The Auld Boys’ Network

Welcome to the People’s House.

Speaker of the House John Boehner

“No longer can we fall short. No longer can we kick the can down the road. … end business as usual… begin to carry out the People’s instructions…”

The rhetoric that opened the 112th Congress makes us resent the hours we have spent standing on lines outside the voting booth, hours we might have put to better use closeted with Milton, Scotch and cigars. Reading the Constitution aloud is just so much unassailable filler proffered by those who have decisively taken the Talking Stick, only to realize they have nothing to say. We read Speaker Boehner’s promise to de-partisanize Congress as a Republican inside guffaw at the President’s expense. Even we would bridle at the degree of cynicism it must otherwise represent.

The photo op of Nancy Pelosi passing the world’s largest gavel to incoming Speaker Boehner may be the last time we see the two of them smiling at each other — the shot of him a couple of days later, weeping as she spoke, is more apt. Boehner’s opening Boy Scout pledge of bi-partisanship is smarter rhetoric than Ms. Pelosi’s “Yes, we wrote the bill! Yes, we won the election!” But surely no one seriously believes the Republicans will do less damage to the Constitution they so self-righteously arrogate to their party. We watch for the new Congress to quickly justify their inability to effect change by complaining that they are “stuck” with programs foist on them by the Other Party.

Applying standard measures, professional economists assure us the economy emerged from the Great Recession in June of 2009. You couldn’t prove that by looking at real levels of current unemployment in excess of ten percent, at millions of Americans who have lost their homes, or at the fact that real incomes have fallen to a degree not experienced since the Depression. This is a short-term trend now. But sure as a losing trade becomes a long-term investment, short-term phenomena get back-burnered by policy makers until we wake up one morning and — voila! — another long-term trend! Speaking of the Great Depression, by many standard economic measures we are experiencing a degree of inequality not experienced since the 1920’s. In 2009, the top five percent of Americans saw their incomes rise, while everyone else’s went down or simple vanished. Wall Street set aside a record bonus pool of $145 billion. You can’t fight economics.

In 1960, one percent of Americans earned 8% of total income. By 2010, one percent of Americans were pocketing 20% of America’s income, a 150% increase in the earnings accruing to this group. In Winner-Take-All Politics, political scientists Jacob Hacker (Yale) and Paul Pierson (UC Berkeley) say income inequality in America is greater than in any advanced industrial democracy. Applying standard economists’ tools, they put American income inequality on a par with that of Turkmenistan. We have never been employed in Turkmenistan, but it doesn’t sound good.

Hacker and Pierson argue that it’s not the economy, stupid. It’s actually government policy, stupider. What we have long Screedified as Washington’s utter abdication of responsibility to America’s citizens, Hacker and Pierson present as targeted policy shifts, starting especially in the 1970’s, where interest groups and like-minded politicians deliberately guided the benefits of America’s explosive economic growth to the increasingly distant top of an increasingly inaccessible pyramid. If ever you really believed that wealth would trickle down to the economically disadvantaged, they argue, you need to get out of the gated community more often.

Look no further than the massive policy change under President Clinton, when two generations of securities law, market regulation and industry standards of good business were swept away so that Sandy Weil could consolidate his power at Citigroup. This was the apotheosis of the phenomenon started when Salomon Bros went public — with the stroke of a pen, Risk was spun off from Reward. Risk was sold to the public, Reward remained in the hands of the insiders, and a new paradigm for American business was born.

This Financial Revolution, like the Industrial Revolution, rested on an explosion of brilliant creativity. And like the earlier revolution, its advances spurred a great increase in wealth — that was likewise concentrated in the hands of the few, creating a yawning gap between rich and poor. Rather than the steam engine, the Financial Revolution gave us mortgage-backed securities, CDOs and co-located high-frequency trading. But its transformational effects on the world have been no less powerful, nor has it done anything to bridge the aps of social inequality.

Fed Chairman Greenspan — capitalism’s Proudhon (“theft is property”) — espoused Wall Street anarchism, where the self interest of participants ruled the marketplace. The Greenspan Infallibility Doctrine trumped reasoned argument by experienced regulators, and millennia of human experience. We argue from a Hedgeye first principle that Greenspan’s embrace of markets failed to account for reversion to mean: the propensity of a significant minority of participants to find ways to game markets, ultimately corrupting the entire system.

Politicians rely on the fact that the vast majority of citizens are politically ignorant. Hacker and Pierson point to the example of Wendy Gramm, chairwoman of the Commodity Futures Trading Commission, who granted Enron a “midnight order” permitting it to trade in derivatives of its own design, free from government oversight. Enron thanked her by awarding her a seat on its board of directors.

Her husband, Senator Phil Gramm, grafted the Commodity Futures Modernization Act onto a massive appropriations bill submitted by a lame-duck Congress and signed into law by President Clinton. The Act did away with the legal basis for regulating new derivatives as they came on line and threw up a definitive roadblock to CFTC chairwoman Brooksley Born’s insistence that expanded capital markets require expanded oversight. As Enron — “America’s Most Innovative Company” — marched ineluctably towards one of the greatest economic disasters in history, the government first provided them a regulatory carve out, then made it unlawful to regulate their activities.

Evidence of a bifurcated political economy surrounds us, yet standard economic writing continues to speak of interacting forces seeking equilibrium. “Equilibrium” implies that each side of the scale gets the same thing. We allow the Wall Street / Washington / media cabal to lull us into behaving as though this were true, although we know it is not. And because our markets visibly thrive on an unprecedented degree of creativity, criticizing the marketplace is seen as being against human progress. Only close inspection reveals which humans are being encouraged to progress.

Goldman Sachs finds itself so overwhelmed by orders for Facebook shares that it closed its order book prematurely (6 January, “Goldman Flooded With Facebook Orders”). Goldman availed itself of a standard parallel market structure, in which a special purpose investment vehicle purchases the Facebook shares, and private investors buy shares in the vehicle. Predictably, Goldman partners get a better deal than others — though we would hardly call any of the prospective buyers “the general public.” Which is our point: one of the frustrations of regulating the securities markets has been regulatory flight.

In the debate over global financial regulation, the argument is often raised that, if regulation is not uniform, investment will flee more restrictive jurisdictions and move to more laissez faire countries. This is a red herring. The real issue is the preponderance of smart investment professionals who constantly shift their business away from any form of regulation at all. The proliferation of hedge funds is the direct result of lack of regulation of private investment partnerships. While the entities with whom they do business are highly regulated — banks, brokerage firms, investment banks and stock exchanges, to name a few — the unregulated tail powerfully wags the dog, as revealed when Long Term Capital created a black hole in the world’s financial system.

The collapse of Lehman provides an example of how useless regulation is even when applied. Their accounting relied on a UK law to make a report in the US, relying on a loophole both countries’ regulators never thought of. (The private marketplace pays much better and attracts superior talent.)

Then there are highly sensitive areas where even regulated firms never actually perform any review. If money is transferred from a regulated entity — bank, investment bank, brokerage firm, etc. — the receiving firm simply notes the delivering firm’s registration status to satisfy its own anti money laundering obligation. A brokerage firm has the right to rely on regulatory regimes and assume that a major bank — Wachovia, for example — would never launder money. When Wachovia was caught laundering hundreds of millions of dollars for the Mexican drug cartel, it unleashed a rush of paper pushing as firms checked to make sure their files were complete. As successive disasters generate new reporting and registration requirements, regulators are unable to keep up with what is required. Especially if, as today, Congress refuses to approve the regulators’ budgets.

What we call Regulatory Flight doesn’t mean moving your business to a jurisdiction where the regulation is more favorable. It means finding a form of business that is not regulated at all. The Facebook / Goldman alliance is perfect in this regard: it allows two of the most powerful organizations on the planet to micromanage the value of their asset; it allows them to reward the select of the select — that one-tenth of one percent, the Mega-Haves — while enforcing cooperation. Without the price discipline of the marketplace or the ability to freely trade one’s shares, Goldman and its client retain effective control of the value of the enterprise.

At the same time as Goldman is running this private offering, the SEC has blessed the nation’s first private stock exchange. There have long been firms making a secondary market in private placement interests. Now Xpert Financial of San Mateo, CA, a registered broker dealer, will offer an electronic trading platform for unlisted equities. It will also offer equity direct to private investors in a form of venture capital. A two-tiered marketplace has now officially emerged for a two-tiered economy. The SEC has blessed this arrangement that formally divides the investment marketplace into the Haves, and the Will-Never-Haves.

It can fairly be argued that these developments represent a necessary change in a sclerotic securities market that has failed to keep up with the times. They also create a yawning chasm between the wealthiest investors and everyone else. Indeed, as transactions such as Facebook are offered privately by Goldman, then trade privately on Xpert, an ever-increasing percentage of the investing population recedes into the Everyone Else category. Innovations are driven by the elite — in brains, in ambition, and in money — but in order for society to remain robust, the benefit of those innovations must accrue to all. In a dynamic society, this would mean small businesses would also be able to offer equity on Xpert, and small investors would be able to band together to make venture capital available to enterprises they understand, such as the local butcher, baker, or candlestick maker.

Instead, the retailization of markets such as Xpert will likely only come when the wealthiest investors need distribution for their illiquid purchases. Watch for the day when your aunt calls to tell you her broker recommends she buy a fractional share of Facebook as part of a group of investors.

Then there is the Law of Unintended Consequences (oddly enough, there is no parallel Law of Unintended Sausages…). It has been called an unintended consequence of the 2009 CARD legislation, designed to protect credit and debit card users from exorbitant charges, that lower income Americans have had to abandon their credit and debit cards and turn to pawnshops, payday lenders, and loansharks. Intended to limit penalty fees and surprise interest rate raises, the act sparked a rash of new annual charges and tighter credit restrictions, as banks seek to offset the loss of 29% interest rates. Banks have also started charging for other services as they try to compensate for the lost revenue, and free checking is becoming as scarce as an extra checked bag on a no-frills airline. As with hedge funds that operated off the regulatory radar for years, the only ones who are able to charge enough interest to make the risky consumer loans viable are those operating outside of the law.

Our final example of government setting the Haves against the Thought-They-Hads comes courtesy of Congressman Darrell Issa, now head of the House Oversight and Government Reform Committee, who sent a letter to over 150 trade organizations asking “for your assistance in identifying existing and proposed regulations that have negatively impacted job growth in your members’ industry.” This is probably the Republicans’ counter-assault to new Consume Protection head Elizabeth Warren asking consumer groups what problems they want her new Agency to address, but market credibility proceeds from the protection of the smallest participants, no less than the vitality of democratic society rests on the protection of the weakest members. The SEC and CFTC are on life support as the Republicans blocked increased funding. The SEC has had to suspend inquiries and recall investigators from the field because they can not afford their travel budgets. As feckless as the SEC has been, a half-blind policeman is arguably better than no policeman at all.

Market credibility comes down to consumer protection. What the Gramms — both wife and husband — failed to recognize is that state and private union pension funds, European investment banks, and the government of China are also consumers in the US financial marketplace. Big consumers, to be sure, who have tremendous clout and resources. But the underlying principles of market transparency and accountability are the same whether your client is Mom, Pop, or Beijing. While Speaker Boehner is proffering protestations of bi-partisanship, his colleagues in the Most Innovative Political Party in America are losing no time in launching a frontal assault on market credibility.

Issa’s office said “There is something fundamentally flawed in embracing a premise that relies on attacking the largest employer in America — private industry.” Congressman Issa may want to check his arithmetic. According to the Bureau of Labor Statistics, “with about 2.0 million civilian employees, the Federal Government, excluding the Postal Service, is the Nation’s largest employer.” Add back the Postal Service, toss in the military, and add state and local government and it’s a wonder there’s anyone left to work the Christmas shift at Wal-Mart. Lobbyists take note: Congressman Issa’s phone number is 202-225-3906.

Happy New Year.

Copyright © 2011 by Hedgeye Risk Management LLC