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Regulation? Regulation?

Ben Stein (yes, that Ben Stein from Ferris Bueller’s Day Off notoriety) penned an insightful piece in Sunday’s New York Times.  Mr. Stein, a frequent contributor to the Times, asks “how on earth did the credit crisis on Wall Street become such a catastrophe?”  Many investors are wondering the same thing.

 The NY Times Article, Wall Street, Run Amok, ponders a number of questions. Namely, weren’t fail-safe devices in place to guard against risk?  Weren’t government watchdogs supposed to be keeping an eye on things?  What about the policing role rating agencies?  Why are we in this mess?

In search of answers, Mr. Stein points the reader to a speech given on April 8th by David Einhorn.  Mr. Einhorn, who runs the successful hedge fund Greenlight Capital, stated that those who run big investment banks have an incentive to maximize assets and leverage themselves into trouble because their compensation is a function of how much debt they can pile on. 

Mr. Stein simplifies this position as follows: “If they (the investment banks) can use relatively low-interest debt to generate slightly higher returns, the firms earn more revenue and executive pay increases.”  Problems therefore arise concerning what type of assets are acquired with the debt.  

The most troubling aspect of Mr. Einhorn’s speech is his observation that the S.E.C. allowed brokerage firms to set their own valuations on assets and liabilities that were by their nature difficult to value.  The result, in essence, was that the hens were allowed to guard the hen house.

This Wall Street culture, and limited examination from regulators, has created an interesting paradox.  It is the old “heads I win, tails you lose” analogy.  If Wall Street’s big bets pay off, it is the firms and their executives who reap the benefit.  However, when things go south (as they did with the recent subprime debacle), it is individual investors and taxpayers who are left to pick up the pieces.

Mr. Stein’s conclusion is that the inmates are running the asylum.  I cannot disagree. 

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