“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity are in a state of shocked disbelief.  I made a mistake in presuming that . . . they were best capable of protecting their own shareholders and their equity in the firms.”

— Alan Greenspan

 

With healthcare reform a done deal, the U.S. Congress is now focused on financial regulation reform. On Monday March 22, the Senate banking committee approved the “Restoring American Financial Stability Act of 2010,” which now goes to the full Senate for consideration. Senate passage is expected by the end of May, at which time it must be reconciled with a similar House bill that was passed in December of last year.

Free Markets Are Usually Best

If asked, my friends would characterize me as a free-market type of guy. I lean more towards viewing government as the problem, not the solution. The innovative spirit and rugged individualism of the American people is the source of our strength and prosperity. Government usually interferes with this energy for the worse, by taxing and redistributing wealth, much of it simply to feed its own parasitic bureaucracy.  This is why yesterday I wrote “The $700 Billion Lie” criticizing the healthcare reform law; it represents a government gone wild, creating massive new entitlement programs that could bankrupt our nation by worsening out-of-control healthcare spending.

But Not in Investment Banking

So, being the free-marketeer that I am, I must be against financial regulation reform too, right? Wrong. The financial crisis of 2008 and deep recession that followed is a glaring example of complete market failure. Even Ayn Rand-disciple and former Federal Reserve Chairman Alan Greenspan, whom I quote above, now realizes that free markets, left to their own devices, sometimes screw up big-time. 

The principal cause of a market failure is the existence of “externalities.” Free market theory assumes that the transaction a buyer and a seller enter into fully accounts for the costs and benefits associated with that transaction. Only if the benefits outweigh the costs will the transaction take place. But in real life, transactions sometimes take place despite costs outweighing the benefits because the costs are not fully borne by the transacting party.

The Agency Problem in Investment Banking

In the financial realm, an example of this is the agency problem. Shareholders own a corporation but they hire agent-managers to run it for them.  In free market theory, the agent and the owner have identical interests. But in reality the agent’s personal financial interests can conflict with those of his owner-employer.

Take, for example, investment banking executives. Investment banks were at the heart of the financial crisis because they were the ones securitizing subprime mortgages and credit default swaps and selling these toxic securities to institutions at a bogus AAA rating (with the help of S&P and Moody’s).  The compensation system for these bank executives did not fully account for the risk of loss that would occur if home mortgages defaulted and the mortgage securities on the bank’s balance sheet became worthless.

These executives had virtually unlimited upside if mortgages did not default and very limited downside if they did (e.g., getting fired).  A few years of million-dollar salaries was all they needed to be set up for life and retire. If, down the road, their activities blew up, costing the company billions of dollars in losses, so what? They would be long gone. The result is that investment bankers took huge risks to maximize their personal earnings at the expense of the companies they worked for.

It wasn’t always this way. Investment banks used to be partnerships where the employees were also the owners. As Michael Lewis, author of Liar’s Poker, put it in a 2008 article on the crisis:

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

But investment banks sold out to the public and became corporations, which transferred the financial risk to the shareholders. Lewis quoted John Gutfreund, former CEO of Salomon Brothers, as explaining the effect of the new corporate form this way: “When things go wrong, it’s their problem.”

This agency problem is the market failure that Greenspan completely missed as Fed Chairman and which mistakenly led him to believe that investment banks could regulate themselves. As an economist, he must have known about agent-problem externalities, but was he so naïve that he thought that investment bankers had sufficient integrity to not exploit it?  Hah!  Integrity and investment bankers is an oxymoron.

Psychopaths Cannot Be Trusted

In fact, most top investment bankers appear to be psychopaths. According to one definition, psychopaths are people who:

fail to feel remorse or guilt. They appear to lack a conscience and are completely self-serving. They routinely disregard rules, social mores and laws, unmindful of putting others at risk. They tend to be extremely organized, secretive and manipulative. The outer personality is often charismatic and charming, hiding the real person beneath. Though psychopaths do not feel for others, they can mimic behaviors that make them appear normal.

Don’t take my word for it. One of my favorite blogs is called the Epicurean Dealmaker, written by an investment banker who prefers to remain anonymous. He should know what his colleagues are like and he writes:

I have yet to encounter a senior executive manager at a large investment bank who does not demonstrate a very substantial number of the commonly accepted markers for psychopathy.  Investment banking is a business which both attracts and rewards individuals with cast iron egos who can stab their closest ally in the back minutes after buying them a drink.

It is also true that investment bankers are a remarkably unreflective bunch. They have neither the time nor inclination to ruminate, contemplate, or introspect concerning their clients or deals. It is his sole job to monetize them all to the greatest extent possible for the greatest pecuniary reward possible. Should he fail in this regard, or display an excessively philosophical or contemplative bent, his superiors will look askance and begin to size him up for a wooden box.

And don’t forget that “American Psycho,” Bret Easton Ellis’ disturbing book about the soulless and status-obsessed 1980’s Wall Street culture, has an investment banker in the starring role.

Lehman Brothers Was a Poster Child of Dysfunction

On March 11^th, Anton Valukas, the legal examiner for Lehman Brothers bankruptcy proceeding, released his 2200-page report on Lehman’s collapse. He found that Lehman’s “traders and business units were incented to enter into transactions for short-term profits, even if those transactions created long-term risks for the firm.”

Valukas also concluded that Lehman intentionally “painted a misleading picture of its financial condition” through the use of an accounting trick called “Repo 105,” which allowed it to hide $50 billion of its assets and make the firm look less leveraged than it really was. Repo 105 accounting constitutes fraud and Valukas concluded that “colorable claims of breach of fiduciary duty exist against CEO Richard Fuld” and others. Yet, the New York Post reported that Fuld feels fully vindicated by the report and did nothing illegal. Huh? How can you feel fully vindicated by a report that says you committed accounting fraud?  That’s not normal. No wonder Fuld was voted the worst CEO of all time by Portfolio.com.

Fuld is not the only one to show a complete lack of remorse for committing accounting fraud.  The New York Observer interviewed three other senior Lehman executives about Repo 105 and they all dismissed the issue as unimportant. Some of their voiced reactions to the Valukas report are as follows:

• “The only people who would worry about using an old trick to reduce leverage are yappers who don’t know anything.”

• “When I read this, I giggle a little bit. Because $50 billion is a drop in the ocean.”

• “It’s just not that big of an event. They don’t know what they’re talking about.”

• “It’s funny, for nonprofessionals, you can try to make it a smoking gun. I’m like, whatever.”

Reread the definition of psychopaths above: fail to feel remorse or guilt, appear to lack a conscience, routinely disregard rules. Hmmm…

Maybe it’s just me, but people like this need to be regulated. It reminds me of Enron starring Ken Lay and Andrew Fastow. And it reminds me of the thousands of people who lost their jobs and retirement savings. A marketplace that gives free reign to investment bankers is not a market I want to be involved in.

Greatest Hits of the Senate Financial Reform Bill

So I hope that financial regulation reform passes.  Some of the regulations in the Senate bill I like the most:

• Requires executives to return compensation when it turns out to have been based on inaccurate financial statements.

• Bans risky executive compensation practices and requires that all members of compensation committees be independent directors.

• Requires that most financial derivatives be traded transparently on exchanges, eliminating counterparty risk.

• Establishes a Financial Stability Oversight Council to detect risks to the financial system.

• Prohibits investment bank officers from serving on the boards of the Fed’s 12 district banks.

• Restricts banks from proprietary trading and owning hedge funds.

Vulgar, But Accurate

To sum up, financial regulation reform is needed because Wall Street proved it did not have the integrity to regulate itself. The market failed. Michael Lewis quotes hedge fund manager Steve Eisman, who made a bundle shorting subprime mortgage debt, as giving as good a rationale as any for increased financial industry regulation:

That Wall Street has gone down because of this is justice. These guys lied to infinity. They fucked people. They built a castle to rip people off. Wall Street didn’t give a shit what it sold. Not once in all these years have I come across a person inside a big Wall Street firm who was having a crisis of conscience.

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