Fixing the financial system

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This two part NYTimes editorial on what happened and how to fix it is worth a glance.

Some highlights with my comments below the fold:

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.

You shouldn't have to tell adults this, but if you think somebody is running a scam, you of course shouldn't do business with him at all. If you can't quite summon that much virtue, then you at least should keep in mind that criminals can't be trusted.

Richard Fuld, the former chief executive of Lehman Brothers, E. Stanley O'Neal, the former chief executive of Merrill Lynch, and Charles O. Prince III, Citigroup's chief executive, may have paid themselves humongous sums of money at the end of each year, as a result of the bond market bonanza. But if any one of them had set himself up as a whistleblower -- had stood up and said "this business is irresponsible and we are not going to participate in it" -- he would probably have been fired. Not immediately, perhaps. But a few quarters of earnings that lagged behind those of every other Wall Street firm would invite outrage from subordinates, who would flee for other, less responsible firms, and from shareholders, who would call for his resignation. Eventually he'd be replaced by someone willing to make money from the credit bubble.

In other words, every investor who grumbled anytime they got less than 15% annualized quarterly return contributed to the bubble and to the current panic. That would be... um nearly everybody

By 2006 MBIA had plunged into the much riskier business of guaranteeing collateralized debt obligations, or C.D.O.'s. But by then it had $7.2 billion in equity against an astounding $26.2 billion in debt. That is, even as it insured ever-greater risks in its business, it also took greater risks on its balance sheet.


Yet the rating agencies didn't so much as blink. On Wall Street the problem was hardly a secret: many people understood that MBIA didn't deserve to be rated triple-A. As far back as 2002, a hedge fund called Gotham Partners published a persuasive report, widely circulated, entitled: "Is MBIA Triple A?" (The answer was obviously no.)

At the same time, almost everyone believed that the rating agencies would never downgrade MBIA, because doing so was not in their short-term financial interest. A downgrade of MBIA would force the rating agencies to go through the costly and cumbersome process of re-rating tens of thousands of credits that bore triple-A ratings simply by virtue of MBIA's guarantee. It would stick a wrench in the machine that enriched them. (In June, finally, the rating agencies downgraded MBIA, after MBIA's failure became such an open secret that nobody any longer cared about its formal credit rating.)

Several people have asked me my opinion on the crisis (I work for a financial planner, but my specific job has almost nothing to do with financial markets -- most of what I know I know because I read economics obsessively), and I tell them that the folks who need to be hanging from light poles are the rating agencies and insurers who gave AAA ratings and gave their backing to junk they didn't understand. The authors say that this subject "might be profitably explored in Washington." I think it could be even more profitably explored in class action suits.

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.

Finally, a one sentence paragraph buried in the middle of a list of measures that could be taken to prevent future market catastrophes deserves to be highlighted: "Another good solution to the too-big-to-fail problem is to break up any institution that becomes too big to fail." Since I operate on the principle that big, unaccountable business is equally evil as big, unaccountable government, this naturally speaks to my heart. I'd like to hear ideas on how it could be accomplished.

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This page contains a single entry by Papa-Lu published on January 12, 2009 4:05 PM.

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