You may well be asking yourself, as I have asked myself, how on earth did the credit crisis on Wall Street become such a catastrophe?
How did all of the mechanisms operated by the mind-bogglingly well-paid men and women of the Street go so wrong that we saw a major investment bank, Bear Stearns, essentially disappear? How did Wall Street firms of ancient lineage take such immense losses that they made banks clam up on lending — at great risk to the economy?
Weren’t fail-safe devices in place to guard against risk? Weren’t government watchdogs there to make sure that catastrophes could not happen? Weren’t ratings agencies on the job to police what was going on in the canyons of Lower Manhattan?
To paraphrase Dr. Evil in the Austin Powers movies: “How about ‘no,’ Scott?”
Anyone who cares about this disaster would be extremely well advised (and I’d underline “extremely” as often as possible) to read a speech on the matter that was presented on April 8 by a genius investor named David Einhorn at a Grant’s Interest Rate Observer event.
Einhorn runs Greenlight Capital, a successful hedge fund. He isn’t an infallible observer of human lapses and regulatory failures — he invested in and briefly served on the board of New Century, a subprime mortgage lender that later went bust amid accounting problems. He didn’t respond to my questions about New Century. Nor did he return calls seeking comment on his masterly essay on the current financial debacle.
Yet his speech so well explains what went wrong that it’s frightening. Here is my CliffsNotes version of it.
First, Maestro Einhorn points out that the fellows who run big investment banks have a strong incentive to maximize their assets and leverage themselves into deep trouble because their pay is a function of how much debt they can pile on. If they can use relatively low-interest debt to generate slightly higher returns, the firm earns more revenue and executive pay increases. Often, an astonishing 50 percent of total revenue goes to employee compensation at Wall Street firms.
Now, you may ask, what kind of assets were they acquiring with that debt? Well, sometimes, as with Bear Stearns, the leveraged assets are mostly government agency debt, which used to be regarded as fairly safe.
Sometimes, as Einhorn notes, those portfolios also hold stocks, bonds, loans awaiting securitization, and pieces of structured finance deals. They also hold heavy exposure to derivatives that have stunning risk profiles and can produce astounding losses in bad circumstances. They might also contain real estate assets and have exposure to private equity deals.
In other words, they can hold some scary “assets.” What do they hold as capital against such risks? You would think it would be cash or Treasury bonds, wouldn’t you? But no.
Under an interesting set of rules promulgated by the Securities and Exchange Commission (SEC) in 2004, called “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” the amount of capital that had to underlie assets was reduced substantially. (Einhorn rightly says that this set of rules should have been called the “Bear Stearns Future Insolvency Act of 2004.”)
Through the act, the SEC — acting as one of Wall Street’s chief regulators, mind you — also allowed things like “hybrid capital instruments” (much riskier than cash or Treasuries), subordinated debt (ditto) and even deferred return of taxes, to be counted as capital. The SEC even allowed the banks to hold securities “for which there is no ready market” as capital.
“These adjustments reduced the amount of required capital to engage in increasingly risky activities,” Einhorn says.
In response to Einhorn’s critique, an SEC spokesman told me that these changes could theoretically lower capital, but that the agency has seen no evidence that that has, in fact, occurred.
But Einhorn has even more troubling observations. He says the SEC also allowed broker-dealers to set their own valuations on assets and liabilities that were hard to value. And broker-dealers could assign their own creditworthiness ratings to counterparties in complex derivatives transactions when those counterparties were otherwise unrated.
In a word, Einhorn says, the SEC told Wall Street to police itself to save on regulatory costs, while not bothering to “discuss the cost to society of increasing the probability that a large broker-dealer could go bust.”
A result of all this, Einhorn says, was as follows:
“The owners, employees and creditors of these institutions are rewarded when they succeed, but it is all of us, the taxpayers, who are left on the hook if they fail. This is called private profits and socialized risk. Heads, I win. Tails you lose. It is a reverse-Robin Hood system.”
And when it all went kaput during the Bear Stearns debacle, the likable chairman of the SEC, Christopher Cox, said that the system was fine and needed no immediate repairs. Of course, Henry Paulson Jr, the Treasury secretary, is calling for merging the SEC with the easygoing Commodity Futures Trading Commission, in the financial equivalent of setting off a Doomsday Device.
The SEC told me that all of its actions were helpful to investors and that no one could have prevented the Bear Stearns collapse because it was caused by liquidity issues, not capital issues. My respectful response is that if Bear were thoroughly well capitalized, why would liquidity issues come up at all?
There is much more in Einhorn’s speech about how dramatically understaffed the ratings agencies are in assessing risk on Wall Street and how even the biggest ratings agencies largely allowed the Street to rate itself.
The big ratings firms, according to Einhorn, do not even bother to assess the major investment banks’ portfolios because they change so often.
It looks to me as if the inmates are running the asylum. One truth, that deregulation is sometimes a good thing, has been followed down so long and winding a road that it has led to an immense lie: that deregulation carried to an extreme will not lead to calamity.
To think that people of this mindset are in charge of the finances of the nation that is the cornerstone of world freedom is terrifying. Einhorn may well have done us a service of great value.
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