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The latest crisis of trust

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Prabhudev Konana

Madoff’s Ponzi scheme defrauding investors to the tune of $50 billion spotlights the fact that trust has become a rare commodity on Wall Street. Bringing back real trust is going to be extremely difficult.

In 1980 Presidential debate, Ronald Reagan famously exclaimed to Jimmy Carter’s response on healthcare: “there you go again!” This response seems to resonate once again about unbridled, unregulated free market capitalism. This time it was Bernard Madoff’s Ponzi scheme (or pyramid scheme) of financially lynching unsuspecting investors to the tune of $50 billion. I guess not many will shed tears for the rich folks who have lost their fortune, but it is indeed sad to see numerous charitable foundations implode.

The champions of free market capitalism are now asking, “where is the SEC?” The Securities and Exchange Commission is the regulatory body in the U.S. to protect investors and markets. This apparent screaming by free market capitalists is an oxymoron, but certainly recognition of the need for regulations and oversight.

Mr. Madoff had a great reputation as a financial genius, philanthropist, and former chairman of NASDAQ. The trust in him was so high that that even SEC ignored numerous warnings and symptoms. Wall Street – the financial capital of the world – relies on the collective trust of all market players. But we now realize trust is becoming a rare commodity on Wall Street. Mr Madoff simply exploited this trust to run a Ponzi scheme.

There is increasing distrust in the financial markets. The creative accounting methods – brought out during the Enron scandal – and the recent financial engineering symbolises the distrust and illusory value. Adding to this mix are the investment advisors, financial analysts, hedge funds, and traders going amuck to further destroy trust in the system.

Goldman Sachs – a gold standard in the investment community – predicted as recently as March 2008 that oil may head to $200 a barrel as part of the ‘super-spike’ oil theory. This was based on the supply disruption and the increasing demand from developing countries. In reaction, we saw speculative capital ratchet up prices of oil and other commodities. There was serious disconnect between the demand and the supply, contrary to what the free market principle would suggest. On the contrary, this mad house created chaos around the world with rapid inflation. How fast times have changed. Now Goldman and other investment firms are in competition to lower the oil price target to $25 a barrel, while bringing some of the same experts to make gloom and doom projections! There appears no sensibility to these projections or advice.

The popular media played a crucial role as well. Business channels like CNBC invited so-called experts to drum up the bullish targets while thrashing anyone who suggested possible speculations or sensible regulations. The popular financial entertainer and advisor, Jim Cramer, made incredible predictions during boom time – Google to $1,000; Baidu to $700; Goldman Sachs to $300; Master Card to $400, etc. He and the countless analysts and experts pumped up the bulls to make that incredible run-up the hill only to fall off the cliff fast and furious. Of course, they have no consequences for their outrageous projections while any potential manipulation is hard to track. The net impact is the loss of trust in the system.

Professor William Baker of San Diego State University reports that the analyst ratings of buy, sell, or hold were usually inaccurate and possibly deceptive owing to conflict of interest. His study suggests stocks with “sell” ratings of Standard & Poor’s 500 index actually outperformed those with “buy” recommendations. This research raises questions about the analysts’ role and the need for accountability.

Yet financial markets are required for raising capital, creating jobs, and keeping the entrepreneurship and innovation cycle running. We need to bring back the ‘real’ trust with greater oversight and accountability. This is not going to be easy. Despite some regulations after the Enron scandal like Sarbanes Oxley, market players seem to find new ways to make the gambling machine spin differently.

(The author is the William H. Seay Centennial Professor and Distinguished Teaching Professor at the University of Texas at Austin and can be contacted at pkonana@mail.utexas.edu)


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