent enough to know where to place data automatically."

No single innovative product, of course, can solve Sun's financial woes. Since the beginning of the year, the company's stock price has fallen more than 75% as server sales have dropped off, leaving Sun with a $3.1 billion market capitalization even as it has $2.6 billion in cash and short term investments. As the economic crisis worsens, Sun will likely face the full brunt of the downturn as its financial services and automotive customers evaporate. (See Sun Eclipsed By Poor Results--Again)

But storage could be a marginally bright spot for Sun. In the quarter ending in late September, Sun reported that its storage business, which accounts for 17% of the company's revenue, had grown ever so slightly to $507 million, compared to $505 million in the same quarter the year before. The company's other hardware revenues, by contrast, fell around 15% compared to the equivalent period in 2007.

That's a sign that storage may be relatively recession-proof, argues Sun's Fowler. "Even in challenging times, our customers are still generating transactions, still storing multimedia files, still dealing with compliance issues," he says.

If the Amber Road system does give Sun's storage revenues a boost, it will be thanks to a simpler user interface, says Forrester Research (nasdaq: FORR - news - people ) analyst Andrew Reichman. He says that the storage systems' open source operating system have taken a welcome step away from older platforms that were too difficult to manage without engineering expertise.

"I'm not ready to say that Sun totally has its act together," says Reichman. "But if they continue on this road, they could be on the right track."

 

The mortgage meltdown is by no means over, but now consumers need to brace for another economic crisis--credit cards.

According to the consumer Web site Credit.com, at the end of last year, U.S. consumers owed more than $961 billion in credit card debt. Although not as large as the $11 trillion mortgage market, that's still a lot of lost cash and lenders are starting to feel the consequences of the huge lines of credit they have been allowing. American's have been borrowing more money than they can pay back, and credit card companies have been there to support the habit every step of the way.

Sound familiar? The situation is almost the same as the housing crisis, in which people have been taking on mortgages they can't afford. Now it all seems to be catching up to them.

People who are already stretched for cash are not only going to have a harder time paying their credit card bills, they may also start using borrowed cash to pay for basic living expenses. Not to mention that the unemployment rate has increased by about 2 million people in the last 12 months. For many, the only solution is to pile debt on top of debt.

Lenders are bracing for consumers defaulting. They are tightening their wallets to soften the blow, and we, as consumers, will feel the pressure. "I would not be surprised if credit card companies start finding creative ways to add to the bottom line," says Bill Hardekopf, CEO of consumer Web site LowCards.com.

Here are some things to be aware of in terms of using credit cards in our current economy.

Lenders are going to start raising the standards of who they loan money to and how the consumer pays them back. It may seem just as easy to get a credit card today as it was yesterday, but the terms and how much you can extend your credit limit are probably going to be stricter.

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You can expect to see more serious consequences for missing a payment. Some lenders are lowering credit limits or hiking up interest rates after just one missed payment. When credit scoring companies, such as Fair Isaac Corp. (FICO) see these negative shifts in your credit, your credit score is probably going to go down. Be aware that some credit cards are decreasing credit limits or increasing interest rates even if you're not at fault. Be sure to monitor your credit card statement. Lenders are allowed to increase your interest rate without even telling you.

You will find that your credit score is going to matter more now than it ever did before, and you'll want to protect it. Credit card companies are not the only suddenly more cautious lenders out there. For example, you may find it harder to get a car loan and you may see student loan interest rates going up. "Lenders are going to be cherry-picking customers," says Gerri Detweiler, author of The Ultimate Credit Handbook: How to Cut Your Debt and Have a Lifetime of Great Credit. You're probably going to need a decent credit score to get a good deal on a loan. Expect to need a credit score about 100 points higher than what you may have needed in the past for a particular loan.

Now is a great time to start thinking about paying off any debt you have so you can avoid paying even more in interest than you already do, if your rates do go up. Consider consolidating your debt with a card that carries a low interest rate. Usually there is a fee to transfer balances, typically been about 3%, but lately fees have been increasing so be sure to do your research. You could opt for the old-fashioned approach; use your card less and pay off more. If any lessons have been learned, it's that credit cards are not smart emergency funds.

If you think the card you have now might not be the best for you--whether the interest rate is too high or the rewards are not what you're looking for, think about switching. Be sure to pay off the balance or consolidate your debt before you do so. Don't start opening too many new cards, though, because this can affect your credit score. Keep this in mind during the holidays as well, when retailers will be pushing cards on you.

If you are shopping around for some new cards, here are a few to check out. ("See Best Credit Cards For The Buck.") Labor union members may want to look into credit union cards. "[Labor union cards] don't engage in some of the more egregious practices such as ... raising your rate at any time for any reason." says Detweiler.

Look for cards that have low rates, but still offer rewards, such as the Advanta (nasdaq: ADVNA - news - people ) Small Business Card or Blue from American Express (nyse: AXP - news - people ). If you are working on building or rebuilding your credit, think about a secured credit card. Secured cards are like pre-paid credit cards. Your line of credit is as high as the amount of money you give to the lender, so you are never really borrowing money, but you are reestablishing your credit history which will use to better loan rates in the future.

You shouldn't stop using credit cards altogether, as we're realizing our credit score is going to be more important as lenders get choosier. In fact, now may be the time to prove yourself to lenders as a trustworthy investment. Keep your debt low and your credit strong, and lenders will be eager to work with you. You may find you'll get benefits with good credit that you haven't been able to get in the past.

U.S. stocks were trading higher Monday, jumping back to earlier highs after Fed chief Ben Bernanke's testimony on signs of loosening in the credit crisis. Investors responded positively to some positive earnings reports and to a narrowing in credit market spreads, which suggests that the government's efforts to stabilize the banking system are starting to work.

European stocks were higher as banks lined up to tap state rescue packages to shore up their finances, part of measures to stem a global financial crisis.

Bonds were slightly lower, with yields moving a bit higher. The dollar index was lower. Gold futures were sharply higher. Oil futures were up on speculation OPEC will cut output at emergency meeting.

On Monday, the Dow Jones industrial average was trading 199.60 points, or 2.25%, to 9,051.82. The S&P 500 index was up 24.36 points, or 2.59%, at 964.91. The tech-heavy Nasdaq composite index rose 21.03 points, or 1.23%, to 1,732.32.

On the New York Stock Exchange, 22 stocks were trading higher for every seven that were in negative territory, while on the Nasdaq the ratio was 17-8 positive, amid moderate trading, according to S&P MarketScope.

Major European indexes were trading higher Monday. In London, the FTSE 100 index surged 5.41% to 4,282.67. In Paris, the CAC 40 bounced 3.56% to 3,448.51, while Germany's DAX index rose 1.12% to 4,835.01.

In Asia, Japan's Nikkei 225 jumped 3.59% to end at 9,005.59, while Hong Kong's Hang Seng index surged 5.28% to close at 15,323.01.

President Bush, looking for answers to an economic emergency with just three months left in office will host an international summit to discuss ways to fix the world financial system but warned against reforms that threaten capitalism. "We will work to strengthen and modernize our nations' financial systems so we can help ensure that this crisis doesn't happen again," Bush said at the Camp David presidential retreat, according to an Associated Press dispatch. Bush, meeting with French President Nicolas Sarkozy and European Commission President Jose Manuel Barroso, did not announce a date or site for the summit. But Sarkozy suggested it be held in the shadow of Wall Street before the end of November.

Governments continued to announce measures to shore up financial institutions. Germany's cabinet approved strict conditions for banks that make use of its €500 billion rescue package, including limits on managers' salaries, bonuses and severance. "The criteria for appropriate (remuneration) are based on responsibilities and personal performance, business conditions and the success and outlook of the company compared to others in its field," the provisions agreed by cabinet stated, according to a Reuters dispatch.

Bavaria's public sector bank, BayernLB, was ready to ask for funds, Bavaria's finance minister said. Commerzbank said it would take a close look at using the funds. Societe Generale led a steep fall by France's top three banks as concern heightened they may be next in line for state funds. On Sunday, the Dutch government agreed a €10 billion cash injection into financial group ING (ING), powering its shares higher by almost 23%. ING said it had agreed to sell its Taiwan Life insurance unit to Fubon Financial for $600 million, increasing its capital in a deal analysts said would benefit shareholders. In Sweden, the government outlined a plan worth more than 1.5 trillion crowns ($271.5 billion) that would include credit guarantees and a bail-out fund. "The government is proposing powerful measures to ease the effects on Swedish households and companies of the financial turbulence," said Financial Markets Minister Mats Odell.

Traders listened to Bernanke's testimony on the U.S. economic recovery to the House Budget Committee. Saying that uncertainties around the economic picture are unusually large, the Fed chief said it would be appropriate for Congress to pass a second fiscal package to stimulate growth. While recovery from what he expects to be a protracted economic slowdown will depend on how quickly confidence returns to the financial system, he said he was confident that the measures the government is taking would help restore people's trust in the financial system.

Also on the Fedspeak calendar Monday: Atlanta Fed President Dennis Lockhart on the U.S. economic outlook and Fed Gov. Randall Kroszner on risk management.

Offering more detail about the Treasury's plan to inject $250 billion into banks, Secretary Henry Paulson said the the new capital should be deployed, not hoarded, though the government hasn't defined the type of lending to avoid forcing bad lending decisions. Paulson also said he expects lenders to step up efforts to aid homeowners in avoiding foreclosures. So far interest has been pretty broad in the program and he emphasized that these are investments, not expenditures, which should ultimately not come at a cost to taxpayers.

In economic news Monday, U.S. leading indicators rebounded by a better than expected 0.3% in September, from a revised 0.9% decline in August (-0.5% previously). That left the 6-month annualized rate of change at -2.5% from -2.1% previously. Positive contributions from money supply, consumer expectations, and the yield curve more than offset negative contributions from building permits, initial jobless claims, stocks, and the factory workweek, notes Action Economics

The troubles sound familiar. Borrowers falling behind on their payments. Defaults rising. Huge swaths of loans souring. Investors getting burned. But forget the now-familiar tales of mortgages gone bad. The next horror for beaten-down financial firms is the $950 billion worth of outstanding credit-card debt—much of it toxic.

That's bad news for players like JPMorgan Chase (JPM) and Bank of America (BAC) that have largely sidestepped—and even benefited from—the mortgage mess but have major credit-card operations. They're hardly alone. The consumer debt bomb is already beginning to spray shrapnel throughout the financial markets, further weakening the U.S. economy. "The next meltdown will be in credit cards," says Gregory Larkin, senior analyst at research firm Innovest Strategic Value Advisors. Adds William Black, senior vice-president of Moody's Investors Service's structured finance team: "We still haven't hit the post-recessionary peaks [in credit-card losses], so things will get worse before they get better." What's more, the U.S. Treasury Dept.'s $700 billion mortgage bailout won't be a lifeline for credit-card issuers.

The big firms say they're prepared for the storm. Early last year JPMorgan started reaching out to troubled borrowers, setting up payment programs and making other adjustments to accounts. "We have seen higher credit-card losses," acknowledges JPMorgan spokeswoman Tanya M. Madison. "We are concerned about [it] but believe we are taking the right steps to help our customers and manage our risk."

But some banks and credit-card companies may be exacerbating their problems. To boost profits and get ahead of coming regulation, they're hiking interest rates. But that's making it harder for consumers to keep up. That'll only make tomorrow's pain worse. Innovest estimates that credit-card issuers will take a $41 billion hit from rotten debt this year and a $96 billion blow in 2009.

Those losses, in turn, will wend their way through the $365 billion market for securities backed by credit-card debt. As with mortgages, banks bundle groups of so-called credit-card receivables, essentially consumers' outstanding balances, and sell them to big investors such as hedge funds and pension funds. Big issuers offload roughly 70% of their credit-card debt.

But it's getting harder for banks to find buyers for that debt. Interest rates have been rising on credit-card securities, a sign that investor appetite is waning. To help entice buyers, credit-card companies are having to put up more money as collateral, a guarantee in case something goes wrong with the securities. Mortgage lenders, in sharp contrast, typically aren't asked to do this—at least not yet. With consumers so shaky, now isn't a good time to put more skin in the game. "Costs will go up for issuers," warns Dennis Moroney of the consultancy Tower Group.

Sure, the credit-card market is just a fraction of the $11.9 trillion mortgage market. But sometimes the losses can be more painful. That's because most credit-card debt is unsecured, meaning consumers don't have to make down payments when opening up their accounts. If they stop making monthly payments and the account goes bad, there are no underlying assets for credit-card companies to recoup. With mortgages, in contrast, some banks are protected both by down payments and by the ability to recover at least some of the money by selling the property.

THE BIG BOYS' BURDEN

Making matters worse, the subprime threat is also greater in credit-card land. Risky borrowers with low credit scores account for roughly 30% of outstanding credit-card debt, compared with 11% of mortgage debt. More than 45% of Washington Mutual's credit-card portfolio is subprime, according to Innovest. That could become a headache for JPMorgan Chase, which agreed on Sept. 25 to buy the troubled thrift's credit-card business and other assets for $1.9 billion. Says a JPMorgan spokeswoman: "