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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