In what little time I have had over the last two weeks to ponder anything other than the difference between adverbs of modification and comparison and the present continuous versus the present simple I've managed to read a bit about the background of the financial crisis (more like review material, or a brief for the prosecution) and have some thoughts to share. I want to talk about real reform. Not the Washington-type band-aid crap. Now, mind you, these are very preliminary ideas, but I think they will make good fodder for discussion between Numerian and I and possibly Stirling as well. (Although I get the sense sometimes that Stirling is more radical than I am and would prefer to let the old burn down and replace it with something new, a feeling I am sympathetic too. Alas, this is the world we live in.)
I think an anecdote is appropriate here first. When the Bear Stearns hedge funds blew up last year I asked Bob Geiger, who has impeccable sources in the Senate, if this was on their radar. I pestered him for several weeks and he never got an answer from any of them that I am aware of. This just goes to show you how out of touch our Congress is with reality. Perception is everything and at that time, the wise men all agreed: it's contained.
That's what I call the rise of 'post-modern finance'(you can substitute politics just as easily), as described by George Soros' ideas on reflexivity:
Reflexivity can be interpreted as a circularity, or two-way feedback loop, between the participants' views and the actual state of affairs. People base their decisions not on the actual situation that confronts them but on their perception or interpretation of that situation. Their decisions make an impact on the situation (the manipulative function), and changes in the situation are liable to change their perceptions (the cognitive function).
It's that whole post-modern "perception versus reality" thing and the idea (based in quantum physics) of the observer altering the outcome.
One serious thing to take away from this is mark-to-the-model finance. That has to stop. As Nicolas Taleb recently said, "we should jail all the quants." (Or something similar.) Mark-to-model should be excised from GAAP and disallowed. End of story. If you can't discover a real price, then there isn't a market for it. This is a part of that whole perception versus reality thing. If people perceive something is valued at such and such a price then it's a self reinforcing reality and leverage can be built atop it, with disastrous results. Indeed, if we take Soros' idea and turn it to the downside of markets, well, isn't that what we are seeing now? We all know that a great deal more of these mortgages are higher valued than they are being now, but because of a negative feedback loop, as they call it, it's all doom and gloom. (Now, as for unsecured credit card debt and sub-prime auto stuff? Well, there's going to be hell to pay there too, it's only a matter of time and it will probably be the next shoe to drop, although it will take a while for the markets to 'get it' because it will only become really problematic when there is no doubt the economy is in the tank.)
Second, disclosure and absolute transparency when it comes to any kind of credit derivatives. As a codicil to this I would add, absolute regulation of CDSs (by the Chicago Merc for example) in a way that preserves the function of the market. (The commodities markets are not designed to be 'investor friendly', they are designed for liquidity and to provide a well functioning market--as opposed to the stock exchanges, which are more 'investor friendly.') There must be limits on the amount of contracts one can write on any specific security, just as there are limits for options trades and futures trades. You can't corner the market like Jesse Livermore did anymore. Absent these three reforms then I would ban CDSs. Period.
Third: I would make it mandatory for all bankers, hedge funds, all bank employees and executives and pretty much anyone who works in a 'securitized' or derivative market to get licenses to work in the securities market, whichever aspect of the market they choose to work in. Why? Well, for starters, to prove they have a basic understanding of what it is they are dealing with. You want to write CDSs? Well, you have to take a test proving you understand the risk to your institution and the counter-party. You want to securitize home loans? Credit cards? You take a test proving you understand the process. Why? So you gain insight into when it might, just might, be getting a little out of whack. Knowledge is fundamental to the proper function and regulation of markets. A 25 year old just out of MIT or Harvard or Yale should never, under any circumstances be allowed to managed a $500million portfolio because his 'daddy' is in the 'biz.' If Conservatives want teachers to take tests, then finance professionals should too!
Another key reason for this is that all of them need to relearn the idea of "fiduciary responsibility." When I was an asset manager I was on the hook if I accepted 'little grannies' order for writing 1000 call options on her deceased husband's Exxon stock. If it was not in her interest I couldn't take the order. And believe me, this happened more than you think. And I lost a lot of clients because of it. (Of course, there were also guys who didn't care, but they usually washed out of the business quickly enough.)
Fourth: executive compensation and clawback provisions. It is simply obscene that Lehman Brother's filed for bankruptcy but in those proceedings their executives were allotted $2.5 billion in bonuses. Are you fucking kidding me? (You didn't know this had happened did you? Well, it is true.) They should disgorge every last penny possible from Fuld, the former CEO. And they've already found a work-around for the executive compensation limits Congress enacted, in case you were curious. Who would enforce these provision? Well, one would hope the Justice Department would, although it's probably been FEMAfied to the point of emasculation.
Fifth: enforce anti-trust laws. If it is too big to fail, it is too big to exist. I repeat: if it is too big to fail, it is too big to exist!
Enforce anti-trust. Break up Wal-Mart, the media conglomerates, the mega-banks, the mega-retailers, Microsoft and quite possibly Google. ATT? You bet. Other phone and cable companies? Oh yeah. We're not a national-socialist state, but we're getting there. Let's have real competition in key markets! No more duopolies (like Wal-Mart and Costco) or the cable companies, or the phone companies. Remember how prices for telecommunications fell through the floor in the eighties and early nineties because there were 7 or 8 good telecom companies? Enforce anti-trust laws so we have real competition. The laws are already on the books and this is not anti-capitalist. Just ask Teddy Roosevelt!
Sixth: regulate hedge funds, although keeping said regulation at a minimum. Basically, I'd propose a law that allows for snap inspections of the books--not disclosure, as hedge funds may have proprietary trades that if discovered by the market as a whole would clobber the fund in question--by the SEC to make sure hedge funds aren't breaking any pre-existing securities laws, i.e. having an illegal amount of options contracts on the books, naked short-selling, CDSs, etc . . . and bar them from excessive leverage: nothing more than 20-1. Mind you, most of the hedge fund guys I know act in good faith. One of my best friends funds just blew up and he was--still is--a good guy. They are real people, and many of them take their fiduciary responsibility seriously. But there are bad apples, and snap-inspections would go a long ways to keeping everyone honest, without blowing up 'hedges' and 'arb' plays.
Seventh: overhaul municipal bond issuance, marketing, selling, and trading regulations. At the present time muni-bond buying and selling (at least on the retail level) is based on principles, there are no real regulations, per se. This needs to change. When I took my Series 7 munis were a large part of it, but the 'laws' weren't really laws, they were guidelines.
Eighth: Insurance industry reform, not really, except for CDSs (see above). It's a good things the states have authority over this or AIG really could have been a cataclysm of an altogether horrific order. Ian Welsh might have some good ideas here.
Ninth: enact a Tobin tax on all cross-border financial trades of say, .01% of the total value added transaction and use it to fund real foreign aid projects like building water wells, and other essentials, not subsidizing the sale of weapons to Israelis and Egyptians as we currently do with our 'foreign aid' budget. Oh, did you think our foreign aid budget actually went to helping poor people? Did you then know that on a per capita basis each Israeli citizen gets about $500USD a year from you, the taxpayer? I bet you didn't.
Finally, everyone in the investment business, instead of having to take obligatory exams on new bullshit Patriot Act money laundering laws--which actually made it harder for new business to start up, not to mention the fact that anyone with half-a-brain and a sound understanding of fiduciary responsibility knows who's laundering and who's not--should take mandatory classes on financial prudence, what systemic risk is, what causes it, etc. . . .
As for 'fractional reserve lending,' well, I'm kind of partial to money creation. And I'm not a fan of the gold standard. But I really wouldn't know where to begin that discussion. I do think the Fed micromanaging interest rates is counter-productive--as the markets should be able to discover their own rates, as they are now, despite the best efforts of global Central Banks. There are many, many other issues. Note them in the comments and I'll try and address them. After all, I can't think of them all.
As much as I dislike Milton Friedman, markets are efficient, but they are prone to excesses when improperly regulated. And when the excesses occur we get what is happening now. The market(s) will discover it's (their) bottom(s), no matter what the Fed or Treasury does. But this could have been prevented. And don't let a single damned politician say it couldn't have.
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Comments: 30
I shake my head at the education and licensing ideas. That would add more barriers to entry into the finance business, but it would have any other impact.
Its not lack of knowledge that is the problem, its the 'masters of the universe' syndrome. Thats when people think they are too smart to follow the rules, and can out wit the markets and all the other players.
If this were to occur in the construction industry, or mining, or agriculture, or world trade, imagine how hard governments would strive to get the problem under control once and for all.
Yet we have seen it happen time after time in the financial sector. Like the Bourbons of old, the Wall Street whiz kids, and their counterparts in other financial centers, forget nothing and learn nothing.
I hope this catastrophe leads to suitable regulation on a world-wide basis. We regulate casinos because of the obvious dangers of having large sums of money available for misappropriation. We can't continue to operate our financial systems as if they were unregulated casinos.
Congratulations Sean-Paul on a thoughtful, incisive article.
"...they've already found a work-around for the executive compensation limits Congress enacted..."
You mention the possibility of banning CDSs entirely. That conforms to a question I heard asked by a congressional committee member (don't know who) a day or two ago. He (as do I) wanted to know why we shouldn't outlaw all of these too-clever-by-half, innovative financial instruments entirely?
Also, I think there should be some sort of provision to prevent the kind of incestuous relationship that exists between our current Secretary of the Treasury and the finance industry. I think he's far more interested in looking out for the interests of his compadres on Wall Street than the poor schmucks on Main Street.
(BTW, I don't think there's much doubt NOW that the economy's in the tank.)
I would submit finance it is not as hard as medicine, but it is equally as hard as engineering, which requires testing; it is as hard as accounting which requires a massive test; these people need to be educated as to the real world risks, not the garbage models they are taught at MIT, Harvard, Yale etc. . . . And there should be barriers to entry. When anyone can get in the business, create a neat little financial gimmick out of thin air that makes hundreds of millions for herself and then suffer no ill consequences when it implodes and causes massive job losses? Little common sense here, please.
I submit that it is not the "common sensical" nature of them that renders them unlikely to be implemented, but rather something far more insidious and unpleasant to consider. I believe that the games have been played so well for so long by some, that they have become "machines" of a sort. Money machines, which some among the hyper-wealthy wish to remain in place.
People with hundreds of Billions of dollars at their disposal, and no real social conscience, can buy a whole lot of political "will" . . . (or won't ; ) I believe there is a level of financial dealings, which reaches into the realms of vast power, even dictatorial power, and we are not actually facing a "political" challenge anymore, but a "master" class. A relatively tiny group of people that literally control the world.
It's not a "conspiracy" exactly, but the natural consequences of prolonged "combat" at the upper reaches of the wealth/power game. The winners, over time, will naturally be the least "queasy" about things like ethics, social responsibility, law, justice, etc. Once the "bad apples" reach the top of the pile, the game becomes one of maintaining and enhancing power. Raw, egocentric, sociopathic, power. A "fair" economic system is an anathema to those who are not fair-minded, and they will resist fairness, just as Al Capone resisted the rule of law. The rule of men, makes perfect sense to the men that rule.
Too technical for me to grasp the fine details, but as far as my gist of your ideas goes, they all seem very reasonable. I'm intrigued by John Knight's concept of an unintentional conspiracy.
Here's hoping that more people of good will that also have the requisite knowledge of how things actually work can take the high road on the reconstruction of our system. I'd LIKE to believe that our elected officials really do have their constituents' best interests in mind when they reform the tax code and these financial regulations.
Yes, exceptional.
Walmart does not have thaat kind of control of the market and should not, at this time, be broken uip. They are big enough to watch and when they start to purchase Target and other similar businesses it is time to say no.
Breakups sometimes benefit the consumer and sometimes not. The breakup of telephone companies seemed to help those who make long distance calls only. Local started subsidizing long distance. The advent of Cell phones was the real competition for ma bell! These companies should be watched and not allowed to merge.
Basically, I am in agreement with the author and recognize that he is far more knowledgeable on finance than I.
I have to agree totally with your concept of an unintentional conspiracy! It wasn't planned and is not purposely maintained but, like so many things, just keeps going along like a well oiled machine!
It is my sincere hope, and that is pure hope, that Obama will be the catalyst for the breaking down of this informal conspiracy. He has as great an opportunity as has been had in many years, if that is his direction of choice. And that is assuming that Obama wins the contest, of course.
If McCain wins, he has an opportunity, but not that of Obama's because of the politics of congress and the fact that he has been a part of the situation for so long he is unable to recognize it.
My background is in sociology (and computers) but I would like to make a couple of suggestions for your consideration.
1) Given the amount of money involved I suggest that regulations can be made and enforcement may be organized and tired and certain things may be banned and so on but they simply cannot be effective. There is too much money involved. Regulations can be ignored. Enforcement can be bought off or be found to be insufficient. Banned activities can be participated in though banned. As an example take organized crime, found in all nations that in any way attempt to regulate any trade. The products of organized crime (drugs, sex, threats, gambling) may be illegal but they are provided in every city in the nation and no matter the enforcement attempts, the laws, and the punishments required, organized crime flourishes despite being a mass market retailer.
In other words, no matter what regulations and limits one attempts to impose on these markets, these markets will behave in an unstable manner and have self destructive tendencies because of the nature of the money we use.
2) Please consider the properties of the money we use. You will find these properties in no economics text and no current or past theories of economics but they are quite simple and quite obvious.
(For the detailed presentation please see www.nopom.info .)
Every form of money in history has been a physical object or some representation of a physical object which we treat as a physical object. (Commodity money, specie, fiat money, and all kinds of bank accounts are or are treated as physical objects.)
Physical objects can be taken from you against your will (including money) by various kinds of force, fraud, and stealth (and cn be lost or destroyed). Thus your money is never safe and everyone has a motive to take your money.
Physical objects are amoral. Therefore they can be used for both good and ill. Money can be used for good ends and bad because it is amoral.
The supply of one physical object is independent of the supply of other physical objects. Therefore the supply of money can change with no corresponding change in the supply of goods and services for sale and vice versa. Inflation and deflation are the result.
The use of physical objects suitable for use as a medium of exchange cannot be controlled by any human agency, organization, or group. Therefore the use of money cannot be controlled.
Money transactions simulate a zero-sum game. That is, the money gained by one party is lost by other party or parties. The gains and losses of money are zero-sum because money is a physical object and physical objects gained by one party must be lost by other parties. This simulation is false but people act as if it were real. Therefore, each person will tend to act as if everyone can gain at their expense and that they can only gain at the expense of others. (Thus the balance of trade when one nation is gaining money is said to be in their favor even though they are receiving less goods and services than they are exporting.)
Finally, phycial objects can be transferred only between two parties. Thus all money transactions are two party interactions. But two party interactions are inherently unstable for as one party gains power, that party can use that party to gain still more power in the relationship. Thus even marriages, which should be very stable since the two parties are in love and have all sorts of social, ethical, and religious support often end in divorce (and money problems are the single greatest cause of divorce.) By using our form of money (physical object money) we base our economy on something which almost guarantees instable relationships.
If I am right about the above then there is no solution for our current problems (they will return over and over in various forms) unless we change the nature of our money. For my ideas on how that can be done please read Invisible Hand here on Gahter or at www.nopom.info (there are no ads at that latter site.)
Thank God for people like you who are able to pick this stuff apart. I just visited The Agonist and plan to visit there more often. Thanks, Sean Paul!
I would be inclined to take this a little further by saying that we all need to change the nature of what we view as fair trade. Bartering comes to mind and it doesn't always need to be something PHYSICAL. Well, I suppose service of some type is still "physical"........all I know is that bartering works. Nowadays, at least.
i think all the ideas are worthy of discussion
but the license requirements while logical is only going to benefit
an employer. the systems are so complicated that younger
people do not understand what they are doing. people cram
and cheat to get these pieces of paper. maybe auditing someone
for a few years or forever might work.
It would be nice to see an article on money creation, I assume
you are referring to money being "loaned" into existence?