Perhaps the most sobering thing we have learned during 2008, or rather since the subprime crisis broke in the middle of 2007, is the benefit of transparency in business dealings. Time after time, when a fiasco has occurred, it has been due to a lack of transparency in a transaction or series of transactions. Subprime mortgages, collateralized debt obligations and credit default swaps were all financial innovations that relied crucially on nobody asking too many questions. Now a $50 billion Ponzi scheme run by Bernard Madoff turns out to have involved some of the most sophisticated investors in the world, and to have rested on the same fatal human omission.

In the subprime mortgage case, investors were not given sufficient information on the contents of the mortgage pools in which they invested, but instead chose to rely on the debt ratings given the pools by the rating agencies. As it turned out, the rating agencies’ models were insufficiently sensitive to correlations between different assets in the same class, and did not deal at all with the possibility that some of the mortgages themselves or the valuations underlying them might be fraudulent. In the old North Country English phrase, investors were buying a “pig in a poke” and should not have been surprised when the “poke” was opened and the pig turned out to be a rat.

Collateralized debt obligations were un-transparent in two ways. First, investors in the pools themselves were given inadequate information on the assets backing them. Second, bank investors were not informed about the extra liabilities that the banks had incurred off their balance sheet in separate securitization vehicles. Hence when the commercial paper markets dried up and banks were forced to choose between defaulting on CDOs they had sponsored and bringing the assets back on their balance sheet, their leverage suddenly markedly increased. Banks that had appeared to be conservatively capitalized were found to be highly risky operations. The worst effects of this problem were avoided for depositors through deposit insurance, but the lack of transparency eventually caused a liquidity collapse in the money market.

The credit default swap sneaked up on everybody, becoming a $62 trillion market, nearly three times the sum total of all US debt obligations outstanding, without anyone outside the business knowing much about it. Settlement procedures were untried in a large bankruptcy, and have since shown themselves to be highly arbitrary, since prices for settlement of billions of dollars of CDS are based on a mini-auction involving a tiny fraction of the amount of CDS outstanding. As the Bear Stearns, Lehman and AIG debacles showed, credit risks in the CDS market are highly non-transparent. As a holder of a CDS you don’t know whether your counterparty has issued only a few of your CDS, in which case you’ll probably get paid in a bankruptcy, or whether he has issued fifty times the outstanding debt you’re trying to hedge, in which case you’re pretty unlikely to get paid. Knowing that he manages his risk by the Value-at-Risk method, which blows apart in turbulent markets, would prevent you from assuming he has managed risk competently.

Finally we have Madoff. The Madoff scheme could not have happened thirty years ago. Any professional investor would have wanted to know how Madoff expected to make his high and consistent returns, and there were no options markets of sufficient size for him plausibly to claim them as sources of exceptional profit. Professional investors in 1975 knew how money could be made in quantity; in 2005 they didn’t because with derivatives and options there were an infinite number of arcane trading strategies that might in theory produce superior returns.

Charles Ponzi could not have swindled professional investors using postal coupons, even in 1920. He relied on finding enough gullible wealthy individuals who would calculate that his scheme might work, and not figure out that it could not be scaled up to the size needed (Ponzi would have needed to deal in 120 million postal coupons to work his scheme on the $10 million he had at his peak; the total global postal coupon “float” was only around 27,000.)

Lack of transparency bears a considerable responsibility for the current debacle – less perhaps than over-expansive monetary policy, but more than any other single factor. A key requirement for recovery is thus to overcome the transparency deficit.

Lovers of regulation have been claiming for months that the solution to the transparency deficit is additional government regulation. The Madoff case has surely shown that to be a false protection. The SEC, with seventy years of legislation behind it, turned out to be incapable on repeated occasions of spotting a $50 billion Ponzi scheme audited by a 3-person outfit. Thus giving the SEC a new transparency rulebook will simply add bureaucracy and not protect significantly against fraud, let alone simple gullibility and failure to take adequate account of risk.

If governments cannot be expected to provide foolproof transparency for investors, then investors will have to take care of the matter for themselves. Good old-fashioned bear-market skepticism can do much of the job. Don’t buy mortgages on the basis of a third party guarantee, nor slices of mortgages sliced up into incomprehensible securities packages. If investor demand for MBS is removed, banks will be forced to hold mortgages on their balance sheet. This will not only be more secure, it will also be cheaper; as I documented some months ago, the cost of mortgages, expressed as a spread over Treasury bond yields, became higher in the securitization era of 2000-06 than it was in the direct-lending era of 1971-77.

In bond investment, demand simplicity. Complex credit structures offer too many opportunities for fraud or simply fudging, and the rating agencies are incapable of giving you an accurate assessment of their merits. Hence direct obligations of companies with published financial information and a straightforward business model should be preferred over messy conglomerates, let alone artificial debt structures. If as an investor you wish to stretch your risk parameters in order to get a higher yield, make sure that the additional risk is in the form of clearly visible leverage in an easily comprehensible situation. Similarly, when investing in international credits, demand obligations of countries like Brazil whose governmental systems are transparent and debt levels are well known, rather than countries like China where the entire banking system is masked by a fog of obfuscation and the political system is both rigid and opaque.

As an investor, you should avoid credit default swaps altogether. The idea that by buying a risky bond and a credit default swap against it you can achieve a risk free return is nonsense. If the bond defaults, the CDS will pay out some arbitrarily determined amount that bears no relation to your loss on the bond. Further in buying a CDS you are assuming a counterparty risk that depends not only on the counterparty’s overall business but on his exposure to that particular credit, and his success in hedging that exposure.

Finally, investors should avoid buying investment products where the mechanism by which returns are achieved is not transparent. In the modern world, relationships and trust are unfortunately not enough – having been at college with Madoff made you more likely to be defrauded by him, not less.

However the prohibition against non-transparent investment should not extend merely to the “black boxes” offered by Madoff and most hedge funds. It should also include many of the artificial derivative-driven products that have in recent years become fashionable investments for retail investors. As well as deliberate opaqueness, the magic world of derivatives can also lose you money through its lack of “operating transparency.”

Exchange Traded Funds (ETFs), in particular, are sometimes not what they seem to be. For example, a short ETF may claim to track various stock and bond indices in reverse, perhaps using leverage. This is achieved generally by taking a short position in the relevant futures contract. The whole structure is entirely above board; both the aim of the funds and the method by which the managers hope to achieve it are made quite clear. However, investors may not realize that, in order to track the relevant index, the ETF must be rebalanced periodically (usually daily) and that such rebalancing can introduce large tracking errors if the index being followed is volatile.

For example, one ETF that shorts the Chinese market on a leveraged basis is down almost 50% over the past year, though without “tracking error,’’ it should have trebled in value. Thus an investor a year ago correctly assessing the overvalued state of Chinese shares and buying this ETF would have been rewarded by the nasty surprise of losing half his money, even though his market view was correct.

The ETF did what it said it would do; nobody has been dishonest. But overall, the investor has lost money. That’s because of a lack of operating transparency.

Investors can achieve transparency, and so sleep at night about their investments, but in order to do so they must demand it. No regulator can provide it reliably.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)