TOPICS IN POLITICAL ECONOMY

FINANCIAL MARKETS, THE G-20 AND UNINTENDED CONSEQUENCES

One year ago, following the collapse of Lehman Brothers, the $3.4 trillion money market fund industry essentially froze up when The Reserve Fund "broke the buck."  That was the real start of the financial crisis, as this blog has suggested in the past.

The best detailed description how this event caught the Fed and the Treasury Department off-guard is now the recent extensively researched article by Bloomberg reporters.

There is a lesson to learn (or relearn, if you have forgotten three hundred years of financial market history) from the article: in a complex financial world with many players, an unexpected, catalytic event can lead to a rush for liquidity which threatens to overwhelm not just all the players, but the customers and spectators as well.

The real danger now is that governments will over-react with poorly thought-out legislation and regulation that will create even greater problems down the road.

While some of the suggestions for reform are sensible (such as requiring larger banks to hold more capital), the list of "further steps" that the G-20 heads of state and ministers are supposed to consider in Pittsburgh later this month contains the potential for substantial amounts of mischief and unintended consequences, e.g. "global standards on pay structure" and "oversight for systemically important firms."  (The latter item has taken on concrete form in the proposed legislation to have the Federal Reserve designate "Tier I" firms, as discussed in my previous blog.)

At Least Lehman Brothers Was Allowed to Fail. Despite much talk of the "mistake" in letting Lehman Brothers fail, there are some astute observers (see Niall Ferguson in yesterday's Financial Times) who point to that event as a much-needed reminder that very large institutions can fail - and all managers, shareholders and creditors of other financial institutions should keep this always in mind.

Never permitting another Lehman-type bankruptcy is the worst possible policy goal of financial reform.  As Ferguson points out, "the real tragedy is that the failure of Lehman has left Wall Street's survivors both bigger in relative terms and more secure politically . . . if only we had learnt from Lehman that no bank should be 'too big to fail', we might still have a real capitalist system, instead of the state-guaranteed monstrosity that is the real legacy of last year's crisis."

Ferguson is a bit too gloomy, and no doubt the attempt to ensure "a level playing field" around the globe will slow down truly ill-advised initiatives. But never underestimate the ego of determined politicians to "do something."

REAL REGULATORY REFORM: FOR MONEY MARKET FUNDS

 

The Securities and Exchange Commission is supposed to look out for the small investor.  So, how did it end up precipitating the collapse, last September, of the entire money market fund (MMF) sector and the need for the U.S. Treasury to step in and guarantee $3.4 trillion in shares?

 

Take a look at Joe Nocera's outstanding piece, "The Risk in Money Funds," in today's New York Times business section, (normally not a solid source for economic and financial analysis). The massive run on all MMF shares was precipitated by The Reserve Fund's "breaking the buck" (marking down the value of its shares from $1.00) because of its holdings of $785 million in bankrupt Lehman Brothers' commercial paper. The run was aborted by the U.S. Treasury Department's guarantee of the $3.4 trillion in outstanding shares last September. 

 

The SEC Sponsors a Shadow Banking System. Originally, MMFs were not allowed to design and market their shares around a stable $1 @ share net asset value.  However, in the late 1970s the investment companies persuaded the SEC to let them follow accounting rules and marketing pitches that permitted them to do so under almost any conditions - and sell them, in effect, as alternatives to bank checking accounts, complete with check writing features - "turbocharged" bank accounts, as Nocera describes them. 

 

In the high interest rate environment of the 1980s, the MMFs prospered mightily. By the 1990s, they had become a parallel banking system, providing billions of dollars of short-term credit in competition with commercial banks. To further confidence in MMFs, the SEC started, with industry support, to mandate investments only with top credit ratings from the likes of Moody's and Standard & Poor's. Then, during the subprime mortgage boom, they plunged, indirectly, into that lending business, too, which the credit rating agencies facilitated with plenty of AAA marks on mortgage-backed securities.

 

In short, the MMFs had everything but FDIC insurance - and now, as a result of last September, they have demonstrated that Washington will guarantee $1 @ share if another run threatens.

 

Now What?  We can't rewrite history - but we can rewrite regulation so that the true riskiness of MMFs is transparent to investors, and reduce the likelihood of another government bailout.  As Nocera points out, the single best way to do that is to undo the SEC regulations that let them price and market their shares under almost any conditions at $1.00. Insist that MMF shares trade the way all other mutual fund shares trade.

 

Another action to make investors more conscious of risk would be to remove the mandate that MMFs invest only in SEC-defined "eligible" securities, and force fund managers to pay more attention to the creditworthiness of their investments. (S&P gave Lehman Brothers' short-term paper their highest credit rating until the day before that firm declared bankruptcy.)

 

Real reform of the money market sector means it will not enjoy all of the SEC-bequeathed competitive advantages they have had in the past.  But if the agency is more concerned about investor protection than the MMF's market share of  deposits v.v. commercial banks and savings institutions, it will take the steps advocated above. Otherwise, we might just as well force the conversion of MMFs into FDIC-insured banks (as Paul Volcker, for example, has advocated).

TIER 1 AND "TOO BIG TO FAIL" - BEWARE THE LAW OF UNINTENDED CONSEQUENCES

 

The problem of how to deal with very large and failing financial firms is as old as the privately-owned Bank of England’s problems in 1797, when it prevailed upon the British government to permit it to suspend payments in specie (coin) to its note holders.  It was carefully analyzed by the British economist Henry Thornton in 1802.  He saw a role for central bank "bailouts" so long as the rescued institution was solvent (e.g. facing a depositor panic that was based on erroneous fears).   

The bailout problem has bedeviled banking regulators in the United States for decades, most prominently (before the current financial cycle) in the case of Continental Illinois in 1984.   Only 10% ($4 billion) of its funding base was in insured deposits. But everyone, including bondholders, got all their money back.

Despite the Continental precedent, up until recently the Federal Reserve, the FDIC and other U.S. banking regulators have been careful to ensure that a reasonably high degree of “constructive ambiguity” existed to try keep bankers and creditors focused on sound banking practices.  Lehman Brothers was allowed to fail.  In the past 12 months, however, all the old rules have been thrown out and replaced with massive bailouts and federal guarantees on nearly every kind of short-term borrowing that exists.

Now comes the Obama Administration's proposal for another way to deal with the problem - and it's a very flawed approach: establish a "Tier 1" category of very large regulated financial firms.

 Such firms would be chosen by the Federal Reserve Board on the basis of their potential to “pose a threat to global or U.S. financial stability or the global or U.S. economy during times of economic stress.”  They would be subjected to more stringent standards than other financial firms.

The Tier 1 concept would apply to any “financial company” with more than $10 billion in assets, $100 billion in assets under management or $2 billion or more in gross annual revenue. In other words,  very large insurance  and investment companies, finance companies, and hedge funds, among others,  are to be herded into the Tier 1 corral. 

In effect, Tier 1 firms would be designated “too big to fail” and become a protected class. All their liabilities (except the shareholders’ investment) would be guaranteed by the Federal government.  Depositors, bondholders, and transaction counter-parties need not concern themselves with the financial stability of the Tier 1 firms they are doing business with.  “Let the regulators worry about that” is the message.

 The proposed legislation tries to inject a shred of uncertainty by requiring a bankruptcy hearing if a firm becomes “critically under-capitalized.”  But the whole purpose of the Tier 1 concept is to make sure this never happens and, even if it does, the only parties at risk are going to be shareholders.

Why “Tier 1” is Bad Policy.  Maintaining a sufficient degree of uncertainty about government support for specific financial institutions (“constructive ambiguity”) is a critically important  incentive for financial firms to act prudently –  historically, even more important than regulatory restrictions on capital and bank operations.

When the uncertainty level is low, e.g. government bailout probabilities are high, we end up with imprudent lending  (the “moral hazard” problem) and massive government bailouts – Fannie Mae and Freddie Mac being today’s prime examples.

By making it 99.9% certain that creditors of the largest financial firms will not be allowed to lose their investment, smaller firms will suffer an even greater  competitive disadvantage. (Small banks are already seriously disadvantaged by the largest banks' free ride in the deposit insurance system - as in the case of Continental.) 

Tier 1 makes analytical sense only if the promised “more stringent” standards on capital and liquidity ratios cost Tier 1 firms more than they gain in lower funding costs. Trying to make the cost of such standards equal to the value of the funding subsidy – across a myriad number and variety of financial institutions via regulatory fiat  - will only result in a massive and counterproductive web of paperwork and bureaucratic intrusions.  And it will lead to the establishment of a lobbying powerhouse (“The Tier 1 Toughs”?) that would make sure their clients came out ahead.

A Better Way Forward.  While there are many debatable aspects to the Administration’s package of financial reform regulation, the Tier 1 concept has the highest probability of major, adverse and unintended consequences.

Already the working assumption in financial markets today is that every “very large” financial institution will be supported.  While the Administration’s recent refusal to assist CIT Financial (a $75 billion finance company) helps to distinguish “large” from “very large,” the Tier 1 concept needs to be totally abandoned. 

Instead of Tier 1, all banking firms (including finance companies and government-sponsored agencies, such as Fannie Mae) should face a relatively seamless series of increasingly higher capital requirements as they grow in size.  Regulators should continue using “constructive ambiguity” (e.g. the possibility of large firms' bankruptcy and losses to their creditors) as a way to encourage prudent management - and to offset any tendency by managers to invest in increasingly risky assets as their capital requirements grow.

Nonbanking institutions, such as insurance and investment companies as well as hedge funds, should be excluded from the new regime.  No substantive evidence has been advanced that demonstrates these institutions, as a group, need to be included;  AIG was an outlier, already subject to federal regulatory oversight.

Final Note.  Unfortunately, rather than focusing on the implications of Tier 1, Congressional and media attention has been directed at relatively minor turf fights among federal regulatory agencies  -  and Treasury Secretary Geithner’s irritation about what is going on in the back of the bus. 

It's time for all the players to pay attention to the dangerous economic and political consequences of establishing a "protected class" of mega financial firms.

STRESS TESTS, KEYNES AND THE BANKING SYSTEM

So, the well-meaning civil servants have dutifully ground through the numbers and their politically-attuned Treasury/White House managers have signed off on the "stress tests" of 19 major shareholder-owned financial institutions.  (Notice that the Social Security System and major public employee pension funds - e.g. the State of California's mega fund Calpers - have not had to undergo similar scrutiny.)

What do we know now that we didn't know yesterday?  Not a great deal more.  The regulators took these institutions' current balance sheets, posited a set of assumptions about future economic conditions and loan losses, and let the Excel spreadsheets generate a set of numbers and ratios. These purport to estimate the "capital buffers" each institution has to have to weather a more severe economic downturn. A fairly simple exercise for any reasonably competent MBA.

The Reality.  What has been the true purpose of this exercise?  The answer can be found in John Maynard Keynes' "The General Theory of Employment, Interest, and Money."  But it has all to do with "confidence" and nothing to do with spending and fiscal stimulus. 

The answer is in Chapter 12, "The State of Long-Term Expectation."  Long term expectations, Keynes pointed out, do not depend solely on forecasts, but also depend upon "the confidence with which we make this forecast."  The state of confidence, in turn, is critical to determining the appetite for investment and enterprise. I suspect that more than a handful of Federal Reserve governors and staffers, and a few Treasury Department types, have been re-reading this classic essay in recent weeks.

In other words, since the rating agencies have been shown to be close to useless in such matters, and the credit default swap market had been so bad-mouthed by politicians and journalists, and the regulators themselves were shown to have been clueless, a hopefully credible alternative had to be immediately established.  

Washington's "stress tests" have been one in a series of actions designed to restore confidence in the financial system and among bankers.  This is to ensure that depositors and other lenders are comfortable in entrusting their funds to such institutions, who in turn will be able to extend credit.   

The Politics. The results of the stress tests rest on fairly credible assumptions: the "more adverse" stress simulation assumed a two-year loss rate of 9.1% of total loans (the highest rate in at least 90 years) and the highest unemployment rate since the 1930s. Ten of the 19 financial institutions evaluated were seen as needing to augment their "Tier I" capital to cope with such a  downturn, but the initial reaction in the market is that this should be feasible without a major problem.

As I have suggested in this corner before, "modern money is magic." Destroy my confidence in my bank - any bank - and you destroy money, as represented by that bank's deposits, as I withdraw my deposit and turn it into currency, gold, or some other borrower's liability (Treasury bills?). The stress tests, originally announced in February, were designed and orchestrated primarily to restore confidence in major financial institutions.

In short, the entertaining saga of the "stress tests"  has more elements of a long-running, elaborate Japanese noh drama than technocratic public policy - but that doesn't mean we can't congratulate the dramatists for a useful script. 

"FINANCIAL CRISIS MANAGEMENT 101" FOR POLITICIANS - AND THE PUBLIC

A short course in current financial market realities is badly needed for most members of Congress and a fair number of the chattering class, many of whom are threatening to exacerbate the current situation.

1. Please don't forget that the primary objective of nearly all of the money that has been pumped into commercial and investment banks and AIG, as well as the expansion of government deposit/money market fund insurance by the FDIC and the Treasury was intended to stop a massive and highly dangerous run on the nation's banking system in the last six months of 2008.

2. That effort has been successful. Give the Treasury and the Federal Reserve some credit for what they did, even if their public explanations were unsatisfactory - as they still are.

3. Stop asking the banks "Where did the TARP money go?" The complexity and daily volume of multimillion dollar transactions on any large bank's balance sheet makes this essentially a rhetorical question. Stopping the run on bank and money fund deposits was the first and most important step in avoiding an excessive contraction of the banking system.

4. Stop trying to get the banks (and the government mortgage agencies) to lend or guarantee more loans. In a recession, such as we are now experiencing, lenders quite properly become more cautious, as do potential borrowers. Wasn't it the combination of loose lending standards and over-leveraged lenders and borrowers/buyers that made this downturn so serious?  The need to generate income will provide sufficient incentive for lenders to extend new credits. (No bank can cover its overhead investing in Treasury bills at 1%.)

5.  Understand business cycles. All recessions are characterized by sharp slowdowns in credit extensions. In fact, in March loans outstanding at large commercial banks to both business and consumers were still at higher levels than a year ago.  At some point in the near future, we should expect them to be below year earlier levels, as they normally are at later stages of the business cycle.   

6. Stop bad-mouthing bankers and threatening to impose regulatory burdens on hedge funds. You need them (1) to sort out the mess of bad assets still on banks' balance sheets and (2) to restart the markets for securitized mortgages and loans if you want the credit markets to open up fully.

7.  Study what recently happened in Iceland where a politician was appointed to head up the Central Bank and was instrumental in creating a real financial disaster.

CHINA, CONVERGENCE, AND MARKET CAPITALISM

Most of the noise coming out of this week’s meeting of the  G-20  heads of state in London will be about regulation,  “stimulation” and new barriers to international trade.   But there Is very likely to be one truly significant long-run political outcome: the functional acceptance of China by “the West” as a major financial and economic power.

This acceptance will take the form of communiqué  language that makes it clearer than ever that China’s share of voting power in the International Monetary Fund (and, perhaps, in the World Bank) will be increased substantially within the next two years.  This shift in voting power will be facilitated by a large increase in IMF resources contributed by member governments, most prominently the Chinese.  

The Death of Market Capitalism?  At the same time, noisemakers at the G-20 meetings will add decibels to the continuing funereal chorus from the chattering classes about “the death of market capitalism.” This, despite the fact that China owes its rise to global power thanks to its embrace of the key elements of market capitalism:  market prices to provide incentives to producers and letting individuals own the means of production and grow rich.

Market capitalism is not going to wither away just because financial regulators around the world decide to insist on less risk-taking by (government-supported) financial institutions, such as FDIC-insured banks, “too big to fail” investment banks, and government real estate lending agencies (FNMA and Freddie Mac). 

It was a form of market capitalism that lifted 400 million Chinese out of dire poverty in the fifteen years between 1990 and 2005, and which now makes some pundits muse about turning global leadership over to the “G-2” – the United States and China. 

Why Losing Market Share May Be Progress.  If market capitalism is not dying, then perhaps the U.S. is threatened by China because of a shrinking share of global economic output?  This notion surfaces in numerous discussions about China’s extraordinary economic achievements as well as international comparisons  of spending on research and development,  patents issued, educational achievements and a myriad of other measures.

But the emphasis on “market share” is simple-minded and incorrect, if the absolute level of economic well-being continues to improve.  In this situation, which certainly describes the past 15 years or so, a smaller market share for #1 simply reflects more rapid growth by lower-ranked countries. 

Furthermore, as Nobel prize winning economist Edward Prescott and Stephen Parente have suggested, if all countries would dismantle “barriers to experimentation”  (ranging from civil strife to monopolies to trade protectionism), “there is no reason why the whole world should not be as rich as the leading industrial country.”  In short, China’s progress over the past two decades is a strong argument in favor of what is known as the “convergence” hypothesis among economic growth theorists – as well as market capitalism.

Cut the Bad-Mouthing.  So, when China sits down in a much bigger chair at IMF board meetings in 2011, there is no reason to bad-mouth either the U.S. or market capitalism.  Instead, congratulate the Chinese and remind yourself that it was a form of market capitalism that got them there.

THE SIREN CALL OF FINANCIAL MARKET REGULATION

At the recent meeting of G-20 finance ministers in London it seems "more regulation" was on everyone's lips as the way to avoid a repeat of the current financial mess.  The only difference between the U.S. and most of the other countries was "how much?" 

The Europeans are hung up on bringing hedge funds under much tighter regulation.  Why is this so?  At first glance, it is hard to understand: no huge "too big to fail" fund had to be bailed out by any government - although a lot have simply folded up and returned a few cents on the dollar to their original investors.  It is true that hedge fund managers became very nervous when their "prime brokers" such as Bear Stearns and Lehman Brothers started looking sickly.  These funds started pulling out their money and securities - or buying credit default swaps to protect themselves if their broker went bust. Were they wrong to behave in this manner?

The standard European politician's complaint is that hedge funds are secretive and disruptive, especially for the managements of old-line, sleepy corporations. That would help explain the push for regulation - along with the fact that they pose a long-run competitive threat to already over-regulated traditional financial institutions. 

Who's the Biggest  Problem?  The fact is that it was the most regulated institutions in the U.S. that have caused us the most problems: investment banks and money market funds overseen by the SEC plus commercial banks and bank-holding companies overseen by the FDIC, the Comptroller of the Currency and the Federal Reserve. 

With respect to the rating agencies (who made a major contribution to the 'perfect storm' of the current financial mess), the SEC has plenty to answer for. They required money market funds to structure their portfolios around S&P and Moody's credit ratings as a substitute for the funds' own due diligence. And anyone who studied the models used by  credit agency analysts to rate complex mortgage securities had to take a dim view of their robustness (i.e. using less than 10 years loss experience). All this, plus the well-known weakness in the agencies' current business model, where issuers, not investors, pay for the rating.

While the new SEC Chairwoman has talked obliquely about moving the agencies towards an "investor pays" model, the major government initiative at the moment seems to be to impose regulation and its attendant costs on the only honest canary in the credit rating coal mine - the unregulated credit default swap market.

And then there's the shadowy links between Bernie Madoff and the SEC staff, and the failures to follow up on credible suspicions of a long-standing Ponzi scheme.

AIG's Regulator: Asleep at the Switch.  Only just coming to light - and lost in the uproar over AIG bonuses -  is the failure of Federal government oversight of AIG's disastrous bets on derivatives.  In an extraordinary "mea culpa" in recent Congressional testimony, the Acting Director of the Office of Thrift Supervision has conceded that his agency (which had authority to examine all parts of AIG due to its ownership of a federal savings bank) fell down on the job despite "continuous, consolidated supervision of the AIG group."

You would think that thoughtful politicians and public officials would understand that it wasn't too little regulation that contributed to the financial mess, but a combination of clueless regulation, perverse incentives (e.g. for rating agencies and financial firms' compensation arrangements) and an inability by the federal government to effectively address the "too big to fail" issue that are the central regulatory issues.  Addressing these subjects effectively is where real leadership in Congress and at the agencies is needed - and sorely lacking.

"MARK TO MARKET" ACCOUNTING: GASOLINE ON THE FIRE?

To understand the importance of the "mark to market" issue that is causing so much anguish in the financial markets  ("gasoline on the fire," in the words of Warren Buffett), here's a homely example.

Personal "Mark to Market" Accounting. Let's say a year ago I drew up a personal financial statement in the form of a balance sheet.  On the asset side, I have a very enjoyable Picasso portrait passed on by a deceased aunt.  Her estate valued the painting at $300,000 and that's what I put in my statement. After making all the other entries, my net worth (assets minus liabilities) came to $200,000.

But I read in the paper today that similar Picasso portraits are now selling for only $100,000. If I updated that financial statement, I would show a net worth of zero.  Should I  (1) declare bankruptcy or (2) ask a still-alive rich uncle for an immediate cash infusion?

Or (3) should I just go on as if nothing much had happened, continuing to admire the painting every time I passed it.  (Although I might advise my future heirs that if the market didn't turn around before I died, the painting wouldn't be as valuable as they had counted on.)

Financial Institutions, Regulators and "Mark to Market."   If you are like most regulated financial institutions these days and it's "subprime" mortgage securities instead of Picassos that we are talking about, your choice is generally limited to (2). Of course, there is no functioning market in such securities, so the valuation numbers are guesses, given an air of authority by complicated formulae. 

The application of "mark to market" accounting to all manner of assets was intended by the regulators to reduce the ability of managements to "cook the books" by demanding an "objective"  and transparent valuation method. But anyone who is familiar with the accounting issues in, say, money market funds, knows how complex and seemingly arbitrary some of these issues can be.  Indeed, in many respects, required accounting approaches are as much philosophical or political as they are technical  (just ask an energy company executive about accounting for oil and gas reserves).

As explained clearly by Holman Jenkins in The Wall Street Journal, because of "mark to market" accounting, the regulatory agencies consider many mortgage-heavy banks as insolvent, or close to it, and demand that they raise new equity capital (or provide it via the U.S. Treasury, with politically generated constraints).  Without this pressure from the authorities, most banks with "toxic assets" could probably earn their way out of the current mess so long as the profit spread between their (government insured) deposits and lending rates remains extremely wide.

It's Called Forbearance.  We've been down this road before - in the early 1980s when every major U.S. international bank had a pot full of developing country debt on their books that was in default. Strict application of regulatory accounting rules at that time would have forced several of the majors out of business. The regulators and the Treasury Department decided to look the other way and concentrate on letting the banks earn their way out of the mess (with a little help in the form of renegotiations with the debtors). All the details are in an excellent FDIC paper of several years ago.

Forbearance increasingly seems to make considerably more sense (and drastically reduce taxpayer investment in the banking system) than the current policy mish-mash - which has every would-be investor in new bank equity issues uncertain about how government action will affect their investment.   

 

NOTES ON "WHAT'S OLD, WHAT'S NEW" IN THE 2007-08 FINANCIAL CRISIS

See the one-pager I used in a recent roundtable discussion of the financial crisis:

• Six traditional factors common to all major financial disturbances, with their manifestations in the current case.

• Five factors distinctive in today's situation, and which have contributed to its' above-average severity.

THE CREDIT CRUNCH: A HELPFUL EARLY POST-MORTEM

Michael Lewis is a deservedly esteemed commentator on matters financial. He and David Einhorn, a hedge fund manager, have recently published in the New York Times an incisive if early post-mortem of the credit crunch/crisis.  (Lewis' recently-published compilation of articles on recent financial crises, "Panic," is useful background.)

Entitled "The End of the Financial World As We Know It," the Times essay's primary contribution is its analysis of the common factors linking the subprime debacle with Bernard Madoff's giant Ponzi scheme. The authors' central point is that in U.S. financial markets "the tyranny of the short-term has extended itself with frightening ease into the entities that were meant to . . . discipline Wall Street and force it to consider its enlightened self-interest." They point to three major "short-term" realities:

1. The intense pressure for short-term financial gains at publicly-held investment banks tends to lead to excessively risky strategies.  As Lewis and Einhorn point out, these pressures are as much internal as external - CEOs who decline to follow the latest apparently profitable play in risky assets risk losing bonus-hungry subordinates who can jump to less responsible competitors, even before the cautious CEO is fired by angry shareholders for being "behind the pack" in earnings gains. 

2. Rating agency oligopolies that are sanctioned by the SEC.  The rating agencies, "in pursuit of the their own short-term earnings . . . did exactly the opposite of what they were supposed to do: rather than expose financial risk, they systematically disguised it."  Case in point:  MBIA was a triple AAA in 1990, insuring municipal securities with a debt/equity ratio of 21%; still a AAA in 2006, but heavily engaged in insuring collateralized debt obligations, etc. and a debt/equity ratio of over 360%.  Underlying issues: regulatory mandates that institutional investors hold agency-rated securities and a business model where issuers, rather than investors, pay for ratings (see my blog of 5/1/2008). 

3. A one-way revolving door between SEC enforcement staff and Wall Street. Thanks to the ease with which SEC staff can migrate to highly-paid positions on Wall Street, "the Commission has somehow evolved into a mechanism for protecting financial predators with political clout from investors."  Apparent case in point: Bernard Madoff and his billion dollar Ponzi scheme. I would add another example:  the April 2004 decision to permit the major investment banks to leverage up their investment/trading exposures. It is clear from the SEC inspector general's testimony this week that the process of regulatory oversight, as well as the particulars of contacts between SEC staffers, Madoff, and others after several alerts, will be reviewed in depth.  

Compared to their analysis of the past, Lewis and Einhorn are less on the mark when it comes to remedies for the future, particularly when it comes to credit default swaps.  But I do like their solution to the "too big to fail" problem  (the practice of bailing out financial institutions whose demise would have "systemic" consequences for many others): "Break up any institution that becomes too big to fail."  I daresay Citibank shareholders might have appreciated that policy step some time ago.

They might also have considered the implications of the fact that many unregulated multibillion dollar hedge funds have come and gone this cycle without creating any systemic problems.

Bottom line:  you don't have to agree fully with either their analysis or recommendations to profit from an enjoyable and instructive read of Lewis and Einhorn's sprightly essay.