Doug Kass: Under-Regulated, Overcompensated

Here is a take from Doug Kass which is free over at TheStreet.com so I'm reprinting it. (Kass being noted hedge fund manager, short oriented in most cases) Long time readers of the blog will see Kass has has used a bevy of terms/themes we've used over the past year....

1. "heads I win, tails I win system" especially in executive management
   
2. "performance all based on 1 year time frames instead of over longer periods of time
3. "the free market will regulate itself - not"
4. we are now just working through the financial dislocations - after that will come the real effects on the "main street" economy - i.e. the stock market has been mostly dealing with the financials issues and denying the credit contraction and recession upon us.

I did not see one CNBC pundit come on and say "I was wrong. I woefully underestimated the scope of this. I'm sorry." Nope. They are sticking to their game plan - "yet another wonderful buying opportunity - good times ahead". There appears to be no shame on financial TV.

I continue to forecast very difficult times for the foreseeable future. At some point the problems in the real economy will take the baton from the problems of the financial economy. But in America they are so intertwined it is hard to separate them - without credit, and loads of it, much of the US system is incredibly impaired. We live on credit.

*********************** Kass below

At the core of financial system's current breakdown is the fact that there remains too little, not too much, financial industry regulation. Too many regulations serve little or no purpose (similar to the pages of silly and lengthy disclosures in Wall Street research reports that few read and even fewer rely on). Regulatory enforcement is arbitrary and, at times, unpredictable -- a system that values form over substance.

Over the past decade Wall Street's compensation was no longer calculated on multiple years of contribution/performance but rather became a short-term (meritocracy) calculation based on a one-year profit and loss statement. The extraordinary compensation at hedge funds, private equity, and in the investment and commercial banks became a "heads I win, tails I win" proposition as a star system emerged that was based on contributions calculated within reduced time frames rather than an assessment of the value-added contributions over lengthy periods of time (subject to high water marks and claw backs).

Importantly, supporting my view of a "heads I win, tails I win" structure, outsized annual compensations were typically not retained but rather were allowed to exit Wall Street every year -- in part, helping to explain the appreciation in home prices between 1995 and 2005 on the East and West Coasts.

A general lack of regulatory scrutiny and enforcement, the absence of risk controls and a continuum of reckless management decisions at the world's leading financial institutions (banks, brokers, hedge funds, private equity, etc.) have combined to create a Black Swan event, which has resulted in a credit market gone amok and a shadow banking system often under the radar of regulators.

Stated simply, allowing investment banks to be levered over 30-1, private equity deals to be levered at 20-1 and hedge funds to be levered over 5-1 is, as a friend mentioned to me over the weekend, "the financial equivalent of playing Russian roulette with five of the six chambers of a loaded gun."

Laissez faire policy has failed. And since the markets have grossly failed to impose the type of discipline that was necessary to protect the system from the accumulated buildup in credit (and the current contraction), regulators will now step in. Unfortunately, it is now too late as once again the regulators will prove to be reactive, not proactive.

For now, the rescue packages will dominate the day.

But for tomorrow, the effect of a credit market running amok will be felt hard by the real economy.

I have long written that the impact of deleveraging was the equivalent of a broad monetary tightening, and with the Lehman Brothers (LEH Quote - Cramer on LEH - Stock Picks)/American International Group (AIG Quote - Cramer on AIG - Stock Picks) news over the weekend, the extent of the economic damage to the real economy, though still unknown, will be widely felt.

Memo to investment strategists/economists and their economic and corporate profit forecasts: Get real.

Memo to investors/traders: Continue to err on the side of conservatism.