January 04, 2009
Einhorn and Lewis on the Financial Crisis
Posted by David Zaring

On a plane back from remote Canada, I got a chance to read Michael Lewis and David Einhorn’s massive lecture on what went wrong regarding the financial imbroglio. Maybe they started writing a magazine article and turned it into an Op Ed – the piece is anecdotey and pat. I like Lewis, and other people like Einhorn, but:·

  •  Most of all, the theme bespeaks an obsession with corruption. This isn’t surprising – Einhorn makes his money by accusing other people of fraud, and, because he and shorts like him are willing to talk to journalists, the investigative arm of the business press seems to largely come by its big stories via short shops trying to make a buck. But corruption is really overstated in free and open markets, and anyway, market solutions often deal with corruption reasonably well.·
  • Still, corruption is the theme here. Einhorn and Lewis think that the problem with the credit rating agencies is that they are paid by those they rate. We’ve all heard about these conflicts before. The same business model has been adopted by accountants, lawyers, and stock exchanges. I might add that professor salaries are paid by the students that they grade. I suspect that Einhorn and Lewis don’t want to nationalize the professions of accountancy, law, and education. But I guess credit rating agencies are different, even though they use a model that is sketchy, but really rather ubiquitous (more interestingly, they posit that the CRAs wouldn’t downgrade seriously interconnected institutions like MBIA because then they’d have to revalue everything those institutions touched – a plausible, to my mind, shirking story).·
  • They say that the SEC falls down on the job because of the revolving door between government and Wall Street. Ho hum, and maybe true in a sense that few SEC officials want to abolish financial intermediaries and most hope that the markets will prosper. But revolving door conspiracy theorists should imagine the results of an empirical study on the career prospects of white collar crime prosecutors. We could check this if we wanted, but I suspect that financial crimes prosecutors who bring big cases against big defendants make much more money when they go into private practice than do prosecutors who bring no cases against no defendants. The revolving door would suggest otherwise, but would you, an ambitious young bureaucrat who secretly really wants to make money rather have been put on the Enron team or the Dynegy team? I’d recommend the former.·
  • They think that Harry Markopolous, the guy who realized that Madoff was running a Ponzi scheme for years (though of course, the financial crisis uncovered Madoff, rather than being caused in any way by him), and told the SEC about it, has “no direct financial interest in exposing Mr. Madoff.” That’s false. Markopolous worked for a Madoff competitor, and was told by his supervisors to match Madoff’s returns or explain why he couldn’t. Einhorn and Lewis must define “financial interest” in a novel way.

Some of the solutions embraced by Lewis and Einhorn make some sense to me. But if anyone suggests, as Einhorn and Lewis do, and, to be sure, as plenty of economists have also done, that there are a “handful of … perfectly obvious changes in the financial system to be made,” you should reach for your wallet. None of these worthies predicted the crisis – Einhorn is getting killed by it. Be my guest if you want to believe those who tell you that those running the show during the crisis – all of Wall Street and much of Washington – are corrupt or stupid or both, and that eight simple rules will lead us out of the business cycle and to paradise. But I prefer to believe that the crisis is complex, and that responding to it takes more than knee-jerk reactions, and, especially, more than moralizing over how dunderheaded the other guys are.

Okay, some praise.  The Joe Nocera article on Value at Risk in the magazine is amazing.

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Comments (10)

1. Posted by Erik on January 5, 2009 @ 7:24 | Permalink

Prof Zaring,

Thanks for your posts on this important issue. If you are inclined, you should check out John Taylor's speech given at the Central Bank of Canada- http://www.stanford.edu/~johntayl/FCPR.pdf. Although the paper itself is a bit technical, I think he nails the wrongheaded policies undertaken by the government.

You also might want to check out Yves Smith critique of the NY Times risk management piece- http://www.nakedcapitalism.com/2009/01/woefully-misleading-piece-on-value-at.html

2. Posted by David on January 5, 2009 @ 12:09 | Permalink

No question that there have been a number of wrongheaded policies, and the Yves Smith post is okay ... but once again, it's just not that plausible that everyone who uses VaR - that is, everyone except Smith and Taleb, are stupid. In my view, anyway. But the links are great!

3. Posted by MDF on January 5, 2009 @ 14:04 | Permalink

Nice points, Professor. I agree that the article is a real mix of interesting ideas and silliness. The point about getting rid of SEC recognition of rating agencies is a good point, but I don't see how getting rid of the issuer-pays model will work in a market where the rating itself (rather than the reason) is what matters and I don't see how you keep a rating change secret in this world. (In other words, who will pay when you can get the info for free?)

One point he makes that is interesting is that under certain market conditions, any executive unwilling to play along with even an obvious bubble market will soon lose his job for "leaving money on the table".

4. Posted by 2L on January 7, 2009 @ 11:39 | Permalink

This post is terrible. You have some odd bent against those who engage in short selling. Einhorn doesn't "accuse" people of fraud. WTF is wrong with you?

Market solutions often deal with corruption well? Yes, in the end . . . because of short sellers. OCA, ALD, MBI.

Have you even read Einhorn's book? The SEC is inept. His story, as it relates to the SEC, is eye-opening. I interviewed at the SEC in DC. When I asked how Enforcement finds leads, I was told SEC attorneys read the WSJ and other newspapers (presumably NYT and WaPo) to find leads. Unbelievable. Unf-ingbelievable. Perhaps the SEC should actually hire some experienced buyside analysts (footnote focused, short selling analysts) to show the SEC how massive frauds exist out in the open while continuing to issue securities under 33.

Einhorn's problem with the CRA's is that they are signals to the marketplace - because they get non-public information not available to you and I. Have you even bother to read his speech on the subject? What a hack.
"According to the rating agency party line, if people disagree, they are free to ignore the ratings. However, a credit rating is not an ordinary opinion. It is a “special” opinion — an insider opinion, because it is based on a different information set. I can’t replicate a rating analysis, because I am not privy to the information. Therefore, I am not on equal footing to be able to decide whether I agree or disagree with a rating agency. Since they know more than I do, the presumption has to be to agree. The rating agencies are structurally set up to have “insider opinions.”"

And have you actually watched his speech on ALD? Perhaps you'd actually have to understand financial reporting, the significance of different accounting standards, and SEC laziness to understand him:

It is absolutely ridiculous seeing law professors lacking a fundamental understanding of accounting and financial reporting. Too much focus on the forest and no desire to not only see the trees, but to also find the roots.

Again, unbelievable.

(I tried posting YT links of Einhorn being interviewed by FT, but the comment got flagged as spam. Just search "david einhorn pt" on YT to find the videos)

5. Posted by Economics of Contempt on January 7, 2009 @ 19:20 | Permalink

I'm sorry, but Zaring lands almost no punches in this post (though not for lack of punches thrown), and betrays an almost laughable naïveté about the real-world workings of financial markets.

This post deserves a critique of its own.

"[C]orruption is really overstated in free and open markets."

I agree. Too bad we don't have anything resembling "free and open" financial markets. When some of the biggest risk-bearers in the financial universe, such as the monolines, can take on most of their risk via Bermuda-based captive transformers with little to no disclosure requirements, then it's simply not credible to characterize financial markets as "open." There's a reason people call Channel Re "MBIA's black box."

"Einhorn makes his money by accusing other people of fraud."

Ummm, no. Shorts, including Einhorn, make money by accusing companies of being overvalued. Sometimes a company is overvalued because of fraud (see: Enron), and almost all fraudulent companies are overvalued, but there's a very elementary difference between the two. Aren't you supposed to be a professor or something?

"But revolving door conspiracy theorists should imagine the results of an empirical study on the career prospects of white collar crime prosecutors."

Lewis and Einhorn's point is that the revolving door between the SEC and the Street has created a class of financial institutions that are "too influential to prosecute." Anyone who has spent any time on Wall Street knows that it's extremely clubby and clannish. Lewis and Einhorn are arguing that a serious SEC investigation of one of the big banks, such as JPM or Morgan Stanley, would roil the markets so much, and cause so much collateral damage among the other big ibanks, that the SEC officials involved would never be able to get a high-paying job at any of the big banks. That's no doubt true. Now, we can argue about whether that really affects SEC officials' decisions (and I think Lewis and Einhorn are more wrong than right here).But you can't dismiss their argument with a blatantly apples-to-oranges comparison to white collar crime prosecutors.

"But if anyone suggests, as Einhorn and Lewis do, and, to be sure, as plenty of economists have also done, that there are a 'handful of ... perfectly obvious changes in the financial system to be made,' you should reach for your wallet. None of these worthies predicted the crisis – Einhorn is getting killed by it. Be my guest if you want to believe those who tell you that those running the show during the crisis – all of Wall Street and much of Washington – are corrupt or stupid or both, and that eight simple rules will lead us out of the business cycle and to paradise."

First, Lewis and Einhorn didn't claim that the changes they discussed in the article would "lead us out of the business cycle and to paradise." That's why they called their list of preferred changes a "short list."

Second, their proposed changes are by no means "simple," and Lewis and Einhorn never claimed that they were. They said that the changes were "obvious." Complex changes can be obvious; indeed, non-obvious changes are almost always simpler than obvious changes. For example, Lewis and Einhorn propose that we "Stop making big regulatory decisions with long-term consequences based on their short-term effect on stock prices." Since when is that a "simple" change?

When critiquing an article, you have to address the arguments the authors actually made, not the arguments you wish they made.

6. Posted by David Zaring on January 7, 2009 @ 21:12 | Permalink

I figured Einhorn would have some defenders. And I'm the last guy to think that he doesn't provide a service. But he used the "simple" language, not me. And markets should be able to evaluate CRA reports, just like they do accounting returns, just fine.

7. Posted by Taxrascal on January 7, 2009 @ 22:30 | Permalink

I think you went a little too far when you went after Einhorn (his fund makes most of its money on the long side, and he did manage to explain what was wrong with Lehman et. al. before the crisis hit).

That said, some of his (and Lewis') ideas are nutty. A regulatory scheme that either a) isn't evolved with lots of trial and error, or b) does not leave room for evolution, is bound to have some holes.

8. Posted by rboston on January 8, 2009 @ 11:38 | Permalink

Zaring seems to know almost nothing about the industry - it seems he is resting on his academic credentials and is no longer doing his homework. Beginning in 2005 the ratings agencies jettisoned a significant amount of the objectivity they formerly sought to maintain when rating products and, through explicit policy changes, the agencies started cozing up to their customers in a calculated effort to increase revenues. Moody's former CEO admitted as much after the auction market collapse. As for white collar proscutors needing a cooling off period so as to not turn a blind eye to their future colleagues'/employers' misdeeds - its true. White collar defense lawyers (I am one)aren't going to embrace some guy that has been busting their chops for years. the dyngens and enrons of the world are not the stuff a career is typically made of - where the corruption is widespread and the win is clear - the defense bar will agree with agressive prosecution after the fact. But if the prosecutor's stint in public service is spent being the naggin mosquito - in which he consistently challenges the most powerful people the financial world by demanding more and better regulation across the board, he will not be beloved, and generally will see the writing on the way and stay in public service.

9. Posted by 2L on January 8, 2009 @ 12:43 | Permalink

"And markets should be able to evaluate CRA reports, just like they do accounting returns, just fine."

At least read another of Einhorn's speeches:

April 8,2008
"I later had an opportunity to meet a recently retired senior executive at one of the large rating agencies. I asked him how this agency went about evaluating the credit worthiness of the investment banks. By then Merrill had acknowledge large losses, so I asked him what the rating team found when it went to examine Merrill's portfolio in detail.

He answered by asking me to refocus what I meant by "team." He told me the group covering the investment banks was only three or four people and they have to cover all of the banks. So they have no team to send to Merrill for a thorough portfolio review. He explained that the agency doesn't even try to look at the actual portfolio because it changes so frequently that there would be now way to keep up.

I asked how the rating agencies monitored the balance sheets so that when an investment bank adds an asset, the agency assesss a capital charge to ensure that the bank doesn't exceed the risk for the rating. He answered that they don't and added the rating agencies don't even have these types of models for the investment banks.

I was shocked by this and I think that most market participants would be surprised, as well. While the rating agencies don't actually say what work they do, I believe the market assumes that they take advance of their exemption from Regulation FD to examine a wide range of non-public material. A few months ago I made a speech where I said that rating agencies should lose the exemption to Regulation FD so that people would not ove rely on their opinions.

The market perceives the rating agencies to be doing much more than they actually do. The agencies themselves don't directly misinform the market, but they don't disabuse the market of misperceptions - often spread by the rated entities - that the agencies do more than they actually do. This creates a false sense of security and in times of stress this actually makes the problems worse. Had the credit rating agencies been doing a reasonable job of disciplining the investment banks - who unfortunately happen to bring the rating agencies lots of other business - then the banks may have been prevented from taking excess risk and the current crisis might have been averted.

10. Posted by MDF on January 10, 2009 @ 21:18 | Permalink

Einhorn's criticism of SEC staff as being corrupt based on some "revolving door" theory is clearly uninformed. Certainly, SEC enforcement heads tend to go off to very well-paid jobs. But they came from very well-paying jobs before joining the SEC -- almost all are partners of top NY or DC law firms. SEC enforcement is also charged with prosecuting, rather than detecting, fraud. By contrast, the head of the SEC's inspections office has been the head of that operation since Arthur Levitt created it. Not much of a revolving door for her. Likewise, the deputy directors and associate directors of most SEC divisions (i.e., the people who actually do most of the work) have been there for years.

The SEC is certainly not very good at detecting fraud in progress (rather than fraud after it has occurred). But the same can be said about the FBI -- it rarely catches murderers in the planning stages. (It has gotten much better at ex ante intelligence work against terrorism, but that's a post 9-11 development.) The SEC gets dozens of "tips" each day, only a few of which pan out (and very very few of those that pan out come from competitors).

All of that said, there very clearly is an expectations problem here. Hedge funds are not regulated in the United States, and registered investment advisers are just that -- registered. Inspections of those operations tend to look for clear violations of the rules and laws. Absent a violation or an investor complaint, the SEC staff over the past decade likely would have just turned to the myriad other cases on its plate (particularly given the open hostility of at least one commissioner to SEC enforcement "fishing expeditions").

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