Tuesday, March 16, 2010

Poachers Turned Gamekeepers

As the slow-motion train wreck which was Lehman Brothers unfolds once more before our eyes, if not in the pages of our mainstream media—who continue to proclaim against all available evidence that they really, really do perform a valuable function in democratic society and hence should continue to be paid more than bupkis for it—then in the febrile, overheated backwaters of the econoblogosphere, Your Oft-Ignored Pontificator has been inspired to venture a few modest observations.

My aperçu of the day was inspired by readings among several of the more rational and composed voices in said bloggy peanut gallery, including David Merkel, Mike Konczal, and Felix Salmon. It was Felix's piece which offered the most direct spur to my reflections, with the following remarks:
In other words, the Fed has the ability to regulate; all that’s needed now (and was missing in 2008) is the willingness to do so and to bare teeth once in a while.

A good way to institutionalize that is to implement what David Merkel calls “dumb regulation” — once you put simple rules in place, it becomes much more difficult (although never, of course, impossible) to override those rules or to ignore them. The problem with Lehman was that there were no simple rules, and that no one at the Fed or the SEC felt comfortable making up new ones on the spot, like “you’ve got to be able to pass the stress test which we invented five minutes ago”. I, for one, wouldn’t want to be the regulator who had to receive the phone call from Dick Fuld after implementing a rule like that, using dubious legal authority.

One of the problems with giving lots of supervisory authority to the Fed is that the Fed is run by economists who care primarily about setting monetary policy, as opposed to being run by bankers who care primarily about bank regulation and systemic risk. The base-case scenario is that unless and until we start staffing the Fed with a bunch of poachers-turned-gamekeepers, the biggest banks are likely to be able to smooth-talk their way past the Fed’s regulators.

Like Felix, I agree with David that "dumb regulation"—or, in less pejorative language, simple and relatively inflexible regulation—is far more likely to do the trick than the kind of complex, encyclopedic, tick-all-the-boxes regulation exemplified by the bloated pig currently wending its way through the legislative python in Congress. But I also agree with Felix (and, so it would seem, with David) that simple regulation will only work if it is overseen, enforced, and modified as necessary by extremely intelligent and motivated regulators.

I have argued in these pages before that delivering regulations which are comprehensive, detailed, and complex only encourages the institutions being regulated to immediately try to engineer their way around them. Simple, broad-brush regulations have a much better chance to operate as a set of principles which are well understood by both regulator and regulatee alike. But having such principles-based regulation is not enough. They must be enforced, as financial collapse in the face of a decidedly principles-based regulatory regime in the United Kingdom amply demonstrated. Not only does this mean, in Felix's example, that regulators must have the authority to make up rules, tests, and procedures on the fly on behalf of preserving systemic stability, they must also have the balls to take that phone call from Dick Fuld. And, moreover, to tell him in no uncertain terms to go fuck himself if he doesn't like it.

* * *

Now Dick Fuld, at least in his prime, was a forceful and scary man. It takes a certain kind of personality to tell such a man to go fuck himself to his face. Fortunately, we just happen to have a substantial supply of brass-balled, take-no-prisoners, kill-'em-all-and-let-God-sort-'em-out people ready to hand. By happy coincidence, these individuals also happen to be intimately familiar with the ins and outs of the global financial system, the nature and construction of the myriad securities and engineered products polluting financial markets, and the numberless tricks and stratagems large financial institutions use to end-run rules and regulations designed to keep them in check.

These people are called investment bankers.

That's right, boys and girls: It's time for the chickens to band together and hire themselves some foxes to guard the chicken coop.

I have made this argument before. Forgive me while I indulge my present lassitude and quote myself at length:

Many observers of the smoking wreckage which now passes for our banking system have opined that, in addition to being hobbled by a fragmented regulatory system riddled with overlapping and ill-defined responsibilities, the regulators who were supposed to be watching the chicken coop were woefully overmatched by the foxes. Staffed primarily by lawyers, on government pay scales, the SEC almost by definition is not up to the task of monitoring Goldman Sachs, JPMorgan, or anyone else, if by "monitoring" we should expect true informed oversight and control. If Harry Markopolos couldn't get the SEC Enforcement Division to understand and investigate what appears to have been a particularly simple—if breathtakingly successful—Ponzi scheme, how can we possibly get comfortable that our government watchdogs can effectively oversee the hugely complicated, mind-numbingly sophisticated, globally distributed trading operations of a modern investment bank?

This shortfall in regulatory intellect has been exacerbated by what the Japanese call amakudari, or "descent from heaven": from time immemorial, a steady stream of former regulators has resigned their posts to assume positions on Wall Street, sometimes at the very firms they had been charged with overseeing. There is very little incentive to push a little harder or dig a little deeper into a question if it irritates a powerful firm that might be your future employer. Furthermore, this practice provides a steady stream of inside knowledge on current regulatory focus, practice, and ignorance that is of tremendous value to oversight-minimizing investment banks.

The answer, of course, is obvious, if politically difficult to put into effect. Staff the SEC, or whatever "Super Regulator" the government decides to deputize to oversee this mess, with a bunch of highly-paid, tough-as-nails, sonofabitch investment bankers. You will have to pay them millions, just like regular bankers. (You can tie their incentive pay to improvements in the value of securities held under TARP and TALF, if you like.) Pay them well, and investment bankers won't be able to treat them like second-class citizens at the negotiating table. Pay them like bankers, and your regulators won't hesitate to read Jamie Dimon or Lloyd Blankfein the riot act, because they won't give a shit about getting a job from them later.

Trust me, these are the kind of people you will need on your team: highly educated, financially sophisticated, psychotically hard-working, experienced professionals who know or can figure out CDOs, SIVs, balance sheet leverage, and credit default derivatives just as easily as the idiots who created and trade this shit. Leading your enforcement and supervision teams you need a bunch of smooth, smart, plausible, grandiosely self-confident senior bankers who will not hesitate to tell Vikram Pandit to go fuck himself, his mother, and the cow she rode in on if he ever tries to fuck with the United States government, the US taxpayer, or the pizza delivery boy again. You know: psychopaths.

This is not a new idea. For yonks, the Brits have known that the best person to hire as gamekeeper on your ancestral estate is a former poacher, someone who knows what they know, how they think, and where to punch them in the genitals to get maximum negotiating effect.

* * *

Of course, my initial reflections on this topic this morning were inspired by an eye-opening and dispiriting exposé of the well-meaning, dedicated, but patently overmatched bank examiners of the Philadelphia Fed by Dennis Berman of The Wall Street Journal. I think the lines which caught my attention most effectively were

The Fed has a peashooter to the AK-47s of Wall Street.


[Fed bank examiner] salaries range from about $40,000 to $140,000.

To which my reactions can best be summarized as: 1) No shit; and 2) What the fuck?

Just to put things in context, the best-paid examiners which the Federal Reserve Bank of Philadelphia relies upon to audit, inspect, and guide the financial institutions under its charge get paid less than a good personal assistant at an average Wall Street firm. Fed examiners make less than Dick Fuld's secretaries, for Christ's sake. Go ahead, tell me that doesn't strike you as a problem. It strikes me as a big fucking problem.

So I rattled away on Twitter this morning, laying out my poachers-turned-gamekeepers theory for the umpteenth time in rapid 140-character bursts. Among other details, I fleshed out my proposal by suggesting regulators get hired from Wall Street banks, big law firms, and elsewhere. An effective wholesale financial regulator 1 should be comprised of forensic accountants, corporate and securities lawyers, investment bankers, derivative structurers, and the like. They should all be paid market rates for their services, which will make their compensation much, much closer to that of the people they regulate. They should be prohibited from accepting positions in private financial industry—and, most especially, at any individual firm they ever directly or indirectly regulated—or firms working for financial firms (law firms, accountancies, etc.) for a minimum of at least three years after they leave government service. Five would be preferable.

While individually expensive, I don't believe you would need to hire many such people to make this kind of regulatory regime work. Given that you really only need high-powered regulators for the very biggest institutions, I am guessing you could get away with fewer than 100 to start. In fact, it might be less, because you really only need these people to direct and train their junior staff, and to interface directly with senior executives of the regulated entities. Fully loaded, I imagine you could fund a financial regulatory SWAT team like this for less than $150 million per year. That's a drop in the bucket compared to the financial losses these supposedly regulated institutions have already inflicted on the American taxpayer, not to mention in comparison with the normal run rate of your average stodgy, inefficient, and ineffective government bureaucracy.2 Even better, you could fund such an agency with a levy indexed to the size of each financial institution under its jurisdiction. The larger and more complex a bank, the more fire-breathing, table-throwing, nail-spitting investment bankers and lawyers you could afford to throw at it. Talk about an incentive to shrink your balance sheet.

* * *

No plan is without its drawbacks, however, and I knew I could rely on my intelligent and well-meaning interlocutors on Twitter to supply some. Among the more cogent of these, Graeme Hein noted that "Smart regulators can always make more money in [the] private sector." This has always been true, and always will be so, but my plan could be structured to minimize this defect. For one thing, you do not need "the best" investment bankers, traders, or lawyers—whatever that's supposed to mean—on the regulatory case. All you really need is good ones, and there are plenty of those. A certain doggedness, and a commitment to preserve systemic stability and enforce rules and regulations regardless of the wealth, prestige, or lung power of their charges would be necessary as well. Remember, you are not looking for the best traders, or the best M&A advisors, or the best derivatives structurers out there; you are looking for people who can understand what those people do and who can stand up to their counterparts across the negotiating table.3

For another, while pay should be very attractive, and likely many multiples of current front-line regulators' salaries, it does not need to equal that of industry practitioners. It can be paid 100% in cash, which dramatically shrinks the gap with nominally much bigger pay packets stuffed to the gills with unvested, restricted funny money. It can also be far less volatile than industry pay, since it should not depend on the vagaries of market performance the way real investment bankers do. Add to that the psychic compensation from working at a powerful, elite organization which generates fear and respect among its regulatees, and you will have a potent package. You might just be surprised how many top flight industry professionals apply for the job.

Now some people might object to the prospect of a federal agency staffed with lots of employees pulling down half a million dollars or more a year, as loadeddice observed. But the answer here is simple: for socially critical functions, money has never been an object when it comes to government spending. Just look at the military. By the same token, I would find it very easy to argue that the cost of a several dozen government employees earning more than the President of the United States is a very reasonable price to pay for financial and economic security. Unlike the military, however, you don't need to spend millions or billions on hardware to do the job. Instead, you spend millions on the software walking around in wingtips and Gucci loafers.

The most frequent objection among those who deigned to comment, however, was simply that—regardless of the attractiveness of my proposal—such a radical change "would never happen." Perhaps these naysayers are right. It certainly would ruffle a lot of feathers, both in the finance industry itself and in Washington, D.C. But I tend to think that is a good thing, and a reliable indicator of the value and importance of the plan, rather than a defect.

At the end of the day, I do believe most Americans actually prefer their government bureaucrats to be slow, bumbling, and ineffective. It reassures them they can stay one step ahead of City Hall, which, as we all know, you ordinarily should not try to fight. Smart, aggressive, and committed government employees terrify most people, because they have so many natural advantages without such personal qualities. The only solution to this, of course, is constant oversight, which is a sine qua non of my proposal.

* * *

So anyway, I'm excited about all this. When do we get started? Mrs. Dealmaker is already calling moving companies to price out the transfer to Washington. And between you and me, I never like to keep her waiting.

She scares the shit out of me.

1 "Wholesale" means big commercial, investment, and universal banks, and any other systemically important financial entity. As opposed to retail oriented firms, which should be regulated by the CFPA or whatever bastardized, emasculated entity the political meat grinder decides to come up with. My focus here is on institutions which can bring the system down, not on the ones trying to screw Grandma out of her last $50,000.
2 Even less in comparison to the tens of billions of dollars in compensation the systemically important financial institutions pay their own employees. A pittance, I tell you.
3 Sadly, given the revelations coming out of the Lehman examiner's report and other sources, this may actually be a very low bar. Perhaps we need regulators who are better than the "best" investment bankers.

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