Jim Chanos Explains Why 'Too Big to Jail' Hurts Banks

Adam Jeffery | CNBC

Lynn Stuart Parramore has a great interview with hedge fund whiz Jim Chanos about the nature of financial fraud.

Chanos points out that the Justice Department's reluctance to investigate fraud at the biggest financial institutions probably lowers the value of their equity.

We've had the stunning admission by the Justice Department in the past month that they put into their calculus as to whether or not to prosecute crimes in the financial arena as to the systemic effect of that. My head is still reeling from that admission. Most people would agree that that's not the Justice Department's role. And I think it's caused a really reasonable, serious, continued undermining of trust in our markets.

While we may have benefitted from not revealing additional fraud during the dark days of '08 and '09 by indictments and so forth, I still think you have the exogenous cost effect of a lack of trust by our public and by other investors. In effect, it raises the cost of capital. It depresses valuations. If people think that the game is rigged and they're not in on it, they're going to put their money somewhere else. And that's almost impossible to quantify. But you know there's an effect.

In other words, Wall Street executives wondering why their stock continues to lag have their answer: The public doesn't trust them because they know the government is turning a blind eye to fraud.

Another cost of financial fraud is burgeoning inequality.

I think that the costs for fraud tend to also disproportionately positively affect the wealthiest people in the country. So it also, in a weird way, increases the income inequality issue, and I think that's something that's beyond the purview of me in this interview, but it's something I think that policy makers should keep in mind, because again, the people taking the biggest risks and taking the biggest paychecks and bonuses—if they had been hedge fund mangers, they would have been wiped out, and that's that. End of game. But because they were doing it in too-big-to-fail institutions, they got to keep playing. In a weird way it is the antithesis of the free market. The free market would have taken these people out a long time ago. But, in fact, the subsidized market that we have, where the taxpayer stands behind all these bad decisions and the bad accounting, continues to exacerbate the income inequality issues.

These two ideas are connected. Once upon a time it seemed safe to assume that a kind of economic Darwinism prevailed on Wall Street. The biggest firms and the bankers with the biggest paydays must actually be hugely talented or they would have been taken down by the competition. In our post-bailout world, however, we know this just isn't true. Survival is no longer a clear signal of competence.

Rational investors taking this into account will apply a discount to shares in companies that don't have to rely on competence to survive.

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