A Sporting Chance for Regulating Capital MarketsRoger L. Martin
How do you fix a broken game? Or more importantly, how do you regulate a game over the long-term to keep it from breaking? These questions should have been on the minds of our financial regulators as they reacted to the 2008 stock market crash. Instead, they focused on how to manage the risk associated with mortgage derivatives and missed the much bigger problem: How do we keep players from gaming our capital markets and causing devastating meltdowns?
Regulators have tried to fix the markets before. In 2002, after the spectacular dot-com bubble burst, the solution was a comprehensive overhaul of regulation, with Sarbanes-Oxley as the centerpiece. Yet, as 2008 proved, Sarbanes-Oxley didn’t fix even a fraction of the market’s ills. Now regulators are again attempting to fix our markets—once and for all—this time with Dodd-Frank.
Washington’s approach to regulating our financial markets follows the most common theory of regulation: Create the perfect set of rules that, once codified, are studiously maintained and protected from challenge or modification.
This approach is pervasive in business (and sports), yet we know that any time there is money to be made and power to be won, clever players will game games to their own benefit. Rather than attempt to outthink future market players, why not accept that perfect, omniscient regulation is impossible? Instead, accept the nature of players and games and continuously tweak the rules to neutralize the innovations by clever market players that threaten the game itself.
The world of sports offers two useful lessons for regulators. Major League Baseball (MLB) is the poster child for the “perfect regulatory paradigm” approach. Despite changes in the marketplace, in team strategy, and in player physiology, MLB has allowed only two consequential rule changes in 90 years—lowering the pitcher’s mound in 1968 and introducing the designated hitter in 1973 (in the American League only).
The National Football League stands in stark contrast to MLB. The NFL embraces the “continuous tweaking” approach. At the end of the 1970s, San Francisco 49ers coach Bill Walsh pioneered the West Coast Offense, a short-passing strategy that created a significant offensive advantage. The result was an amazing four Super Bowl wins in nine years. In the mid-1980s, New York Giants coach Bill Parcells pioneered a blitzing defense that rendered opposing offenses utterly ineffective. That led to two Super Bowls as well.
Each innovation created tremendous advantage on one side of the ball, and in so doing, threatened the parity between offense and defense. In response, the NFL tweaked the rules of the game—allowing defensive backs more latitude in the face of Walsh’s innovation and then giving more latitude to offensive lineman in reaction to Parcells. The changes were aimed at restoring balance to the game and taking away new-found advantages.
After every season, the NFL Competition Committee meets to adjust the rules of its game to make sure the fan experience is the best it can be. One result is that the NFL has dramatically eclipsed in fan support, television ratings, and revenues what used to be America’s game—baseball.
The capital markets have their Walshs and Parcells: incredibly clever hedge fund managers, CEOs, and investment bankers dedicated to gaining advantage in playing the game. There are plenty of examples: John Paulson and Goldman Sachs getting together to create synthetic mortgage products for the purpose of shorting the mortgage market; AIG setting up its Financial Products Group in London under the supervision of the U.S. Office for Thrift Supervision instead of the SEC; and hedge funds launching short attacks on Lehman Brothers to ensure that it went down. And that’s just a few.
SOME FIRST STEPS
America doesn’t need its regulators to protect the current regulatory regime, acting like the owners of MLB. It needs its regulators to keep tweaking the capital markets to offset the gaming, just like the NFL. Since on-going tweaks will always be necessary, it is impossible to enumerate all the changes that would fix the capital markets. But some first steps are clear:
• The Safe Harbor Provision in the Securities Act of 1995 should be repealed. This provision enabled CEOs to safely dispense “earnings guidance,” which has no value for society and focuses executives on playing useless games with stock analysts rather than on pleasing their customers and their long-term shareholders.
• As has long been the case for mutual fund managers, “fulcrum fees” should be mandated for all private equity managers. Fulcrum fees are structured to ensure that if there is a performance component to a money manager’s fee, the downside for the manager has to have the same structure as the upside—meaning that however much it is possible for the hedge fund manager to earn on its 20 percent (or more) carried interest, it should be liable for paying the investor on the downside. This would change the current “heads I win, tails you lose” structure of the hedge fund business.
• There should be a “Tobin tax” on trading so that it is simply no longer possible to earn a massive return on extremely short-run trading strategies, as is currently the case for hedge funds. James Simons of Renaissance Technologies, for example, earned $2.5 billion in cash compensation in 2008 as the market crashed. His strategy: trading vast volumes of shares over incredibly short trading intervals—and he did the same as the market recovered in 2009.
As with Walsh and Parcells, this isn’t illegal. But it has no societal value and certainly a societal cost—every pension fund has to collect more contributions from its future pensioners and/or employer to provide for the retirement benefits it promises, because every year the top 25 hedge fund managers take home $25 billion in personal earnings.
• Finally, executive stock-based compensation should not be allowed to vest until at least three years after retirement. This would keep executives focused on building true value, not just pumping expectations up and down.
Eventually, of course, clever players will figure out how to game each of these changes. But if regulators see that as the natural course of events and that further adjusting is all that is required, it would be the start of a fundamentally more productive approach to America’s most important game.