John Bogle, Harry Markopolos, Michael Lewis, and the Self-Inflicted Crash of the US Financial System

This weekend I was listening to John Bogle, the founder of Vanguard being interviewed on NPR. I tried to find the interview but couldn't. But in it, he said that the small investor doesn't stand a chance in the stock market. Essentially, the large hedge funds, banks, traders, etc. take their cream off the top and leave the scraps for you and me. The game is rigged against the average investor.

To make it even worse, it appears that conflicts-of-interest make Wall Street a seething cauldron of snakes willing to bend princples and overlook long-term damage in the sake of maximizing short term profits and not rocking the boat.

Michael Lewis writes an interesting piece in the NY Times that essentially says that conflict-of-interest brought down the US Financial system. It's an interesting read and one that has some plausibility.

Take the case of uber-swindler Bernard Madoff. The SEC had received information as far back as 2001 that something was afoul with his operation. In 2005, an investment professional Harry Markopolous sent the SEC in Boston a detailed document (PDF link) which showed how it was mathematically impossible for Madoff to generate his returns using the techniques he professed to be implementing. The paper actually says that is probable that Madoff is involved in one of the biggest Ponzi schemes in financial history. While to their credit the SEC conducted a cursory review of Madoff's operation, they found no wrong-doing and chose to look the other way.

The same perverse incentives exist for the bank rating agencies. As Michael Lewis writers in his Times article:

"Over the last 20 years American financial institutions have taken on more and more risk, with the blessing of regulators, with hardly a word from the rating agencies, which, incidentally, are paid by the issuers of the bonds they rate. Seldom if ever did Moody’s or Standard & Poor’s say, 'If you put one more risky asset on your balance sheet, you will face a serious downgrade.'

The American International Group, Fannie Mae, Freddie Mac, General Electric and the municipal bond guarantors Ambac Financial and MBIA all had triple-A ratings. (G.E. still does!) Large investment banks like Lehman and Merrill Lynch all had solid investment grade ratings. It’s almost as if the higher the rating of a financial institution, the more likely it was to contribute to financial catastrophe. But of course all these big financial companies fueled the creation of the credit products that in turn fueled the revenues of Moody’s and Standard & Poor’s."

The sad thing is that nothing has changed. The government has pumped billions our money into a financial system that is broken. We've stabilized the banks so a few bank CEOs can keep their jobs. Have they started lending again? No, they don't have the incentive to do so. Until a new, more highly regulated system is put in place to ensure the responsible conduct of those managing our money, providing more capital is like pouring water into a bucket full of holes.