Regulation

Why Isn't the Government Hiring Short Sellers?

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Short seller good.

The Goldman Sachs Abacus fraud investigation is already losing the attention of a public ready to move on to fresh fields and scandals new. But one aspect of the story of Fabulous Fab and the hedge fund Paulson & Co. has gotten surprisingly little attention.

Specifically, the collateralized debt obligations that John Paulson advised Goldman to create were based on very extensive research about housing prices and specific subprime mortgage performance in particular local markets. Former Paulson analyst Paolo Pellegrini—who is best known for providing information to the Securities and Exchange Commission and for somehow being rich—discovered where the biggest bubbles had grown and which were in the process of blowing up. His bets against these bubbles, of course, turned out to be right. 

Pellegrini figured all this out using information that was readily available to anybody who was sufficiently motivated. You would think somewhere in the United States government there might be such motivated people. After all, we have an SEC, a Federal Reserve Bank, a Treasury Department, the formerly government sponsored entities Fannie Mae and Freddie Mac, the Census Bureau, many data collection and analysis agencies, and too many congressional committees. All of these entities have the stability of the economy as part of their job description. Yet all of them combined could not manage your money as intelligently as one short seller from Rome managed John Paulson's.

Pellegrini is an interesting figure not just for his good bets, but for some pretty idiosyncratic views on fiscal policy. From a Bloomberg profile:

He sees no reason why Americans should deposit their savings in private banks, since the government already guarantees those deposits… The public's cash, he says, can be held at accounts at the Federal Reserve. Loans can be made by nonbank lending institutions.

At a minimum, he says, there should be limits on bank profits—perhaps a 10 percent return on equity—to keep them from taking the kinds of risks that led to the housing bubble.

"You need a system where people won't be incentivized to take risks," Pellegrini says. "We don't need bankers to take risks with our money."

[…]

How has the U.S. central bank handled the crisis? "The Fed is printing money, as instructed by the financial services industry, so that they can stick all of us with the bill," Pellegrini says, slouching in a conference room chair in his offices in the former IBM Building in Manhattan….

And Federal Reserve Chairman Ben S. Bernanke? "I have zero confidence in what the Fed is doing."

Senator bad.

Pellegrini and Paulson are not the only people who made money by assessing the abundant evidence that the real estate market was bubbling over. (And just to be clear, I'm only talking about their role as overt short sellers, not Goldman Sachs' alleged misrepresentations to its clients.) But if Sen. Chrisopher Dodd (D-Connecticut), who heads one of the many committees that failed to identify the bubble, were serious about fixing the failures that led to the ongoing real estate correction, he'd be writing law that gets more people to act like these guys. A smarter regulatory approach would be to encourage the creation of these crazy derivatives and complicated bets against the market, because these contain information that the market needs and regulators could pay attention to. At the very least, Dodd's financial regulatory bill should not be doing more to suppress the information that bears, short sellers and other "speculators" provide.

Needless to say, the Dodd bill takes a different approach. It also continues to get worse. Yesterday Senate Democrats stripped out one of the few sensible things in it—an amendment to wind down the failed GSEs. (If you're keeping score at home, keeping Fannie and Freddie on life support has cost your grandchildren another $40.1 billion just in the last ten days.) The bill [pdf] does at least shunt short selling curbs into a "conduct a study" siding, but at the moment it's aimed at sharply reducing use of derivatives.

If the purpose of regulation is to prevent excesses in markets, how can anybody justify a bill that reinforces all the excesses that caused the bubble?

I owe the main ideas about Pellegrini above to Mike Alissi, who clearly just wants an Italian to be the hero of the story.