Monday, December 15, 2008

Opportunity to actually fix stuff

By now, pretty much everyone with an internet connection and a passing interest in the economy has heard about the Madoff hedge fund Ponzi scheme, and it's global fallout. Rather than dwell on this as an unmitigated disaster in financial oversight on the part of the SEC (it certainly is), or as a referendum on the utter failure of governmental oversight in preventing fraud (yep, that too), or even as a parallel to the pitfalls of non-transparent investment of enormous amounts of money in extremely questionable vehicles for ulterior motives (see: the Fed), I thought I'd instead hypothesize about how we could productively learn from this meltdown, and try to prevent future disasters when there inevitably is fraud.

Rather than get into the obvious (eg: effective oversight, which may be near impossible), or abolishing hedge funds in general (which does nothing, since the problem is fraud not hedge funds), I figure the best way to prevent fallout in the future is to take this opportunity to more clearly define who can, should, and cannot participate in "unsafe" investments such as unregulated hedge funds. See, they are already available only to "qualified" investors, which basically means people with enough assets that they can lose a lot and still be fine. That, as a basis, works well; it's in the secondary markets where it seems to break down.

See, the SEC doesn't track who invests in hedge funds, which effectively allows companies to "launder" the risk associated with them. For example, say a public company puts some of its assets in a hedge fund, and a pension fund buys shares in the public company. Now the public company meets the criteria of a "qualified" investor, so it's allowed to buy into hedge funds. However, the pension fund almost certainly should not be making risky investments, so it's buying public company stock instead of hedge funds. However, we have created a problem: if the hedge fund goes under, the public company loses lots of money, and thus so does the pension fund. In effect, the pension fund is investing in risky assets.

How to fix this? Well, I'd suggest a tracking qualification of "risk level", tracked by the SEC, based on underlying asset classes and purchases. As an entity offering an investment (company, fund, etc.), you should be required to maintain and publish your risk level, based on your investments and level of disclosure. This would allow every entity which should not be gambling in risky investments (eg: pension funds, banks, public corporations with retained assets, etc.) to be precluded from doing so at the organization level, without substantially increasing the regulatory or oversight burdens, which (as demonstrated) has no beneficial effects. Plus, if done correctly, you wouldn't have bubble explosions of risk like the most recent one, as ultra-risky investments like RMBS's backed by hopes of dreams (unrealistic ones at that) would be marked as "ultra-risky", and thus be precluded from ending up indirectly on the balance sheets of "essential" financial corporations or the government itself through risk laundering.

Simple solutions are usually the best.

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