The End of the Financial World as We Know It

By Michael Lewis and David Einhorn, The New York Times. Posted January 6, 2009.

Credit-default swaps may not be Exhibit No. 1 in the case against financial complexity, but they are useful evidence. Whatever credit defaults are in theory, in practice they have become mainly side bets on whether some company, or some subprime mortgage-backed bond, some municipality, or even the United States government will go bust. In the extreme case, subprime mortgage bonds were created so that smart investors, using credit-default swaps, could bet against them. Call it insurance if you like, but it's not the insurance most people know. It's more like buying fire insurance on your neighbor's house, possibly for many times the value of that house -- from a company that probably doesn't have any real ability to pay you if someone sets fire to the whole neighborhood. The most critical role for regulation is to make sure that the sellers of risk have the capital to support their bets.

Impose new capital requirements on banks. The new international standard now being adopted by American banks is known in the trade as Basel II. Basel II is premised on the belief that banks do a better job than regulators of measuring their own risks -- because the banks have the greater interest in not failing. Back in 2004, the S.E.C. put in place its own version of this standard for investment banks. We know how that turned out. A better idea would be to require banks to hold less capital in bad times and more capital in good times. Now that we have seen how too-big-to-fail financial institutions behave, it is clear that relieving them of stringent requirements is not the way to go.

Another good solution to the too-big-to-fail problem is to break up any institution that becomes too big to fail.

Close the revolving door between the S.E.C. and Wall Street. At every turn we keep coming back to an enormous barrier to reform: Wall Street's political influence. Its influence over the S.E.C. is further compromised by its ability to enrich the people who work for it. Realistically, there is only so much that can be done to fix the problem, but one measure is obvious: forbid regulators, for some meaningful amount of time after they have left the S.E.C., from accepting high-paying jobs with Wall Street firms.

But keep the door open the other way. If the S.E.C. is to restore its credibility as an investor protection agency, it should have some experienced, respected investors (which is not the same thing as investment bankers) as commissioners. President-elect Barack Obama should nominate at least one with a notable career investing capital, and another with experience uncovering corporate misconduct. As it happens, the most critical job, chief of enforcement, now has a perfect candidate, a civic-minded former investor with firsthand experience of the S.E.C.'s ineptitude: Harry Markopolos.

The funny thing is, there's nothing all that radical about most of these changes. A disinterested person would probably wonder why many of them had not been made long ago. A committee of people whose financial interests are somehow bound up with Wall Street is a different matter.

© 2008 The New York Times

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