It’s only Monday, but I’m pretty confident this piece in The New York Times yesterday will be the must-read of the week.
Journalist Michael Lewis and hedge fund manager/author David Einhorn teamed up to crank out, with the gift of nearly a page of space in the Week in Review section, a cogent and easy-to-read synopsis of what’s wrong with the financial system and what needs to be done to fix it.
In discussing Harry Markopolos, who blew the whistle on Madoff loudly, repeatedly, and convincingly, Lewis and Einhorn write:
What’s interesting about the Madoff scandal, in retrospect, is how little interest anyone inside the financial system had in exposing it. It wasn’t just Harry Markopolos who smelled a rat. As Mr. Markopolos explained in his letter, Goldman Sachs was refusing to do business with Mr. Madoff; many others doubted Mr. Madoff’s profits or assumed he was front-running his customers and steered clear of him. Between the lines, Mr. Markopolos hinted that even some of Mr. Madoff’s investors may have suspected that they were the beneficiaries of a scam. After all, it wasn’t all that hard to see that the profits were too good to be true. Some of Mr. Madoff’s investors may have reasoned that the worst that could happen to them, if the authorities put a stop to the front-running, was that a good thing would come to an end.
The Madoff scandal echoes a deeper absence inside our financial system, which has been undermined not merely by bad behavior but by the lack of checks and balances to discourage it. “Greed” doesn’t cut it as a satisfying explanation for the current financial crisis. Greed was necessary but insufficient; in any case, we are as likely to eliminate greed from our national character as we are lust and envy. The fixable problem isn’t the greed of the few but the misaligned interests of the many…
OUR financial catastrophe, like Bernard Madoff’s pyramid scheme, required all sorts of important, plugged-in people to sacrifice our collective long-term interests for short-term gain. The pressure to do this in today’s financial markets is immense. Obviously the greater the market pressure to excel in the short term, the greater the need for pressure from outside the market to consider the longer term. But that’s the problem: there is no longer any serious pressure from outside the market. The tyranny of the short term has extended itself with frightening ease into the entities that were meant to, one way or another, discipline Wall Street, and force it to consider its enlightened self-interest.
The authors correctly lay a heap of the blame at the feet of the credit-ratings agencies such as Moody’s, and recommend that they be essentially done away with in their current form because of the perverse incentives and conflicts of interest inherent in a model that has firms with a quasi-regulatory function paid by the firms they’re supposed to regulate.
Another helping of blame goes, of course, to the SEC, and the authors cleverly endeavor to explain why it’s been so dysfunctional (besides the whole administration philosophy that would naturally water down its functionality):
IT’S not hard to see why the S.E.C. behaves as it does. If you work for the enforcement division of the S.E.C. you probably know in the back of your mind, and in the front too, that if you maintain good relations with Wall Street you might soon be paid huge sums of money to be employed by it.
The commission’s most recent director of enforcement is the general counsel at JPMorgan Chase; the enforcement chief before him became general counsel at Deutsche Bank; and one of his predecessors became a managing director for Credit Suisse before moving on to Morgan Stanley. A casual observer could be forgiven for thinking that the whole point of landing the job as the S.E.C.’s director of enforcement is to position oneself for the better paying one on Wall Street.
The Treasury and Henry Paulson also come in for a deserved spanking for their inept response to the crisis, which has been all over the map but has in the main handed hundreds of billions of dollars over to the very fools who got us in this trouble and made millions doing it.
In the middle of all this, Treasury Secretary Henry M. Paulson Jr. persuaded Congress that he needed $700 billion to buy distressed assets from banks — telling the senators and representatives that if they didn’t give him the money the stock market would collapse. Once handed the money, he abandoned his promised strategy, and instead of buying assets at market prices, began to overpay for preferred stocks in the banks themselves. Which is to say that he essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival. The stock market fell anyway.
It’s hard to know what Mr. Paulson was thinking as he never really had to explain himself, at least not in public. But the general idea appears to be that if you give the banks capital they will in turn use it to make loans in order to stimulate the economy. Never mind that if you want banks to make smart, prudent loans, you probably shouldn’t give money to bankers who sunk themselves by making a lot of stupid, imprudent ones. If you want banks to re-lend the money, you need to provide them not with preferred stock, which is essentially a loan, but with tangible common equity — so that they might write off their losses, resolve their troubled assets and then begin to make new loans, something they won’t be able to do until they’re confident in their own balance sheets. But as it happened, the banks took the taxpayer money and just sat on it.
The Times annoyingly splits up the piece into two separate stories online so everything from here on down comes from this link.
Lewis and Einhorn spell out clearly what ought to be done now:
THERE are other things the Treasury might do when a major financial firm assumed to be “too big to fail” comes knocking, asking for free money. Here’s one: Let it fail.
Not as chaotically as Lehman Brothers was allowed to fail. If a failing firm is deemed “too big” for that honor, then it should be explicitly nationalized, both to limit its effect on other firms and to protect the guts of the system. Its shareholders should be wiped out, and its management replaced. Its valuable parts should be sold off as functioning businesses to the highest bidders — perhaps to some bank that was not swept up in the credit bubble. The rest should be liquidated, in calm markets. Do this and, for everyone except the firms that invented the mess, the pain will likely subside.
The only thing preventing that is the vestigial free-market religion that somehow hasn’t been expunged yet—you know, the one that says we can’t tell insolvent banks that led us to ruin what to do, even though we’ve given them hundreds of billions of dollars to keep them afloat because they didn’t know how to run their businesses.
Lewis and Einhorn also recommend the regulation of credit-default swaps, a bailout for homeowners, new capital requirements for banks, and a waiting-period for SEC officials to leave for Wall Street. And my favorite of them all:
Another good solution to the too-big-to-fail problem is to break up any institution that becomes too big to fail.
Amen to that. Read the whole thing.
Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR’s business section. If you see notable business journalism, give him a heads-up at rc2538@columbia.edu. Follow him on Twitter at @ryanchittum.