Michael Lewis on the financial mess

Great op-ed by Michael Lewis and David Einhorn, “The End of the Financial World as We Know It,” in Sunday’s New York Times.  Epic, too — two full newspaper pages.  I’ve been a big Michael Lewis fan ever since Liar’s Poker, but this is in a different category — not breezy and funny as usual, but serious and long on specifics.  Einhorn is a president of a hedge fund, so the relative wonkiness of the piece likely reflects his contribution.

Some highlights from the first half:

“Americans enter the New Year in a strange new role: financial lunatics.

“… 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?….

“The instinct to avoid short-term political heat is part of the problem; anything the S.E.C. does to roil the markets, or reduce the share price of any given company, also roils the careers of the people who run the S.E.C. Thus it seldom penalizes serious corporate and management malfeasance — out of some misguided notion that to do so would cause stock prices to fall, shareholders to suffer and confidence to be undermined. Preserving confidence, even when that confidence is false, has been near the top of the S.E.C.’s agenda.

“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 first half also tells “the strange story of Harry Markopolos,” an officer at a Boston investment management company who blew the whistle on Bernard Madoff’s Ponzi scheme for nine years beginning in 1999 with repeated communications to the S.E.C. that got ignored.   (Lewis and Einhorn tout Markopolos as a natural for the S.E.C.’s next Chief of Enforcement.  If only.)

Some highlights from the second half, in which the authors make some specific recommendations:

“Thereare 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.

“This is more plausible than it may sound. Sweden, of all places, did it successfully in 1992….”

“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….

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.

“Credit-default swaps may not be Exhibit No. 1 in the case against financial complexity, but they are useful evidence. Whatever credit defaults are in theory, in practice they have become mainly side bets on whether some company, or some subprime mortgage-backed bond, some municipality, or even the United States government will go bust. In the extreme case, subprime mortgage bonds were created so that smart investors, using credit-default swaps, could bet against them. Call it insurance if you like, but it’s not the insurance most people know. It’s more like buying fire insurance on your neighbor’s house, possibly for many times the value of that house — from a company that probably doesn’t have any real ability to pay you if someone sets fire to the whole neighborhood. The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets.

“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.  [Note: Eliot Spitzer had much the same suggestion a few weeks ago in Slate.com.  I expressed skepticism, pointing to the apparent economies of scale in banking, but it seems time for a new look at whether those scale economies outweigh the risks of creating more too-big-to-fail institutions.]

“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.”

If there is one good thing about the shambles that our economy and financial system have become, it’s that the Lewis, one of the most delightful writers around, has a lot of fresh material to work with.  Lewis’s long quasi-epilogue to Liar’s Poker ran in the Dec. 2008 Conde Nast Portfolio.  He is currently working on a book on the Wall Street debacle.  And he’s already out with an edited collection of others’ articles, essays, and book excerpts, titled Panic! The Story of Modern Financial Insanity.

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One Response to “Michael Lewis on the financial mess”

  1. Michael Lewis on the financial mess « Blogging Through the Wreckage | companiesmortgage.com Says:

    […] Michael Lewis on the financial mess « Blogging Through the Wreckage […]

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