Two of the sharpest minds in the Wall Street analysis and commentary business–Michael Lewis and David Einhorn–team up in the NYT to provide a recap of our historic charge off the financial cliff.
The main message: Sure, greed played a role, as it always does, but the ridiculous conflicts, self-interest, and short-termism in our system made the current mess inevitable.
AMERICANS enter the New Year in a strange new role: financial lunatics. We’ve been viewed by the wider world with mistrust and suspicion on other matters, but on the subject of money even our harshest critics have been inclined to believe that we knew what we were doing. They watched our investment bankers and emulated them: for a long time now half the planet’s college graduates seemed to want nothing more out of life than a job on Wall Street.
This is one reason the collapse of our financial system has inspired not merely a national but a global crisis of confidence. Good God, the world seems to be saying, if they don’t know what they are doing with money, who does?
Incredibly, intelligent people the world over remain willing to lend us money and even listen to our advice; they appear not to have realised the full extent of our madness. We have at least a brief chance to cure ourselves. But first we need to ask: of what?
To that end consider the strange story of Harry Markopolos. Mr. Markopolos is the former investment officer with Rampart Investment Management in Boston who, for nine years, tried to explain to the Securities and Exchange Commission that Bernard L. Madoff couldn’t be anything other than a fraud. Mr. Madoff’s investment performance, given his stated strategy, was not merely improbable but mathematically impossible. And so, Mr. Markopolos reasoned, Bernard Madoff must be doing something other than what he said he was doing.
In his devastatingly persuasive 17-page letter to the S.E.C., Mr. Markopolos saw two possible scenarios. In the “Unlikely” scenario: Mr. Madoff, who acted as a broker as well as an investor, was “front-running” his brokerage customers. A customer might submit an order to Madoff Securities to buy shares in I.B.M. at a certain price, for example, and Madoff Securities instantly would buy I.B.M. shares for its own portfolio ahead of the customer order. If I.B.M.’s shares rose, Mr. Madoff kept them; if they fell he fobbed them off onto the poor customer.
In the “Highly Likely” scenario, wrote Mr. Markopolos, “Madoff Securities is the world’s largest Ponzi Scheme.” Which, as we now know, it was.
Harry Markopolos sent his report to the S.E.C. on Nov. 7, 2005 — more than three years before Mr. Madoff was finally exposed — but he had been trying to explain the fraud to them since 1999. He had no direct financial interest in exposing Mr. Madoff — he wasn’t an unhappy investor or a disgruntled employee. There was no way to short shares in Madoff Securities, and so Mr. Markopolos could not have made money directly from Mr. Madoff’s failure. To judge from his letter, Harry Markopolos anticipated mainly downsides for himself: he declined to put his name on it for fear of what might happen to him and his family if anyone found out he had written it. And yet the S.E.C.’s cursory investigation of Mr. Madoff pronounced him free of fraud.
What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it…
In a second instalment , Lewis and Einhorn provide some solutions:
Congress might grant qualifying homeowners the ability to get new government loans based on the current appraised values without requiring their bank’s consent. When a corporation gets into trouble, its lenders often accept a partial payment in return for some share in any future recovery. Similarly, homeowners should be permitted to satisfy current first mortgages with a combination of the proceeds of the new government loan and a share in any future recovery from the future sale or refinancing of their homes. Lenders who issued second mortgages should be forced to release their claims on property. The important point is that homeowners, not lenders, be granted the right to obtain new government loans. To work, the program needs to be universal and should not require homeowners to file for bankruptcy.
There are also a handful of other perfectly obvious changes in the financial system to be made, to prevent some version of what has happened from happening all over again. A short list:
Stop making big regulatory decisions with long-term consequences based on their short-term effect on stock prices. Stock prices go up and down: let them. An absurd number of the official crises have been negotiated and resolved over weekends so that they may be presented as a fait accompli “before the Asian markets open.” The hasty crisis-to-crisis policy decision-making lacks coherence for the obvious reason that it is more or less driven by a desire to please the stock market. The Treasury, the Federal Reserve and the S.E.C. all seem to view propping up stock prices as a critical part of their mission — indeed, the Federal Reserve sometimes seems more concerned than the average Wall Street trader with the market’s day-to-day movements. If the policies are sound, the stock market will eventually learn to take care of itself.
End the official status of the rating agencies. Given their performance it’s hard to believe credit rating agencies are still around. There’s no question that the world is worse off for the existence of companies like Moody’s and Standard & Poor’s. There should be a rule against issuers paying for ratings. Either investors should pay for them privately or, if public ratings are deemed essential, they should be publicly provided.
Regulate credit-default swaps. There are now tens of trillions of dollars in these contracts between big financial firms. An awful lot of the bad stuff that has happened to our financial system has happened because it was never explained in plain, simple language. Financial innovators were able to create new products and markets without anyone thinking too much about their broader financial consequences — and without regulators knowing very much about them at all. It doesn’t matter how transparent financial markets are if no one can understand what’s inside them. Until very recently, companies haven’t had to provide even cursory disclosure of credit-default swaps in their financial statements.
Impose new capital requirements on banks. The new international standard now being adopted by American banks is known in the trade as Basel II. Basel II is premised on the belief that banks do a better job than regulators of measuring their own risks — because the banks have the greater interest in not failing. Back in 2004, the S.E.C. put in place its own version of this standard for investment banks. We know how that turned out. A better idea would be to require banks to hold less capital in bad times and more capital in good times. Now that we have seen how too-big-to-fail financial institutions behave, it is clear that relieving them of stringent requirements is not the way to go. Another good solution to the too-big-to-fail problem is to break up any institution that becomes too big to fail.
Close the revolving door between the S.E.C. and Wall Street. At every turn we keep coming back to an enormous barrier to reform: Wall Street’s political influence. Its influence over the S.E.C. is further compromised by its ability to enrich the people who work for it. Realistically, there is only so much that can be done to fix the problem, but one measure is obvious: forbid regulators, for some meaningful amount of time after they have left the S.E.C., from accepting high-paying jobs with Wall Street firms.
But keep the door open the other way. If the S.E.C. is to restore its credibility as an investor protection agency, it should have some experienced, respected investors (which is not the same thing as investment bankers) as commissioners. President-elect Barack Obama should nominate at least one with a notable career investing capital, and another with experience uncovering corporate misconduct. As it happens, the most critical job, chief of enforcement, now has a perfect candidate, a civic-minded former investor with firsthand experience of the S.E.C.’s ineptitude: Harry Markopolos.
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