Michael Lewis and David Einhorn have an important pair of pieces on what went wrong in our financial markets, and what needs to be done to fix them. Their diagnosis makes a lot of good points, among them the revolving door between the SEC's enforcement division and Wall Street. "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," they write. But if tighter enforcement might have caught Madoff, it would have done little to avert the subprime crisis. That wasn't a problem of the market rather than the government:
A lot has been said and written, for instance, about the corrupting effects on Wall Street of gigantic bonuses. What happened inside the major Wall Street firms, though, was more deeply unsettling than greedy people lusting for big checks: leaders of public corporations, especially financial corporations, are as good as required to lead for the short term.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.
You can't get away from the fact that everyone had the incentives to do almost exactly what they did. Fuld didn't betray the market in chasing subprime profits. He obeyed it. And for all Lewis and Einhorn's intellectual firepower, they don't have a good answer to that problem. Because the CEO's are not the autonomous actors Forbes profiles present them as. If Fuld refused to invest in subprime then his returns would lag in comparison to his competitors. His investors, who don't know much of the market or its history, would make a simple calculation and go with the higher-performing firm down the road. That is why Fuld's traders would go to other firms and his board would fire him. The market can stay irrational longer than he can stay solvent. Henry Blodget tells the story of Julian Robertson, an iconic hedge fund manager who correctly assessed the tech bubble as, well, a bubble. So he shorted it. Between 1998 and 2000, most of his investors had left, taking the fund from $20 billion to $6 billion. In spring of that year, he closed down his fund. The next year, the bubble popped. Lewis and Einhorn do have one worthwhile suggestion though: Make it hurt. A cold read of the past year would reveal that few but Lehman paid for their actions. The executives at most of the firms survived. The firms survived. The shareholders survived. Come the next bubble, an executive who recalled these days would be hard-pressed to decide that the consequences of herd behavior were worse than the isolation of heterodoxy. So Lewis and Einhorn suggest an alternative approach in the future:
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.
This, they say, is what Sweden did when faced with its financial crisis, and it worked rather well.
