What do the deaths of Michael Jackson and Robert McNamara have to do with Wall Street?  Not much, directly, unless re Jackson you count how he turned to Wall Street’s financiers more than once in his lifetime to do deals (the Beatles rights) and to refinance his lifestyle.  And McNamara, who could easily have gone into investment banking early in his career but went to Detroit instead, saved Ford, then became perhaps the most controversial secretary of defense, ever. 

But it’s interesting to see how the two, in death, are being treated as men who left great legacies in their wake.  Jackson’s frailties and foibles as a human being are being overlooked.  McNamara’s are not.  In both cases there’s not much talk about what such men sacrifice, personally, for their fame and accomplishments.  Jackson certainly became something of a complex personality, ultimately alone in life, unable to relate in any significant way to adults and perhaps, for observers, too comfortably with children.  We wonder if the price of his fame was the metaphorical prison he found himself in at mid-life, the prison, that is, of his own idiosyncratic manner and lifestyle. 

McNamara paid a different price.  Before he left the Pentagon he had what amounted to a religious conversion about the Vietnam War deciding, rightly, that it couldn’t be won by the U.S.  That converted into a crisis of conscience and then, ultimately, a somewhat perverse mea culpa that few of his generation forgave him for.  He was, after all, the architect of a war that sent 16,000 American men, some of them just out of boyhood, and countless hundreds of thousands of Vietnamese, to their deaths.  But the price he paid was to be haunted by those deaths.  His was a prison of his guilt.

It’s a cardinal rule when, as a public figure, you have really messed up that you don’t lose control of your apology.  Simple reputation management 101.  Then there’s the case of Governor Sanford.  He just can’t stop talking about his failings.  We wonder if what’s driving him is some kind of self-imposed and masochistic public cleansing; as if the more he reveals his weaknesses, errors of judgment and betrayals of his wife, family, friends, colleagues, citizens of South Carolina, and the Republican Party, he’ll somehow emerge renewed, and forgiven.  Don’t think so.  It’s only getting worse for him. 

Do consumers need more protections from the banks?  Obama thinks so and seems determined to give real teeth to the new agency he wants to create.  After all, how much more evidence does Washington, or anyone else need, that the virtually unfettered behavior of some financial institutions (can you say “Countrywide”), especially in the mortgage space, was not a good idea.  Sure, blame the consumer for not reading the fine print, or for letting their egos write checks their bank account could cash.  But that still gets you back to who owns the larger share of the burden of being responsible about these things.  One view is that the more expertly informed party should be, hence, the banks. 

The ABA is going to fight this tooth and nail.  We’ll see if Obama can stand up to the full force of the industry’s lobbying storm.  The bankers will no doubt argue that existing legislation is adequate to protect consumers.  They will say that existing regulators just have to do a better job.  Obama will have to walk a delicate line between not portraying consumers as totally helpless and without responsibility (the old model that bred many welfare state “protections”) and demonizing Wall Street.  Not an easy path. 

Booz & Co., in a recent study, says that if you look at the world’s 2,500 largest companies by market cap, among the financial services firms in that group, 18% lost their CEOs in 2008.  That’s not very surprising.  There’s a lot of messed up companies in the sector.  The bigger problem, though, is finding replacements.  And that, as much as anything, is a reputational problem – but only in the short term.  Here’s why:

Besides the fact that there are a lot of damaged goods out there among CEO candidates (Thain, Steel, Fuld, Schwartz, Callan, etc., etc.), those who are qualified and untarnished don’t want the jobs, and for good reason.  And we’re talking here about a reputational sensitivity – the fear of failure.  The odds are imposing.  Government intervention, toxic assets, the flight of talent, new competitive pressures from boutique shops, and that next scandal which may surface.  But the fact is memories fade.  Or at least, the climate of criticism and populist hostility against the sector will improve.  Even Obama will mellow as he moves deeper into his term and starts thinking about re-election (he’ll need friends on Wall Street again).

So our view is have patience.  And our prediction is Thain, Steel, and even Fuld, will lead banks again in the fullness of time. 

It’s really quite astounding that it’s taken the hedge fund industry as long as it has to realize that even a little bit of lobbying money can go a long way in Washington.  Whether or not the industry’s stepped up spending saved them from more stringent oversight in Obama’s recent overhaul plan is not certain – but it also isn’t such a stretch to think there’s direct causality between a visit from a lobbyist and the shaping of public policy.  Happens every day. 

Whether this fledgling effort will pay off as more meat is put on the plan, and it is converted to legislation, remains to be seen.  We expect hedge funds to aggressively resist (in back room private sessions with legislative staff of course) those aspects of the plan that call for documenting trades and lowering fees charged to investors.  The former speaks to the “secret sauce” aspects of what makes these funds so valuable to investors (especially the black box traders).  The latter speaks to the essence of what attracts so many of the best and brightest minds to hedge funds.  And many, in these tougher times, have already adjusted their fees to meet investor demands (or raised their high water marks).  Essentially, then, hedge funds are highly sensitive to investor issues and largely self-correcting.  This nimbleness is something you don’t see at the large financial institutions. 

That’s what administration “officials” are quoted as characterizing the delicate balancing act they’re attempting between the need for a new regulatory structure for the financial services sector and the equally compelling requirement for continued innovation and economic growth.  There’s a lot in this.  And Obama doesn’t need Congress to get most of these “reforms” through.  That can be done via the regulatory structure.  But from where we sit, here’s what all this means:

1. Is it really possible, through regulatory reform, to create the stability Obama seeks?  To shave off some of the highs in the economic cycles and soften the landing in the lows? 
2. Would more stringent capital and liquidity requirements for the systemically critical banks convert these institutions into low-margin, lumbering giants?
3. Is it unreasonable to expect the Fed to perform as now expected even with the greater powers?
4. Is morphing the Fed in this way in conflict with its core role in monetary policy?

We have to admit that when this crisis began we were grateful for the intervention by Paulson and Bernanke.  But now we’re wary of systemic solutions seeking to prevent systemic problems.  It makes us sound libertarian, which we aren’t, yet the last 110 years of history has shown that concentrating power and responsibility in our system of government and regulation is something to be wary of.  Government, when it approaches a problem, largely thinks that the solution means a more powerful government.  But that in itself has so often led to the stifling of private initiative.  So here’s our thoughts at the right solution:

1. Consumers do need more protection and we whole heartedly support the formation of the Consumer Financial Protection Agency.  This is long overdue, especially when it comes to credit card marketing and the fiasco that revolving debt has become over the last 30 years. 
2. The stability Obama seeks runs the risk of creating the mediocrity we as a culture abhor.  You can’t have reward without a degree of risk.  Our concern is that Obama will diminish the spirit of risk taking out of the economy not intentionally but as an unintended consequence.
3. The economy will recover.  It always does.  When that happens we’ll all look back at these reforms and realize we didn’t need some, or most of them.  But it’ll be too late and the arguments over recasting, or repealing them, will go on for decades.  Just look at how long it took to change the Glass-Steagall Act.
4. Too much power in the hands of any government entity is just a bad idea.  Period.
5. No one yet is saying anything about the phenomenon of large financial institutions going astray when they get too big and become unmanageable.  Think AIG and Citigroup.  No CEO can possibly manage a company that large and diversified in the financial service sector.  
6. As we’ve said in prior posts, every such crisis has a lot to do with behaviors being modeled by management.  It’s not the regulatory structure, or the rules, that failed.  It’s the people.  The judgments they made.  The behavior they tolerated around them.  We recall the story of an investment banker in the CDO space who said that he knew many of the deals they were doing stunk and that the bank was taking on too much risk.  But he did the deal because if he didn’t the competition would.  That’s a failure not of the rules but of human judgment.  Where are the bankers who would stand up and at the risk of criticism from peers, or loss of confidence from underlings, or even at the cost of their own compensation would say: “I don’t care who does this deal.  We’re not going to. It’s not good for the bank.”  We need more of that President Obama.

How do you revamp the regulation of Wall Street following the worst meltdown since, well, all the other meltdowns?  Akin to the saying about how porcupines mate, carefully.  Or at least that’s how it’s seeming this week when Obama announces his plan on Wednesday.  The truly radical move, creating one super-regulator and rationalizing the patchwork quilt of agencies, has thankfully been scrapped.  Replacing it is the expected proposal that would give the Federal Reserve expanded powers of oversight and the ability to police and essentially take over and wrestle to the ground companies big enough to pose a systemic threat – an idea that could prove equally as controversial.

The point, of course, is to instill not just laws and regulations to impose tougher capital requirements and prevent risk-taking that is inherently destabilizing. It is also to have a monitoring system that prevents us from ever getting to that brink of disaster again.  If that’s done effectively, the Fed doesn’t need expanded powers of control at the restructuring stage.  But, then, without that ultimate power maybe this whole plan won’t really have any teeth.

We’ll wait and see on this one.  More regulation has never seemed the right solution for just about any problem.  Better policing of existing regulations, yes.  It’s an old saw about corporate policies, codified in company manuals, against discrimination in the work place, etc. But what prevents those infractions is not obedience to the written policies so much as the behaviors modeled by the leadership.  In the end, we think this is why we ended up in this mess.  Corporate leaders knew the difference between a good risk and a bad one, too much risk and just enough, but lost touch with their internal compass which helps guide them, and others, along the right course.

How would like to be sitting in your law office in Washington DC mulling over just how much to pay the CEO of Citibank?  Or GM?  Or GMAC?  Not us.  It’s a surreal picture.  And not just because it stands so much in contrast with how these decisions used to be made (granted, with a bit of a smoke-filled room flavor to it).  It has the feel to it, we hate to say, of a centrally planned economy.  We know that’s not how, in practice, these compensation decisions will be made.  More of a consultation (which will include reputational implications for these organizations) than handing down a dictate.  But the very notion of the CEO of Citi sitting in his office on Park Avenue waiting to hear the final decision on what he’ll be making in 2010 just doesn’t feel like capitalism, even a reformed version post financial meltdown.

Obama will look back at his plan to cast a wide net over Wall Street compensation as a pivotal strategic error for his administration and his legacy.  We wonder if this was one of those issues that his economic inner circle debated heatedly or not.  We hope so.  And we hope there are dissenters who will write books, in the years to come, about the debate.  It’s one thing to limit compensation at TARP recipient companies.  Quite another at companies that haven’t received any public money.  At the heart of it is a mechanism which will fail on its face: this notion of tying compensation to a given level of risk-taking.  The idea is that companies taking too much risk will have to alter compensation levels.  Just what constitutes too much risk is what will have to be defined.  But however it is determined the impact will be the same: it’ll stifle innovation and limit economic growth. 

Risk is at the heart of what Wall Street is about.  Identifying the right risks to take and managing them accordingly.  No one would say that risk wasn’t managed all that well in recent years.  And from time to time that’s always going to happen.  And those companies that couldn’t properly manage risk will perish, as they always have.  That’s how the system works.  To corral risk is to diminish the system itself.  Not good.

Politically, this will come back to bite Obama.  It’s not about losing the support of Wall Street.  He clearly doesn’t feel he needs that for reelection.  It’s about government being over-reaching.  That’s what his reelection will turn on.  That’s what the Republicans will use against him, namely, that he meant well but injected too much government into solution which created new problems that he didn’t know how to solve.

Credit default swaps (CDSs) won the dubious distinction of being labeled the boogeyman of the meltdown on Wall Street.  Invented by heritage J.P. Morgan, and practiced responsibly there, CDSs were not just profitable but also not a disaster waiting to happen.  That all changed as competition heated up and everyone and their uncle chased CDS deals taking on more and more risk.  Witness AIG’s problems.  CDS-based.  Not the writing of insurance policies.

Now Wall Street is lobbying Washington heavily on how this instrument for distributing risk will be regulated going forward.  Attempts at doing so in the past failed.  That will change, clearly.  But at the nub of it is whether the regulation should occur in a clearing house setting or an exchange one.  For government, it’s all about transparency and control.  Washington wants a better handle on how much risk is being taken and it’s right about that.  Wall Street wants less transparency on competitive grounds but this is also clearly how it thinks more money can be made from using CDSs.

The markets (at least bonds, equities, emerging) are rising.  Hiring is starting again and salaries and, dare we say, bonuses are coming back on Wall Street.  The Boys of Finance are feeling their oats again.  But we suspect the Obama administration is not going to roll over on this one easily.  And it’s right not to.  CDSs have to be regulated and along with the issue of Tier 1 capital on bank balance sheets in a way that prevents a systemic meltdown at the next cycle.  That shouldn’t kill the incentive to use these instruments profitably.  It should inject more caution into the psychology around this market, which was what was lacking.