Madoff as a signal to go for “regulation heavy”

On a recent Bloomberg Radio with Tom Keene broadcast, Harvey Pitt and Arthur Levitt, two former SEC Chairman were guests. Levitt made the suggestion that hedge funds had once been given the choice of “regulation-light” or “regulation-heavy.” Now, in the wake of the Madoff scandal, “regulation-heavy” is all but assured. But, isn’t this just?

Listen to what Nobel-winning economist Paul Krugman makes of this:

How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?

The financial services industry has claimed an ever-growing share of the nation’s income over the past generation, making the people who run the industry incredibly rich. Yet, at this point, it looks as if much of the industry has been destroying value, not creating it. And it’s not just a matter of money: the vast riches achieved by those who managed other people’s money have had a corrupting effect on our society as a whole.

Let’s start with those paychecks. Last year, the average salary of employees in “securities, commodity contracts, and investments” was more than four times the average salary in the rest of the economy. Earning a million dollars was nothing special, and even incomes of $20 million or more were fairly common. The incomes of the richest Americans have exploded over the past generation, even as wages of ordinary workers have stagnated; high pay on Wall Street was a major cause of that divergence.

But surely those financial superstars must have been earning their millions, right? No, not necessarily. The pay system on Wall Street lavishly rewards the appearance of profit, even if that appearance later turns out to have been an illusion.

Consider the hypothetical example of a money manager who leverages up his clients’ money with lots of debt, then invests the bulked-up total in high-yielding but risky assets, such as dubious mortgage-backed securities. For a while — say, as long as a housing bubble continues to inflate — he (it’s almost always a he) will make big profits and receive big bonuses. Then, when the bubble bursts and his investments turn into toxic waste, his investors will lose big — but he’ll keep those bonuses.

O.K., maybe my example wasn’t hypothetical after all.

So, how different is what Wall Street in general did from the Madoff affair? Well, Mr. Madoff allegedly skipped a few steps, simply stealing his clients’ money rather than collecting big fees while exposing investors to risks they didn’t understand. And while Mr. Madoff was apparently a self-conscious fraud, many people on Wall Street believed their own hype. Still, the end result was the same (except for the house arrest): the money managers got rich; the investors saw their money disappear.

What Mr. Krugman just described is what Kevin Phillips calls the “financialization” of America. The financial services industry is a behemoth unlike the military-industrial complex, which has taken on an ever larger share of U.S. jobs, U.S. GDP, and until recently what we thought was U.S. profits. However, witness the extreme levels of debt used to achieve these phantom profits in the chart below.

The fact is that two decades of deregulation has created a financial services monster, which is both an important lobbying group in Washington and of disproportionate size to the real economy. This allowed fund of fund hedge funds to pyramid fees on top of Madoff’s own fees without doing the necessary due diligence regarding the primary funds. No investor would ever have suspected a thing as they received their statements from the fund of funds and not from Madoff directly.

Moreover, the Madoff scandal reveals the laxity in SEC regulation as multiple warnings had been given about Madoff as far back as 1999. Pitt assured the listeners that Madoff could have happened even in a more regulated environment because this was not systemic regulatory failure but human regulatory failure.

Really? I would label this whole episode systemic regulatory capture. And it all leads back to the lack of regulation. This is a systemic problem that needs a systemic fix. Deregulation is the problem here, not the solution.

If it’s broke, fix it – but how? – Willem Buiter’s Mavercon
The Madoff Economy – Paul Krugman, NY Times

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