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Put simply, the new rules don’t create a wide enough net.

-         Vikram Pandit

Just because Vikram Pandit says something, doesn’t mean it’s wrong. 

Compliance: Vic or Treat - Vikram Pandit

We were spooked as we saw the entire world financial system going down the tubes.  America had fomented a housing disaster.  The traditional Manufacture and Distribute model of American finance had found a golden egg-laying goose, courtesy of our elected officials who, outdoing our Third World brothers and sisters, promised Americans not merely a chicken in every pot, but a kitchen to house the pot, and a four bedroom house – complete with two-car garage, trash compacter and satellite dish (in-ground pool optional) – to surround it.  Americans of every stripe – from the criminal, to the gullible, to the hard-working hopeful Believers in the Dream – lined up clutching their worn bank deposit books and three years’ worth of tax returns to get their piece of the American pie. 

Never mind that most Americans realized they were going to have to uphold their end of the bargain by staying employed, putting in an honest day’s work for an honest day’s pay.  If, as our Hedgeye watchword has it, everything important happens at the margin, the margin of homeowner finance soon swelled like a rampant tumor.  Fraudulent financings became increasingly the order of the day as bankers and their administrative minions actually coached people on how to lie on their mortgage applications.  We get that there are gullible, vulnerable and dishonest people out there who leapt at the chance to get something for nothing.  And there is likely a significant number of failed homeowners who allowed themselves to believe that lying on your mortgage app is like cheating on your taxes: everyone does it, no one is hurt by it.  I can get away with it.

For a moment it looked like the banks were actually the Greater Fools, about to be brought low by their own greed.  What a relief, then, when Secretary Paulson stepped in and spread our cash over the crisis like oil upon the waters.  We were wrong.  The homeowners did get flushed away like so many troublesome small turds.  The banks were made whole, and then some, and it was, after all, we who were the Greater Fool of Last Resort.

Speaking at a conference sponsored by The Economist magazine, Pandit said the legislative changes to date could give rise to a new shadow banking system.  “Could,” Mr. Pandit?  Nay, must.  Quoth the Pandit, “Any time the amount of capital required by regulation exceeds the levels judged necessary by the market, opportunities for arbitrage arise.”  Pandit is noting something a fact approximately as obvious, and as rarely remarked upon, as the sun’s rising in the East.  And he made the useful distinction that “the banking system is not synonymous with the financial system as a whole – and Basel only affects the former.” 

As always, the money has done all the talking, though we are not sure exactly who has done its bidding.  Dodd-Frankenstein, as observed by NY Times chief financial correspondent Floyd Norris (http://norris.blogs.nytimes.com/ 25 October, “Return of the Shadow”) “does give regulators authority to oversee the next AIG – a huge financial institution that is systemically important even if it is not fully in the conventional regulatory system.”  However, observes Norris, “Congress rejected proposals to let regulators go after shadow sectors,” those being precisely the marginal areas of activity that will take up the slack.  As our neighbor’s bumper sticker reads: “If they outlaw guns, then only outlaws will carry guns.”  And you can bet that if they outlaw mortgage-backed CDS… well, you get the idea.

We are intrigued that Pandit is so afraid of this that he felt the need to speak about it in a public forum.  We are not sure whether he is saying it prophylactically, to prevent being taken to task next time the banking system implodes, or as a way of marking his territory and calling for pre-emptive regulatory approval of his future actions at the helm of Citi.

One thing, though.  He’s got it right.  The regulated banks played with a will into the morass of the unregulated marketplace, extending lines of finance and credit far beyond what the foreshortened horizon of their own regulations permitted them to see.  It is, of course, a fallacy to say that there was not already sufficient regulation in place to prevent the latest disaster.  There was, rather, a lack of will on the part of the regulated marketplace to exercise the caution and diligence required of them by their fiduciary brief.  The fact remains that no bank analyst – and no analyst from the rating agencies – ever visited any of the vast housing developments that were being sold off like hotcakes, all on no-documentation mortgages.  The banks rolled up these same mortgages and sold them to overseas investors, to Orange County – indeed, to one another, and even to other divisions within their own entity. 

One obvious answer is for Congress to force regulators to drop an iron curtain between regulated and unregulated activities, allowing the unregulated market to bear all the risk – with the recognition that they will also reap the profit, while the banks continue to plod along.  For our money – and in your Humble Scrivener’s case, Mr. Pandit has most of it in his tottering institution – plodding is just fine.

But it’s not just fine for the shareholders.  Despite Jack Welch’s recent disavowal of Shareholder Value as “the stupidest idea” to come along in years, bank executives want their institutions to prosper because Dodd-Frankenstein does nothing to undercut Wall Street’s compensation model.  The problem is, as far as the regulated banking system is concerned, there’s no such thing as safe sex.  As has been observed again and again, that first dip into the unregulated world creates instant addiction.  And, like the addict who sells his grandmother’s jewelry and clock radio, the banks will stop at nothing once they are hooked.

On the other hand, we recognize that it is in the unregulated world that all the truly creative ideas are hatched.  Let the word “unregulated” be divorced in the public mind from the word “criminal.”  Indeed, by definition it is easier to violate the rules in a market that has many, than in a venue where there are none.  If this seems cynical, please recognize that many of the greatest advances in all areas of human endeavor have come from outsiders working on their own, and often against the opposition of the institutionalized mainstream.  We need only point to examples such as Galileo and Darwin.  Or if you prefer, Moses, Jesus and Mohammed.  You get the point.

Far from holding the regulated and unregulated markets apart from one another, Dodd-Frankenstein appears to leave the door wide open for the next round of Minskian boom and bust as these two incompatible species attempt once again to produce viable offspring.  Many in our industry gaze despairingly on the micro-meddling going on in Washington and wish the Austrian school of economic theory had more influence in our system, with its notion that “creative destruction” creates fecund soil from which future economic success will sprout.  Does no one in government have the moral courage to stand by and allow significant economic failure to ensue?  If you want destruction, we remind you there is at least one Austrian in government in this land: Arnold Schwarzenegger.

Moshe Silver

Chief Compliance Officer