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The State of Things



"The view that the consumer is helpless and needs protection by a benevolent government is expressed [by the consumer advisory council]. The view, once widely accepted in this country that competition forces business to serve the public is not even given token nod...The Constitution of the United States was based in part on the belief that people needed protection, primarily from the government, and that free, competitive enterprise was the most efficient engine for promoting the public good."

"At one time, the intellectual climate of this country placed the burden of proof for the necessity of interference with the market process on those who would interfere. Interference was presumed to be an error unless an overwhelming case could be made for it. In the present intellectual climate, the reverse is probably true-actions by the government to regulate business are presumed to be beneficent and the burden of proof is on those who oppose."

James Lorie

As we watch Refco (RFX) open at $1 only a little over two months after issuing stock to the public in an IPO at $22, some might say that we need more government regulation to solve this problem.

First, let's look at the problem. The company each quarter transferred almost half a billion dollars of debt off of its books to a third party in order to make its balance sheet and returns on equity look much better than they really were. Goldman and CSFB, the two leading underwriters, failed to discover this chicanery; they failed in their fiduciary responsibility. Goldman and CSFB earned over $40 million in fees for their effort, or lack thereof.

So too little government regulation is the problem right? I would argue that too much regulation is the problem for the following reasoning. Companies are self-serving where they are always going to maximize return (where they fail is when they do not execute properly or mis-manage risk), that is something that we can depend on. The question is what is the best way to make sure that they don't do things to harm the system in the process?

I believe that government regulation is the least effective way to do this. Companies don't respect regulation; they are always trying to get around it and quite frankly, for every loophole the government plugs, companies find a new one to drill.

The most effective way is for the market to regulate companies. This means customers, suppliers, shareholders, etc. Goldman Sachs is going to do a bang up job analyzing RFX if they know that if they fail their customers will desert them. They will be out of business fast. And by the way, I have heard SEC and private opinion state that underwriters could not have caught RFX at their shell game, that if a CEO really wants to hide something they can always get away with it, at least for a long period of time. This is absolute nonsense. Goldman and CSFB merely looked at end of period financial statements in their analysis; by doing that everything looked fine. But if they really wanted to understand the situation all they had to do is look at the flow of funds and they would find massive amounts of cash and debt being transferred back and forth. For two savvy financial firms this should have been second nature.

But they felt there was little risk in actually being held accountable by their customers so they didn't do the work. And so far they have not been. Oh they have been sued and they will likely settle on some amount, but the fact is customers doing business with Goldman will continue to do so because they have been conditioned by the government that they do not have to look out for themselves.

The worst thing that could happen here is for the government to step in and reward the market for this calamity and I suspect that behind the scenes they have. Certainly the people that bought the stock on the IPO will lose money, but this situation should have opened the eyes of the market to the potential that this could happen (maybe not to this extent) in any company, especially financial ones where it is all debt (Goldman and CSFB should have known this especially). The market itself should be discounting this episode much more than it is simply because it is conditioned to believe that the government will step in and always "control" the situation.

People say, "What do you want, the market to implode and everyone lose money?" Well, perhaps the cumulative effect of government intervention will ultimately be that when the chickens come home to roost, the problem will be much, much bigger than if we had let the market sort things out each time.

Whether it is the "Greenspan put" or an ever expanding money supply, markets have been conditioned to respond sanguinely to these situations. This fosters cronyism and more importantly, allows imbalances to build to the point to where the system is in danger of imploding.

I see these risks higher than ever while most market participants have been conditioned to ignore them.

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