When one of the best money managers on Wall Street who correctly called the stock market and financial crash (e.g. shorting Lehman Brothers when no one else was) makes a rare on camera interview, investors should take note. So over lunch, coffee, or whatever, take some time to listen to Greenlight Capital’s David Einhorn.

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Einhorn’s comments on FinReg are particularly interesting, because nearly every person I know thinks everything is just perfect with our financial system now that the S&P 500 has recovered. When, in fact, very little has changed other than their are fewer players in the investment banking business via mergers and takeovers, and the underlying fundamentals of the economy have gotten worse.

Moreover, the interesting thing is perhaps what he doesn’t say but imply: that we don’t need new laws, but need to enforce the laws that we already have but ignore.

CONSUELO MACK: If you are looking for a morality tale about the financial crisis and the long trail of its aftermath, which we are still navigating, I think we have found just the ticket.

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The financing company Einhorn shorted, ultimately successfully after 7 long years, is no more. Suffice it to say, as you can see from this stock chart of Allied Capital, it was a harrowing ride. A roller coaster from 2002 when Einhorn’s firm Greenlight Capital started shorting its shares, to 2007 when the stock went into a free fall But that’s not the half of it. In the process, Einhorn was, as he describes it, “attacked by the company, vilified by the press, and investigated by the Securities and Exchange Commission.” And that’s the mild stuff.

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As for the morality tale, Einhorn believes the Allied Capital saga has a meaning far beyond the company. He says it represents what’s still wrong with the entire financial system. I asked him for some specifics.

DAVID EINHORN: The basic problems were that you had accountants that weren’t doing proper oversight. You had the SEC, which was not doing proper oversight. So you have rules on the books that are not actually being enforced. You have a management team that is being dishonest. And you have all of the support network, which is supposed to actually be sort of a watch dog, actually enabling it.

So you have Wall Street analysts touting management’s side of the story. You have the financial media taking on their sound bytes and adopting them as just the way that things ought to be. And so you have this entire sort of breakdown in terms of watch dogs, and then cheerleading section that is actually enabling the bad behavior to persist, ultimately to the detriment of the people who are supposed to be protected, which were the investors.

CONSUELO MACK: Has anything changed? Are any of the watch dogs doing their job better?

DAVID EINHORN: Well, the truth actually is, what we’ve seen is, even in the bigger financial crisis, the same watch dogs have just repeated the same behavior, just in a much bigger way. So what we’ve seen, the same kind of sort of forbearance towards Allied Capital has been granted to the big banks, the big investment banks, and so forth. The credit rating agencies, which did such a bad job with a subsidiary of Allied Capital, we now know that they did such a horrible job, perpetuating the whole crisis, and quite honestly, even though we passed a financial reform bill which is longer than a telephone book …

CONSUELO MACK: Right, 2,000-some odd pages, right?

DAVID EINHORN: Yes. It doesn’t actually address the obvious things that came out of the crisis that a common sense person would say, we need to simply fix them.

CONSUELO MACK: So what do we need to fix?

DAVID EINHORN: Number one is, we shouldn’t have credit rating agencies in any form. Even in their best, they add to cyclical pressures. They say positive things when things are good, that restores confidence; and then when things start getting into a crisis, they actually exacerbate the crisis by now saying that things are bad. Another thing that needs to be changed is, we learned that the money markets are unregulated banking institutions without reserves and without regulation, such that they can’t suffer even the smallest amount of loss. That was the big fallout from the Lehman crisis, was when the money market started appearing to have runs on them. And …

CONSUELO MACK: And a couple broke the buck.

DAVID EINHORN: That’s right. And soon the investors there, they basically believed that the buck could not be broken, and so the whole system was going to collapse around that. And that remains very much in place today, with all of that same risk. Number three, we learned that big financial institutions, if they’re so big, and you allow them to fail, they’re going to have domino effects.

CONSUELO MACK: So even with what we’ve seen, with the banks being more prescribed in what they are able to do, I mean, using much less leverage, being more scrutinized, you don’t think that that’s enough?

DAVID EINHORN: It’s just not enough. If you look at the big banks, they’ve gone from maybe 25 or 30 times leverage to 15 or 16 times leverage, or something like that. That’s still a lot of leverage. And it doesn’t count the derivatives books. And you have these huge notional derivatives books that, they’re just sort of tail risks that are sort of out there, and nobody really knows what’s in them, and nobody knows what risk they pose, and you certainly know that if any of the big four or five books that have the massive derivatives books was going to be on the cusp of failing; you would need to bail them out, the same way, in the future, that you would in the past. Notwithstanding whatever the new rules supposedly say.

CONSUELO MACK: So as an investor listening to you, would you touch a bank with a ten foot pole? At this point, would you invest in one of the major money center banks?

DAVID EINHORN: No. We wouldn’t invest in the major money center banks.

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Wealthtrack by Consuelo Mack