How to Fix Wall Street – Madoff’s Law

 First there are the innovators. Then there are the imitators. Then there are the idiots.  

Its starts off with “I have a great idea” that makes money.   Then someone says “Thats a great idea, only XYZ is doing it. They made a ton of money.   We should do it too”.   Then it becomes have you seen what is happening with XYZ , ABC and DEF ?  They are making a killing. We need to be there too”.   Which in turn becomes, ” Everyone is doing it and making money.  My relative and all of his friends are making a killing.  We can get in on it with my broker or banker. ”    Then its over.

It has happened time and time again for hundreds of years. It is exactly why there will always be bubbles. In the financial markets, the players realize that they can make enormouos amounts of money by copying what already works and applying bigger dollars. Because  “the consistent track record” of the scheme is well documented, its an easy sell to bankers who will lend you money, or investors that will give you money.   Each successive iteration of the scheme finds participants not only willing to take on a smaller return because of the consistency of returns in the presentation they just reviewed, but to lend or invest more and more money. After all, its worked for such a long time, what could go wrong ?    Of course its all great, until its not.

What the administration and most people have not taken to heart and may not understand is that contrary to conventional wisdom, in the financial markets, CONSISTENCY DOESN”T REDUCE RISK, IT INCREASES RISK. How can this be ? Because of the laws of capitalism. The less the perceived risk, the less return participants are willing to take. The less return in percentage terms participants are willing to take, the more money they have to put at risk in order to “hit their numbers”. 

If you work on wall street and want to make $500k with the least amount of perceived risk as possible, you copy what everyone else is doing , only you use bigger amounts then then person who only wants to make 200k. The same applies to companies. If a major investment bank wants to hit their quarterly earnings number for Wall Street, they do the exact same thing, only the numbers are much, much, much larger.

When multiple  financial institutions on Wall Street get beyond big, the profits they are required to generate grow beyond anything we have seen before.  They become institutions that are “too big to fail”. The amount of capital, in aggregate they are required to put at risk generates what is now referred to as “systemic risk”.   When they fail, the entire economy is at risk.

But here is the scary part. In the minds of the management and boards of the banks, they thought they were “operating conservatively”.  In their minds, all they were doing was applying more capital to business lines that had a long history of being successful for them.  Again, in their minds, that is obviously far less risky than taking on or inventing new types of unproven businesses and services and deploying  capital in that direction.

Remember, on Wall Street, there is no such thing as enough. There can only be more. It ALWAYS has to be more than last year. Always. Which in turn requires bigger numbers. Which in turn makes idiots out of otherwise very smart people who thought they were taking conservative business steps.

Call it Madoff’s Law. Where there are consistent returns, it doesn’t mean that the risk is reduced, it means you can’t see the risk.  

In a world where public companies always have to make more money than last year, they have no choice but to convince themselves they are avoiding risk. Now with Madoff’s law, they can know that is not the case.

So how do we fix Wall Street ?  Rather than limiting pay on Wall Street, I would do the exact opposite. I would ask the Obama administration to recognize where the real problems are. The problems are not with the innovators. The problem is less with the immitators. The problem is with the 3rd group, the idiots who think that by copying the others while accepting lower returns, they are making smart decisions.

I would create additional forms  of  licenses (outside the patent office, managed by the treasury ?) that any financial institution can apply for ( with a signicant fee that makes this a government profit center and keeps out patent trolls) and receive for a new financial instrument.  Once approved as original, with as many risks as can be having been documented, I would grant the financial institution some period of exclusivity to market and sell the product. It could be 3, 5, 10 years. I dont know what the exact right number is.  What I do know is that while it will keep the price of that financial service artificially high for some period of time, it will also give the government a means of tracking what new financial instruments are being considered and marketed.  The ones with the greatest upside will always try to get protection. It will also give the innovator and the markets a chance to see how the “law of unintended consequences” applies to the product.  Before all the copycats get their shot at it.

In addition, because the companies that receive the “exclusive license” will always try to protect their license, the government will always be made aware of anyone trying to compete with their products.  Which will make them a far more effective “regulator” than anything a government institution can do. 

This approach would have made a whole lot more money for the company that created the CDS, but kept out the immitators and because it was offered by a single company and maybe its licensees, would have put a cap on the size of the market. The same could be applied to the low end mortgage industry as new products, which turned out to be toxic, would have been limited in their distribution and scale.

One caveat I would add is that these “financial licenses” cant be applied to products already in the market place. This shouldnt be a lawyer stimulus program .  It should be for new products that are significantly different than those already in the marketplace. There are also international implications.  But if this were to work here, I would guess that existing treaties could be applied to these as well.


 Here is what it comes down to.  The problems we have experienced did not come from the innovators, they came from the idiots who thought there was no risk for them if it worked for the imitators before them. That caused the market to inflate quickly and with the undesirable consequences we have all experienced.  If you try to limit pay on wall street, the innovators will go outside the reach of regulators and do what they need to do to get paid. If instead you reward the innovators and make it easier to make money, you will be able to monitor, reform and understand the impact of the new financial products before they go “generic” and the imitators and idiots get a hold of them. 

 

18 thoughts on “How to Fix Wall Street – Madoff’s Law

  1. why bother with all this regulation when it is politically challenging and inefficient. Companies will always find loop holes around these regulations. Why not just reinstate the Glass Steagle and forbid investment banks, hedge funds, and private equitys to become a public company? This way, the owners/partners of the firms will be their own regulators. They can take as much risk as they want, but they will have to suffer the consequences of their own risk taking.

    Comment by wrx2005 -

  2. FYI: I wish to forewarn others – many of us do not know what insider trading is defined as, how such situations progress (are handled by the SEC), and the incredible amount of money and stress involved to defend oneself to prove ones innocence. Just the defense alone can ruin one financially – as can the settlements themselves. Not everyone is a Madoff or involved with any investors. Option trading in particular is not considered the same as buying stock in a company – especially if for a company one works in, something any investor/trader should be forewarned of and best avoid as there is hi risk of perceived “inside information”, and even run of the mill “employee awareness” may be considered inside information even if one is not an insider.

    Comment by visionxcl -

  3. http://www.webgelisim.net

    Comment by koxper -

  4. This issue really goes way beyond Wall Street though. It’s the natural life cycle of a business idea.

    Someone has a money making idea, someone copies it, then tons of people are doing it, then before you know it, it’s done, it needs to be reinvented or it needs a gimmick.

    The amount of consumers buying it becomes so diluted among the amount people selling it that it becomes less and less profitable while costs have gone up.

    Costs related to marketing against all your new competitors, costs in regards to researching new ideas to produce your product cheaper or faster.

    Before you know it, you are injecting your products with steroids and preservatives, or things to make it addictive, or creating new solutions to new problems that you created, or creating fake or floating interest rates that look good on the surface and all kinds of other gimmicks.

    Banks, fast food chains, drug companies, printing companies, investment companies, retail companies, software companies they all do it in some way shape or form.

    This is when a product or an idea’s risk level skyrockets, once that company has to rely on gimmicks to push the product. Then you know the niche is gone and when the niche is gone the competition is encroaching.

    Then bam, the economy hits a rough patch, the weaker competition falls away and the strong are left. Financial Darwinism. The companies that remain are the ones that should remain.

    When you start bailing companies out, you start inter-fearing with the natural order of things, you start propping up the companies that were relying on the gimmicks.

    Comment by aschitown -

  5. It is a simply elagant idea with two major flaws.

    1) The patent office does not have the capacity for the deluge of patents finance firms would attempt to get. (nor do I believe they have the right people to evaluate these instruments)

    2) There would ahve to be someone to enforce and regulate these patents. This would seem to fall under the SEC, wich remains incompetant and understaffed.

    Bottom line is that money will always find its highest and best use, so we will likely never have the right minds in place to regulate such a complicated industry. The government can never pay enough to get the best employees with regards to the financial sector. Just my two cents.

    Michael Lear
    Portfolio Manager

    Comment by mlear1973 -

  6. Mark, here is the good thing: You are thinking! And, another good thing, others in this blog are also thinking. Now for the bad thing: The SEC and even FINRA are not thinking. They only react. And mere reaction makes them just about useless!

    Markets are supposed to be fair. Fair for everyone including the investor who is putting $50.00 a month in his/her IRA mutual fund account.

    Our markets are becoming too complex and diverse. Long time investmenting has always been sound advice….or is it? The in and out investing of online brokers is a bad idea–these institutions are market makers for gamblers. The SEC continues to fail in creating a “fair and equitable” market place with REASONABLE violality.

    Comment by estateman -

  7. Hi Mark,

    I understand a blog post can’t be comprehensive, but I think the impact of moral hazard needs be given a certain level of attention.

    Lehman Brothers aside, the government is propping up hundreds of financial institutions undeservedly. Bankers correctly predicted that this would happen, since it has always happened in the past. The equity in many (but not all) of the TARP firms should be wiped out.

    The short term pain for long-term gain would be well worth it.

    Comment by ylevitan -

  8. Hey Mark, I love your optimistic view on things. On the other hand trying to make Wall Street honest is like trying to teach the scorpion not to sting the frog when he gets to the other side of the flooded river. Its not going to happen dude. Stick with something you have a better chance of changing. Maybe the asinine insider trading rules. Thanks for the thoughts.

    Comment by Frankie from Lawnside -

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  10. I guess my previous comment did not get added. My computer is kind of faulty which is a relief. In bed I was tossing and turning over this proposed plan and here is how I feel.

    The stock market is sort of a love/hate topic right now for me.
    I have spent years trying to figure out some way to make money at it. Looking at the Commitment of Traders Reports and other tools. I wanted to have the odds stacked in my favor when trading. I will not go into all the systems that I have tried and bore you. A couple worked, most Did Not.

    I assume from reading this blog you have innovated a new system you want to market to make money. I am not surprised you have a great mind for that sort of thing. I remember reading a previous blog about how you used statistical analysis in regards to the fouling in the NBA and how it was unfair. I also enjoyed your stats on the NBA all star numbers where you gave impact% and clutch% and other factors to rate players. So if anyone can figure out a successful system for the markets. It would be you.

    In some cases people give all their money to Bernard Madoff and Sir Allen Stanford because their funds have been so successful for years. So your quote is so important. “Call it Madoff’s Law. Where there are consistent returns, it doesn’t mean that the risk is reduced, it means you can’t see the risk.” This quote is great and should be put in gold writing.

    I do not necessarily believe these people are idiot’s, but they are naive. They believe in these fund managers and the SEC to protect their capital in blind faith. They believed a Ponzi Scheme could never happen in today’s world. However it did happen before and it will happen again. It’s still Mind boggling to believe how much was lost.

    I have found a few technical things that have worked if I had of followed the rules and stuck to the system. But I got to emotionally attached to a stock or got cocky.
    I needed to preserve my capital with closer stops and not use margin money. I needed to have more humility because that comes before honor. I admit sometimes I have imitated or copied systems or tried to adapt them for better results.

    I do not feel it is necessarily a bad thing I enjoy reading new concepts and ideas in the market. I like to learn from successful people. There are so many ideas out there. It is fun to look at other people’s attempts and see if they are worthy in real time. For example I looked at Woody’s CCI. No comment.

    I am not sure this plan would be feasible. I am just a private investor. So now I will have to pay for this new product or service? How much will this cost me? How much will it cost the institution? How much more Government will be needed to follow all these systems and licenses? How much more safer will the investor be?

    I thought we could not trust the system or anyone?
    If I use this product. I am going to have to pay to use their system and if I do not the institution’s will have even more of an advantage over me. Due to the fact that their product is being monitored by the government. This monitoring in the past has not worked look at the SEC. Government can not run or fix Wall Street.

    “The one’s with the greatest upside would want protection.”
    I thought we already established the fact that no system out there is foolproof and by believing this would be foolish. You already stated that CONSISTENCY DOESN”T REDUCE RISK, IT INCREASES RISK. So now I am depending on the institutions and government again but just paying an extra tax to do so. A Ponzi Scheme could still result imho. By investing in these products I will still be a copycat or imitator and i will still be an idiot to believe in them with all my capital. The Market is never stable or consistent.

    The more people that buy these products the less the products will work and that is a fact. You have to have a buyer and seller in the market. Too many buyers and then a collapse could occur when the product’s success hits a peak. Maybe after the 5 yrs of being artificially held up by these 2 entities or when there is no more buyers. These are just the flaws I see that could happen.

    I do agree with you that Obama can not limit brokers salaries or the brokers will probably be able to get their money some other way. This is scary..

    I really do not think anyone can fix Wall Street it has been around for a 100 years. There will be Scams and Ponzi scheme’s and people losing there money on stocks like GM Ford and Nortel. This is inevitable people will just have to be more smarter with how they trade and invest and not put blind faith in someone else. There is always a winner and a loser and over 90% are losers. As Kenny Rodgers would say, “Know when to fold em.

    On a personal note I will put my regrets and resentments behind me and start over again. It is to much of an anchor on my soul.
    Enjoy your blog and MMA.

    Mark Farwell

    Aka WW

    Comment by wildwhitewoody -

  11. I think one thing the commenters are missing is the fact that the free market does not and never has corrected itself. The last eight years have proven this. The whole point of Cuban’s post is to create a sort of buffer so that when problems do occur with “free markets” (which they will), they don’t cripple the entire economy.

    Comment by dewfish -

  12. Yes, my favorite subject is the stock market. Glad I keep tuning into this informative blog. It is a real education.
    The stock market is sort of a love/hate topic right now for me.
    I have spent years trying to figure out some way to make money at it. Even trying to do the opposite of the majority of people. Or by looking at the Commitment of Traders Reports. I wanted to have the odds stacked in my favor when trading. I will not go into all the systems that I have tried and bore you. A couple worked, most Did Not.

    I assume from reading this blog you have innovated a new system you want to market to make money. I am not surprised you have a great mind for that sort of thing. I remember reading a previous blog about how you used statistical analysis in regards to the fouling in the NBA and how it was unfair. I also enjoyed your stats on the NBA all star numbers where you gave impact% and clutch% and other factors to rate players. So if anyone can figure out a successful system for the markets. It would be you. Let’s gather the lobbyists to make it happen.

    In some cases people give all their money to Bernard Madoff and Sir Allen Stanford because their funds have been so successful for years. So your quote is so important. “Call it Madoff’s Law. Where there are consistent returns, it doesn’t mean that the risk is reduced, it means you can’t see the risk.” This quote is great and should be put in gold writing.

    I do not necessarily believe these people are idiot’s, but they are naive. They believe in these fund managers and the SEC to protect their capital in blind faith. They believed a Ponzi Scheme could never happen in today’s world. However it did happen before and it will happen again. It’s still Mind boggling to believe how much was lost. Billions.

    I have found a few technical things that have worked if I had of followed the rules and stuck to the system. But I got to emotionally attached to a stock or got cocky.
    I needed to preserve my capital with closer stops and not use margin money. I needed to have more humility because that comes before honor. I admit sometimes I have imitated or copied systems or tried to adapt them for better results. So I guess I am one of the imitators you have mentioned.

    I do not feel it is necessarily a bad thing. I enjoy reading new concepts and ideas in the market. I like to learn from successful people. There are so many ideas around. It is fun to look at other people’s attempts and see if they are worthy in real time. For example I looked at Woody’s CCI. No comment.

    I have wasted a lot of time on the markets. It was a dream and obsession of mine since I was young. A couple of my favorite movies were Wall Street and Trading Places, that I watched with my dad. That got me hooked in the markets. I even quit University so I could work and obtain capital to put in the market. I put the money into different systems trying to make it rich in the markets. Huge mistake, I regret this. Now I realize it was a gambling addiction.

    I have to start keeping my addictions in check. Such as the Stock Market and of course Poker. Sometimes I get so consumed with winning I forget what is important in life. I will put my regrets and resentments behind me and start over again. It is too much of an anchor on my soul.

    Mark Farwell

    Aka WW

    Comment by wildwhitewoody -

  13. If you’re the one who coined ‘Madoff’s Law,’ (and I like it), I would reword it as, ‘Where there are consistent returns, risk is not reduced, it is obscured.’

    Easier to say, write, and read. And, in my mind, less confusing. I had to read the original a couple times to make sure my mind had synthesized it.

    Comment by waiternotes -

  14. I agree with most of your assessment of the problem. However, you’re leaving out one of the most important parts. The reason why the 3rd group, the idiots, is able to get money in the first place is because credit is so easy to obtain thanks to the Federal Reserve’s manipulation of interest rates.

    You’re absolutely correct when you say that as more and more players enter the market there is not less risk, but rather, risk you cannot see. However, if interest rates for credit were set by the free-market, and not the government, the lenders would surely figure out a way to see this, as they would stand to lose a lot of money for betting wrong. Because credit would be more difficult to obtain, they would not be lending out money to the group of idiots, and if they did, they would likely lose it. The free-market would punish them for their failure.

    Your solution implies that the government would be good at figuring out who gets what licenses and so forth. However, the government decides things on an arbitrary basis, and always slanted towards those with the most influence. Where is the dividing line between “too similar to existing product/service” and “significantly different”. I have no doubt that the companies with large pocketbooks for lobbying would gain tremendously in this circumstance.

    The better, and far easier method is to stop letting interest rates be manipulated by the government. As risk gets higher, interest rates will rise. Low interest rates caused overconsumption and overbuilding in the housing market. Now we have too many new houses and too few people to live in them, and people in existing houses are finding these places to be unaffordable. If we could go back a few years and let the free-market set interest rates, we would have seen that as housing supply started to go down due to increased demand, interest rates would have risen, and new home building would have increased at a much more normal rate. Instead, we had an explosion in new housing and we are suffering for it now.

    Comment by libertariansteeze -

  15. Good point about the idiots/copycats, but your solution doesn’t consider the distinctive global nature of markets.

    In pharma, consumers have no choice but to buy from the drug companies due to accessiblity in local pharmacies, this makes the intellectual property enforceable (drugs from china can’t enter the market).

    Financial markets are GLOBAL. If the US sets this regulation, imitators will come from CHINA offering the same product at cheaper prices…and unlike pharma its accessible to investors.

    Comment by chernyak -

  16. I’m with Brian above. More government is not the solution, but you have correctly identified the problem.

    A more comprehensive solution is to eliminate limited liability and institute proportional unlimited liability. The shareowners of corporations, both financial and otherwise, could be personally and proportionally liable for the liabilities of the corporation. You would then see a dramatic reduction in risky behavior.

    Limited liability is the “government endorsed free lunch” that has allowed corporations to engage in risky actions that no real person would likely even contemplate- much to the detriment of all.

    Comment by tkelly1478 -

  17. I think you made a valid point about imitators and the fallacy that being a copy cat means lower risk.

    However, I have to respectfully disagree with your solution. Making government aware of new financial instruments I don’t think will solve anything – this assumes more government regulation is a solution. Government will always be slower to react and gets in the way of what the free market does automatically.

    A beautiful things happens when these companies fail: they disappear (assuming you don’t bail them out). This self correction is elegant and efficient and doesn’t involve lots of bureaucrats who’s salaries come out of our paychecks. Our court system is a pretty good solution as well that is already in place: do something illegal and lots of people sue you, so it makes doing something illegal a bad business strategy.

    In short, people (and companies) who understand that fallacy you mentioned – that being a copy cat doesn’t reduce risk – will naturally be the ones to prevail in a free market, and the problem is solved.

    Brian
    http://www.StartBreakingFree.com

    Comment by krypton1 -

  18. The problem with a government enforced monopoly like the one you suggest is that the industry inevitably lobbies congress to extend the monopoly. This is true of copyrights and patents which did not last as long initially as they do today.

    Comment by dereksthered -

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