Posted on January 7, 2009 by David Laidlaw
In her novel, Atlas Shrugged, Ayn Rand describes the inexorable decline of the United States and her heroine’s dilemma to accelerate the downward spiral or confront it to the best of her abilities. The country’s decline is caused by the strike of society’s most talented individuals led by John Galt who realized that unproductive members of the country have been playing on their guilt to extract unearned benefits. The uber-humans decide to stop contributing their efforts to any productive enterprise and relocate to a Utopia where their efforts will be rewarded and they will not have to subsidize others. Ayn Rand’s objectivist philosophy has been unfairly maligned recently regarding our current economic problems. Unfettered greed and criminality, not capitalism, have played leading roles in the economic weakness and market panic of the last quarter.
Many of the country’s most energetic and charismatic individuals (not necessarily the most intelligent) pursued businesses that enriched themselves, yet weakened our financial system to an incredible degree. There is nothing inherently wrong with securitizing mortgages or providing credit default swaps. Both instruments theoretically allow risks to be spread from institutions that want to reduce their financial exposures to investors that are able to bear more risk in return for potentially higher returns. However, the problems arose when Wall Street securitized mortgages it knew were low-quality investments and fraudulently sold those investments to risk-averse and unsophisticated investors.
In late December, the Wall Street Journal profiled the sale of Collateralized Debt Obligations to small towns in the Australian Outback. JP Morgan created pools of cash flows arising from various Credit Default Swaps. These pools were structured to pay interest like payments to investors as long as the underlying companies of the Credit Default Swaps did not default on their obligations. However, once a certain threshold was met (in this case the trigger was about 4% of the underlying pool defaulting) the investor would lose all of his or her investment. An Australian bank, Grange, then sold these pools to small towns throughout Australia with very low tolerances for risk. As the defaults mounted, the CDO investors lost their investment since the pools were liable for the Credit Default Swaps held by those who had bet against the solvency of the underlying companies.
Grange’s bankers ignored their duty to sell suitable products to its clients who did not understand the risks that they bore. JP Morgan was also at the very least negligent since it should have been aware of where its complicated products ended up. Instead, JP Morgan created and sold products and collected its fee without regard for the consequences to the bank’s customers or the after-shocks throughout the economy.
The spectacular crimes that have come to light in investing, politics and law have left the public numb. Bernard Madoff swindled $50 billion out of his investors including many charities through an old fashioned Ponzi scheme. Illinois’s Governor, Rod Blagojevich, was caught by the FBI trying to sell the Senate seat soon to be vacated by Barack Obama.
Finally, Mark Dreier’s escapades have been overshadowed by the previous scandals, but his crimes were equally brazen. Dreier formed a large national law firm with hundreds of attorneys practicing at high levels throughout the country. He staged an elaborate fraud where he sold bogus promissory notes to hedge funds. He also impersonated his own clients and other lawyers while perpetrating the hoax.
These crimes are extreme examples, but point to a general breakdown in the underpinnings of our society. High performing individuals turned to criminal enterprises where their honest efforts were no longer sufficient to satisfy their greed.
The rest of our society also shares a degree of culpability for abetting a culture that fetes the Madoffs, Blagojeviches and Dreiers of the world based on such nebulous characteristics as “reputation.” No investment strategy produces the consistently high returns that Madoff’s investments produced for decades. Just because Madoff ran a successful market-making firm, it should not have provided any insight into his investing prowess. It is also incredibly ironic that Blagojevich could have been elected as a reformer.
The only possible benefit from these scandals is that they will produce a more skeptical public and investing class. WorldCom’s fraud changed the way we have analyzed financial statements. We are now much quicker to sell when there are any signs of malfeasance or rumors regarding financial reporting irregularities.
We also hope that the current crisis brings more transparency to financial reporting, especially in the financial sector.In many cases, it is still impossible for investors to gain a clear understanding of the financial health of investments through thorough readings of financial statements.For example, a reading of Wachovia’s books shows a well-capitalized bank with a strong deposit base.However, way too many assets were held “off balance sheet” or priced inaccurately.Previous regulatory efforts such as Sarbanes-Oxley provided some benefit in holding management responsible for the accuracy of reports; however, many provisions did little more than provide continuous work for auditing firms without shedding additional light on the underlying financials.