The 91% Solution

The Quick & Simple Way to Fix Wall Street

[Editor's Note: in a post last week, "Financier, Heal Thyself? Don't Count On It," I promised a part 2. This is it. Heads up: if you read this blog purely for real estate content, or want a post with a little levity -- skip this one.]

Want to test your knowledge of political Americana?

Answer this puzzler:

Which U.S. Presidential candidate endorsed a 91% marginal tax rate on income?

A. George McGovern
B. Dennis Kucinich
C. FDR
D. Dwight Eisenhower

Answer: D.

In fact, the question is a bit of a curve ball: Eisenhower never campaigned on a platform of 91% marginal tax rates -- he didn't have to. That's because Eisenhower inherited a 91% marginal rate from the Truman administration -- and saw fit to leave it there during his eight years in office.

Dwight D. Eisenhower: West Point graduate. Supreme Allied Commander in World War II. President of Columbia University. Two-term Republican(!) U.S. President . . . wealth-redistributing, Commie radical!

Beaver Cleaver

If you don't remember the '50's -- and you won't unless you're at least 60 years old -- it wasn't exactly a Communist love-fest.

On the contrary, that era notably witnessed the Cold War, "duck-and-cover," and Joe McCarthy and his anti-Communist witch hunts ("are you now, or have you ever been . . .?").

Some other tidbits of '50's culture: Beaver Cleaver, "Father Knows Best," Bob Hope, Doris Day, and drive-in movies. (And to be sure, "colored-only" drinking fountains, restrooms, etc. in the South.)

Still, not exactly Haight-Ashbury in the '60's.

And yet.

And yet society and its lawmakers saw fit to levy a 91% marginal rate on annual income over $400,000 (equivalent to about $3 million today).

What were they thinking?!?

Values, Then & Now

A couple things, perhaps.

--That the country's social fabric was more important than the (very) well-being of its richest .05%.

--That the pursuit of ungodly sums of money was unhealthy -- even corrosive -- to one's self, and one's larger community.

--That the ability to make such ungodly sums of money was itself due to a peculiar historical confluence of built-up legal and political institutions; heretofore unimaginable gains in technology and productivity; and the sacrifices of many, many preceding generations.

Isaac Newton said that "if I have seen further, it's because I have stood on the shoulders of giants."

Today's CEO's are pygmies who think they are giants -- and that modern economic life began with them (obviously not true, but if we're not careful, it certainly may end with them).

It's hard to tell which trait best defines today's CEO's: hubris -- or greed.

Financial Reform, Circa 2010

Which brings us back to financial reform.

First, three stipulations:

One. The current financial system is so enormous and complicated, and has so many moving parts and interconnections, that few people understand half of it. Unfortunately, almost none of those people are elected officials in Washington.

Two. Even if FDR and his brain trust somehow sprang back to life with a divinely inspired blueprint for reform, they would be thwarted by today's political system. Too partisan, too balky, too corrupt.

Three. More limited, strategic reforms have either been ineffective -- or backfired spectacularly.

Case in point: legislation passed by Congress in 1993 to limit executive compensation -- considered excessive back then, even though it was a fraction of today's levels.

Barred from deducting executive salaries greater than $1 million, publicly traded corporations simply switched to awarding stock options and bonuses to CEO's.

More accurately, CEO's -- via their handpicked boards of directors -- started paying themselves in stock options and bonuses.

The 91% Solution, or, "I Like Ike"

Add the foregoing "stipulations" together and what do you get?

A broken, dysfunctional financial system that cannot be fixed.

Or can it?

To paraphrase Albert Einstein, the problem of Wall Street cannot be solved at the same level of thinking with which it was created.

So, go up a level.

What is Wall Street ultimately about, at least today?

Not service to one's fellow man ("God's work" -- the real kind); one's country (the definition of patriotism); or even just providing and efficiently allocating capital to the rest of the economy (Wall Street's putative purpose and raison d'être).

It's all about making money.

Obscene, unprecedented tidal waves of money.

To pick just one example, last year -- not a banner year for most, to put it mildly -- the top 25 hedge fund managers averaged $1 billion in compensation. That they paid 15% income tax on.

$30 Million a Year

Such a financial bonanza also suggests the solution: go back to Eisenhower-era marginal tax rates.

Hell, bump them up 10-fold, just to account for today's more expensive luxuries and toys (tycoons really couldn’t buy Lear Jets in 1955).

So, the John Paulson's and Lloyd Blankfein's of the world can make up to $30 million annually before coughing up the lion's share of it to Uncle Sam. Thirty million a year -- still not too shabby.

Such a remedy has the virtue of being simple, efficient, and laser-focused on the underlying problem plaguing today's financial system.

Oncologists now understand that the best way to kill an advanced or otherwise inoperable tumor (because of its proximity to vital organs) is to cut off its blood supply.

Raising marginal tax rates to 91% will have the same effect on the metastasizing cancer that modern-day Wall Street has become.

Today's Investing Strategies: Buy & Hold, FIFO & LIFO

Explanation for Jumpy Markets

Want a(nother) reason for heightened stock market volatility?

More investors are switching from buy-and-hold to "FIFO": first in, first out -- and ask questions later.

Such is the aftermath of a decade-plus of negative overall stock market returns. And that's before inflation.

As I've blogged before, welcome to "risk without return."

Risk Without Return

When stocks are trading on momentum and liquidity rather than fundamentals -- as now appears to be the case -- you never know when the "jig" is going to be up.

All you know is that the exits are narrow, and that the penalty for getting out late is horrific (ask tech stock investors from a decade ago).

So, every "dip" and reversal sends skittish investors looking for daylight.

When the scare passes, these same, jumpy traders have to buy back in again.

LIFO: FIFO for Experts

Of course, there's an even higher stakes trading strategy than FIFO for profiting from precarious markets -- albeit one best practiced only by experts: 'LIFO,' or last in, first out.

Also known as short selling, it consists of betting against bubbles just as they're about to deflate.

Whereas investors who "go long" make money when something goes up, short sellers profit when whatever they short goes down.

In fact, little-known hedge fund investor John Paulson (no relation to Henry) pocketed something like $20 billion the last three years betting that housing would collapse.

As Wall Street has just demonstrated (again), the best way to profitably short-sell a bubble is to know when it's about to pop, for real.*

And the best way to do that is to have helped inflate it.

*What do you call a short-seller who is right but early (like all the pro's who shorted overvalued tech stocks in '98 and '99)?

Wrong . . . and busted.

That's because if you short-sell something that keeps going up, you face wave after wave of margin calls requiring you to put up more money.

Goldman Sachs: 'It's Not My Dog'

Goldman Sachs: Preying on its Clients
(& Taxpayers, too)

[Note to Readers: No, this hasn't become the "anti-Goldman Sachs rant" blog. It's just that: a) the firm's conduct is/was so outrageous; b) the economic harm it caused so far-reaching; and c) authorities' response to the firm's conduct so feeble (if you can call it that).

Perhaps most significantly, there are a number of new stories -- like the one below -- documenting many previously unknown details about the firm's behavior. Back to "regularly scheduled" real estate posts soon . . . promise!]

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

--"Banks Bundled Debt, Bet Against It and Won"; The New York Times (12/23/09)

So . . . the accusation is that Goldman Sachs screwed its customers, big-time.

Specifically, Goldman Sachs made billions selling its customers garbage.

Then, it made even more billions betting against ("shorting") the garbage.

"It's Not My Dog"

What does Goldman Sachs say in its defense?

A. It told its customers that they were buying garbage, i.e., it disclosed all the risks.

B. It told its customers that it was betting against them (again, via disclosures).

C. Other Wall Street firms sold their customers garbage and bet against it/them, too.

D. Goldman Sachs' customers were big, institutional investors ("big boys") capable of assessing the risks for themselves. (Legal translation: Goldman's clients didn't -- or shouldn't have -- relied on Goldman's representations.)

E. It sold its customers garbage because . . . its customers asked them to! (it was only responding to demand; if Goldman Sachs hadn't sold the garbage securities . . . their competitors would have).

F. Even though Goldman Sachs made tens of billions overall betting against the garbage, some of its bets lost money, too.

G. Goldman Sachs didn't really bet against the garbage, because those bets were merely designed to offset other bets the firm made (contradicted by "F.").

Answer: all of the above.

Lawyer Jokes

Connoisseurs of lawyer jokes will recognize the above as a variant of the "it's not my dog" defense.

When the lawyer's neighbor charges that the lawyer's dog viciously attacked him, the lawyer gives the following, layered defense:

First, he denies that there even was an attack.

When neighbors step forward to say they witnessed the attack, the lawyer says the victim wasn't really hurt.

When the victim presents the lawyer with graphic photos and a copy of the hospital bill, the lawyer argues that his dog attacked in self defense.

When the neighbor produces affidavits from witnesses testifying that the attack was unprovoked, the lawyer asserts that . . . it's not his dog!

"No Comment"

If Goldman Sachs' official spokesman is trotting out the "it's not my dog" defense, what do the actual principals -- current and former employees -- have to say for themselves? How about other Wall Street firms alleged to have done the same thing?

According to the NY Times article:

--Michael DuVally, a Goldman Sachs spokesman, declined to make [trader] Jonathan Egol available for comment.

--Henry Paulson declined to comment (Paulson runs a hedge fund that made more than $15 billion betting against the housing market).

--[Goldman trader] Tetsuya Ishikawa, who now works for another financial firm in London, declined to comment on his work at Goldman.

--Deutsche Bank . . . declined to comment (on a smaller scale, Deutsche Bank is alleged to have done the same thing to its customers that Goldman Sachs did).

--Michael Barnes, the co-head of Tricadia . . . declined to comment.

--Lewis Sachs, Mariner’s vice chairman . . . declined to comment.

Detect a theme here??

I know a way to make people talk (that doesn't involve Mafioso tactics): give a handful of these guys limited immunity, so they can't invoke their 5th Amendment right against self-incrimination, then compel them under oath to rat out their colleagues.

As distasteful as it is to let a few of these rats off the hook to get at the rest . . . it's a lot less distasteful than giving Wall Street trillions in taxpayer loans, guaranties, and free money (courtesy of the Federal Reserve)!

John Paulson's Billions

How the Billions Are Made Today

John who?

If you didn't know, John Paulson (no relation to former Treasury Secretary and Goldman Sachs chief Henry Paulson), apparently is the guy who's made the most money the last two years or so. In the world.

After making $4 billion or so in 2007, Paulson made another $4 billion last year. Himself. As in one person.

For that kind of dough, you'd figure Paulson must have done something truly amazing.

Like cure a disease. Or design a better, faster computer. Or come up with a more productive, pest-resistant strain of rice (like Norman Borlaug, who just past away, did).

So, is that what Paulson did?

Nah.

Paulson made his money running a Wall Street hedge fund that figured out how to use exotic credit instruments ("collateralized debt obligations," "structured asset-backed securities," and the like) to bet on falling housing prices.

Needless to say, his ship came in, big-time.

Paulson's certainly better off.

Are we?

P.S.: Show me an economy where the big winners create nothing of real value -- or worse, benefit from exploiting market excesses and dysfunction -- and I'll show you a dysfunctional economy.