Lessons Learned From This Financial Crisis
 

I was talking to a friend tonight. He's a hedge fund manager in NYC, the kind of guy who you'd think would be happy and making money in this market. But he wasn't happy about the damage being done to the financial system and thus to the real economy, and we talked about what could be different.

(He wasn't making money either, which may inspire another thread later.)

So I thought I'd start a thread about what lessons should be learned, and what should be changed, in the global financial system.

I'll start with some views, some will be boringly technical but I think still important.

First, a single regulator must monitor and control the systemic risk being taken by all players in the financial markets.
- Traditionally, the Fed, FDIC, and Treasury govt closely monitors depository institutions like conventional banks, S&Ls, etc. They are required to maintain certain capital ratios, report detailed information to the bank regulators, follow specific accounting practices, and can be quickly seized and brought under control or wound up.
- Investment banks and securities brokers are not under this level of scrutiny. They have been primarily regulated by the SEC, which is focused on investor protection issues (underwriting practices, insider trading, etc), but has had little concern with how much risk the investment banks/brokers are taking on their own account. Notice how absent the SEC has been during this crisis - its like they are out of the loop, because they are.
- Insurers are regulated by state insurance bureaus. They care about policyholder issues, but wouldn't know a complex derivative if it came to dinner. Notice how blindsided the NY insurance commissioner was by AIG's problems?
- Hedge funds are barely regulated at all. The SEC is supposedly in charge, but they have very little insight into these industries.
- With the repeal of Glass-Stegal and other deregulation of the financial markets, all of these entities have been piling into each others' markets. Traditional banks like C and JPM are in the investment banking and securities business, investment banks like MS are making commercial loans, insurers like AIG are writing credit default swaps. Hedge funds are making commercial loans, investment banks have become major traders of physical commodities. The regulators have been many steps behind. Its been the Wild West, and the constables are nearsighted and undergunned.
- We need a single lead regulator of the financial markets, with expertise in and authority over all aspects of the markets and all market players, the power and resources to seize and liquidate, and the political independence to ignore Wall Street lobbying. That regulator should understand and control the risk-taking of the players. For example, during the financial boom, investment banks operated with 30-to-1 leverage. Commercial banks are required to have much lower leverage. Yet aren't the investment banks in an inherently more risky business?

Second, the market must be transparent.
- A huge amount of activity now takes place out of public view, in the so-called over the counter market. The $60 trillion (nominal) CDS market is an example. CDS are not traded on any exchange, many are illiquid, the contracts are untested and sometimes not standardized, no-one really knows who is buying and selling what, and no regulator is able to monitor this market for manipulation or fraud. Yet CDS premiums are basically deciding the fates of major financial institutions like MS and AIG now.
- When markets get to a certain size and importance, they should be forced on to open exchanges, to operate publicly and transparently. Using an exchange moves counterparty risk to a visible, central entity. If the security is a continuing obligation, like a CDS, it can be settled daily like a futures contract is, meaning that the actual counterparty risk is limited to a single day's price movement. The regulator can then scrutinize the trading for manipulation, and investors can better judge what price action is meaningful and what is not.

Third, feedback loops must be controlled.
- The current crisis is being exacerbated by feedback loops. For example, MS' CDS premiums rise, hedge funds short the stock, the stock falls, that makes it harder for MS to raise capital, that drives the CDS higher, more hedge funds short MS, that sends the stock down more, etc etc. That's part of why these big institutions' stocks suddenly start plunging -50% a day and spiral to zero.
- As another example, RMBS start getting discounted as mortgage delinquencies rise, banks are forced to immediately mark them to market and liquidate what they can, the selling drives RMBS to higher discounts, they are marked down further and sold harder, the discount goes up more, the marks get worse and the liquidation accelerates. That's part of why senior RMBS are being marked down to 20 and 30 cents on the dollar. Take 10,000 Alt-A mortgages across the country, then select the best performing 20%, I do not believe the ultimate recovery will be as low as 30 cents on the dollar. Is every single house of that 10,000 going to be foreclosed and sold for 30% of its purchase price? I don't think so.
- Some feedback loops can't be stopped, but some steps can probably be taken. For example, about 2 years ago the SEC eliminated the uptick rule, which said that a new short position had to be taken on a uptick in the stock. I noticed an increase in the severity of stock declines then. The SEC has also basically ignored naked shorting. Thus there are some stocks out there, where the short interest is 90% of the free float. As another example, marking to market could be based on the rolling past 4 quarters, not on the most recent CDS premium or market quotes.

Fourth, accounting standards and regulations should be counter-cyclical.
- Right now, financial institutions are subject to various accounting-based requirements that essentially let them hold less capital when markets are rising, and force them to hold more capital when markets are falling. One example is value at risk measures, which report lower [higher] risk when markets are less [more] volatile. Another example is strict reserve rules, that require banks to set their loss reserves based on the default rates of the past few years, meaning that during the good [bad] times, reserves are low [high].
- That means that during the booms, credit is even looser, while during the busts, credit gets even tighter. By "even" I mean even more than the human optimism-pessimism cycle would otherwise cause.
- Instead, you really should encourage those optimistic humans to be a little tighter on credit during the booms, and to be a little looser during the busts.

Fifth, executives and employees should be rewarded based on the ultimate outcome of a transaction, not on simply having arranged the transaction.
- In some cases you can measure a successful outcome - e.g. a mortgage broker wouldn't be fully paid until the mortgage has been performing for X years.
- When it is too complicated to measure the outcome, a rough way to do the same thing would be to require bonuses and commissions earned in a given year to be paid out over several years, and to make this obligation dischargeable in bankruptcy and cancellable in event of a govt seizure/rescue.
- I don't know, this might be too complicated to be practical?


Anyway, those are some thoughts. Any others?

instate legislation that requires the majority chunk of the payouts to CxO's to be frozen for certain times pending evaluation of the results of their rule, screwups go home empty handed, no more golden parachutes for early leavers...

I've learned that sometimes booze and hookers really ARE the safest place to put your money - at least you get something in return!

Your solution sounds pretty "tyrannical."

I have a much simpler one:

1. Eliminate the Federal Reserve.

2. Exchange all the Federal Reserve Notes outstanding for the gold and silver the Treasury (hopefully) has in Fort Knox.

3a. Make it a capital crime for any banker to engage in fractional reserve banking against demand deposits. 3b. And along with that, have stiff jail sentences for any banker who does not match his lending with his borrowing -- meaning, no more borrowing (from depositors) using short-term instruments (like 6-month CDs) and lending out that money long term (like for 30-year mortgages).

Do those simple things, then let a free, unregulated market, take care of the rest.

Get serious. These are not practical ideas. They are crackpot ideas.

Take, for example, #3b. Every bank borrows short (i.e. takes deposits) and lends long (i.e. mortgages). How else do you expect loans to be funded? How many people are going to walk down the bank and put their money in a 30-year CD? - ZERO. How many people can afford a 30-day mortgage? - ZERO.

And #2. There is not enough gold in Fort Knox to replace a fraction of the USD $ in circulation. There is not enough gold in the world to replace a fraction of the euros, yuan, swiss francs, US dollars, etc in circulation. The world has grown beyond gold.

You might as well say we should all use anti-gravity.

Herpes and a hangover?

Then you can continue to expect to have "boom and bust" business cycles created by artificial credit expansions and contractions caused by the double-entry bookkeeping (which would be considered as fraud in any other business) practiced by bankers.

People buy 30-year government bonds, why do you think people wouldn't buy 30-year CDs?

Nonsense. You can use any amount of gold to back all the outstanding fiat currencies -- it is all just a matter of what ratio of gold-to-fiat currency you use.

When something like gold backs a currency, and banks are prohibited from issuing more notes than they have gold deposited, you do not have price inflation in the economy, nor the boom-bust cycles created by inflation of the money supply.

With a non-inflating currency, savers and thrifty are rewarded, as the currency would be appreciating in value as the economy grows.

Those who live irresponsibly, consuming large amounts of assets before they have produced an equal amount of wealth to trade for their consumption -- using the easy credit offered by the banking system -- would be penalized with an appreciating currency.

(Let me guess, you're living with large amounts of debt? Which would explain your objections to the forced fiscal responsibility a precious metals backed currency would require.)

http://http://www.rockingham.k12.va....mages/yawn.jpg[QUOTE=jyl;4187563]I was talking to a friend tonight. He's a hedge fund manager in NYC, the kind of guy who you'd think would be happy and making money in this market. But he wasn't happy about the damage being done to the financial system and thus to the real economy, and we talked about what could be different.

(He wasn't making money either, which may inspire another thread later.)

So I thought I'd start a thread about what lessons should be learned, and what should be changed, in the global financial system.

I'll start with some views, some will be boringly technical but I think still important.

First, a single regulator must monitor and control the systemic risk being taken by all players in the financial markets.
- Traditionally, the Fed, FDIC, and Treasury govt closely monitors depository institutions like conventional banks, S&Ls, etc. They are required to maintain certain capital ratios, report detailed information to the bank regulators, follow specific accounting practices, and can be quickly seized and brought under control or wound up.
- Investment banks and securities brokers are not under this level of scrutiny. They have been primarily regulated by the SEC, which is focused on investor protection issues (underwriting practices, insider trading, etc), but has had little concern with how much risk the investment banks/brokers are taking on their own account. Notice how absent the SEC has been during this crisis - its like they are out of the loop, because they are.
- Insurers are regulated by state insurance bureaus. They care about policyholder issues, but wouldn't know a complex derivative if it came to dinner. Notice how blindsided the NY insurance commissioner was by AIG's problems?
- Hedge funds are barely regulated at all. The SEC is supposedly in charge, but they have very little insight into these industries.
- With the repeal of Glass-Stegal and other deregulation of the financial markets, all of these entities have been piling into each others' markets. Traditional banks like C and JPM are in the investment banking and securities business, investment banks like MS are making commercial loans, insurers like AIG are writing credit default swaps. Hedge funds are making commercial loans, investment banks have become major traders of physical commodities. The regulators have been many steps behind. Its been the Wild West, and the constables are nearsighted and undergunned.
- We need a single lead regulator of the financial markets, with expertise in and authority over all aspects of the markets and all market players, the power and resources to seize and liquidate, and the political independence to ignore Wall Street lobbying. That regulator should understand and control the risk-taking of the players. For example, during the financial boom, investment banks operated with 30-to-1 leverage. Commercial banks are required to have much lower leverage. Yet aren't the investment banks in an inherently more risky business?

Second, the market must be transparent.
- A huge amount of activity now takes place out of public view, in the so-called over the counter market. The $60 trillion (nominal) CDS market is an example. CDS are not traded on any exchange, many are illiquid, the contracts are untested and sometimes not standardized, no-one really knows who is buying and selling what, and no regulator is able to monitor this market for manipulation or fraud. Yet CDS premiums are basically deciding the fates of major financial institutions like MS and AIG now.
- When markets get to a certain size and importance, they should be forced on to open exchanges, to operate publicly and transparently. Using an exchange moves counterparty risk to a visible, central entity. If the security is a continuing obligation, like a CDS, it can be settled daily like a futures contract is, meaning that the actual counterparty risk is limited to a single day's price movement. The regulator can then scrutinize the trading for manipulation, and investors can better judge what price action is meaningful and what is not.

Third, feedback loops must be controlled.
- The current crisis is being exacerbated by feedback loops. For example, MS' CDS premiums rise, hedge funds short the stock, the stock falls, that makes it harder for MS to raise capital, that drives the CDS higher, more hedge funds short MS, that sends the stock down more, etc etc. That's part of why these big institutions' stocks suddenly start plunging -50% a day and spiral to zero.
- As another example, RMBS start getting discounted as mortgage delinquencies rise, banks are forced to immediately mark them to market and liquidate what they can, the selling drives RMBS to higher discounts, they are marked down further and sold harder, the discount goes up more, the marks get worse and the liquidation accelerates. That's part of why senior RMBS are being marked down to 20 and 30 cents on the dollar. Take 10,000 Alt-A mortgages across the country, then select the best performing 20%, I do not believe the ultimate recovery will be as low as 30 cents on the dollar. Is every single house of that 10,000 going to be foreclosed and sold for 30% of its purchase price? I don't think so.
- Some feedback loops can't be stopped, but some steps can probably be taken. For example, about 2 years ago the SEC eliminated the uptick rule, which said that a new short position had to be taken on a uptick in the stock. I noticed an increase in the severity of stock declines then. The SEC has also basically ignored naked shorting. Thus there are some stocks out there, where the short interest is 90% of the free float. As another example, marking to market could be based on the rolling past 4 quarters, not on the most recent CDS premium or market quotes.

Fourth, accounting standards and regulations should be counter-cyclical.
- Right now, financial institutions are subject to various accounting-based requirements that essentially let them hold less capital when markets are rising, and force them to hold more capital when markets are falling. One example is value at risk measures, which report lower [higher] risk when markets are less [more] volatile. Another example is strict reserve rules, that require banks to set their loss reserves based on the default rates of the past few years, meaning that during the good [bad] times, reserves are low [high].
- That means that during the booms, credit is even looser, while during the busts, credit gets even tighter. By "even" I mean even more than the human optimism-pessimism cycle would otherwise cause.
- Instead, you really should encourage those optimistic humans to be a little tighter on credit during the booms, and to be a little looser during the busts.

Fifth, executives and employees should be rewarded based on the ultimate outcome of a transaction, not on simply having arranged the transaction.
- In some cases you can measure a successful outcome - e.g. a mortgage broker wouldn't be fully paid until the mortgage has been performing for X years.
- When it is too complicated to measure the outcome, a rough way to do the same thing would be to require bonuses and commissions earned in a given year to be paid out over several years, and to make this obligation dischargeable in bankruptcy and cancellable in event of a govt seizure/rescue.
- I don't know, this might be too complicated to be practical?


Anyway, those are some thoughts. Any others?


http://forums.pelicanparts.com/uploa...1221749461.jpg

Jyl, I appreciate your thoughts on this. Not being involved in the Finance World I can't add to what you've listed, but I appreciate your view on it. You are one of the jewels in OT SmileWavy

I don't like the idea of having one regulator: it's one-stop shopping for lobbying efforts.

It's kind of funny that we are seeing the exact same problems again that Glass-Steagal was designed to prevent. Insurance companies having banking operations, and can invest their "float" in options. Not a good mix IMO.

We will always have boom and bust cycles in the financial system, just as we do in the rest of the economy. There is nothing wrong with that. The point is to limit the severity of the booms and the busts.

As for exchanging currency for gold, here's a reality check. There is $2 trillion of US currency and equivalents in circulation. http://www.fms.treas.gov/bulletin/b2008-3uscc.doc There is 4600 tons of gold in Fort Knox. So requiring all $2 trillion to be exchanged for Fort Knox's gold implies gold price goes to USD $13,700 per ounce. But that's only currency in circulation - logically, all cash-equivalents like bank deposits then must be backed by gold too - unless you want to make all the money in your bank account as well as your monthly payroll check worthless. Bank deposits alone are another $7 trillion, implying gold at $61,200/oz. Up some 7,600% from today's appx $800/oz.

This would create all kinds of insane and disruptive results. I can't even start to think of them all.

But the most colorful is that war breaks out all over the world. Think about who has and who mines the gold. Who really has a lot of gold is the Indian public with 13,000 tons in jewelry form. So now the Indian public will have USD $25 trillion in wealth - almost 25X more than that country's entire GDP. We'd better invade that country before the Russians and Chinese do. South Africa mines about 270 tons/yr, that will be $530BN/yr. Indonesia will be $340BN/yr, Peru $340BN/yr. Pick the two that are easiest to invade.

And perhaps the most severe is that economic growth and inflation/deflation are now hostage to the growth in gold supply. If supply of new gold (i.e. mining) doesn't keep pace with economy's need for growth in capital, then either economy is forced to grow less, or we get gold price inflation. If economic growth slows and needed capital growth falls below new gold supply, or if new gold supply grows due to more intensive mining or more reclamation from industrial/other uses, we get gold price deflation. In other words, now we'd have an additional constraint on economic growth, without gaining any stability in the new gold-based currency.

When you eliminate greed, will you solve the problem. Remember: laws are for the law abiding. People stay up all night finding ways to get around the rules, laws, etc. It's who we are.

Problem solving requires looking and finding the root cause. We only fix the surfaces.

I have heard a story that 1/3 of the world's gold is buried in the back yards of Europe. Countries constantly got invaded, had high inflation, the currencies and government weak. The only thing people could count on was what they could carry and gold. I'm beginning to think my grandmother was right.

Look up the long term return on gold vs on the stock market, bond market, housing market, practically any market you like. Over multi-decade periods, gold is one of the worst investments anyone could have chosen.

A 30-year govt bond is liquid. You can sell it with a mouse click.

A 30-year CD, if such a thing existed, is not liquid. Your money is tied up for three decades.

Who in the world is going to replace their bank deposits - meaning, their checking and savings accounts - with a 30-year CD?

NO-ONE.

John,

Define long term for me. Gold's value has been around longer than anything you describe. I was historically speaking. America isn't that old.

I live in an upper income area outside Chicago. My intention is/was to downsize as my family is grown and I'm about 8 years away from retirement. My house has plummeted in value 35%. I bought my house in 1998 and I'm probably at 2001 prices. My investments got hammered in 2000, I lost 40% of my largest 401K account. Admittedly, I was very heavily loaded in companies that disappeared. I learned to diversify after the experience. I had recovered about 60% of that loss until the 4th quarter of last year. I'm down again. I feel that this a lost 9 years for me personally. I'm also 9 years older. I'm runnin' out of time and need to heavy up on money. Not that easy. I'm probably emotional here but a mattress looks good right now.

What do I learn from this? I'm not going to retire early. About 2 years ago, I decided what is important to me and it isn't 'stuff' so I'm livin' very lean right now and I'm ok - actually I'm kickin' myself for not starting earlier. My values, what's important to me changes as you get older; I'm going back to basics - something my parents drilled into my head.

So I think everyone's situation is different. The younger you are you certainly have time and I wouldn't panic. The economic situation we are in impacts us differently depending on age, assets, etc. There just ain't no sure thing - except what you can carry and the 'gold' in your pocket.

Sorry, I was meaning long-term like 20-50 years. Any longer and you start getting beyond the investing lifetime of a human being.

[chart deleted until I can verify]

John,

The gold story is a metaphor. Over the last 8 years I feel like I treaded water. I actually believe I worse off now than 8 years ago. I'm an older guy and the last 8 years are 8 less than I have to work with as I come close to retiring. I do believe in the time value of money - I don't have that time; I need to make the difference in money and right now things are very expensive; I have learned to live with less.

Going back to lessons learned from this crises, I have become more cynical, less trusting than before. I'm the only one who can take care of me. Government, politicians and greed have let me down - This goes back to the solution of eliminate the greed, eliminate the rich preying on the poor, the strong over the weak and you have got a chance. History tells us otherwise.

I will tell you I was very excited about this election early on. We have/had candidates that are intelligent; I liked the notion of change. I'm an underdog kind of guy. As the race progressed and found all flip/flopping on everything; I am disgusted. When this financial crises hit; everyone is at fault and we are searching for the guilty but we are all in on it.

Do we need some regulations; absolutely!! I don't know what that looks like. There is a balance here - but we need to let things settle down and not just react. Got to let the emotions subside.

Meanwhile. I'm not panicing; I haven't pulled my money out of the market; I actually did a smart thing. I pulled $20K out of the market last Oct/Nov and have been re investing about $1500/month since last Oct. Did I plan this?; no - I got lucky.

I appologize if I came off like a smart a$$ but I'm very sincere in my attitude at present. It doen't mean it is for you or anyone else. It's mine. I taking a more conservitive approach in investing and in living. I'll adjust to the fallout from this mess. I consider myself very lucky as I'm in better shape than most. I really feel for those who have got hurt in this.

Room monkey # 1 (my stepson) works for the Bank of Montreal. As a 'special' program, he has spent much of the last several weeks liquidating people's portfolios who guessed wrong on derivatives. They don't call the customer, they just sell it off for market. There are a lot of unhappy customers.

Ian

Sounds like you are still "in the money" with your house if you bought in '98 and you are at '01 prices. people who look at homes they live in to be the piggy bank to retire on are sadly mistaken. On the other hand, you got a nice place to live without putting up with the annoyance of a landlord, a tax writeoff, the opportunity for some small appreciation. This idea of ones home funding their retirement in a new one...and not a very wise one...although some folks are luck into such a situation. Buying a home 18 years before retirement and expecting it to provide a significant amount of retirement is amazing. Perhaps 30 or 40 years might make a bit more sense. If you are like me, you probably put almost nothing dopwn on your home...so why woulkd anyone expect such a huge return on such a small amount? If you want to look at home ownership and retirement the way your grandparents likely did...you pay your home off so you can live in it without payments in your golden years when you income is reduced...not as the retirement piggybank. That is what savings are for.

Not me. I had to learn the hard way, let the new comers learn by mistakes. Sure, in the long run we all pay, but this isn't going to last too much into the next generation anyway.

I wonder what the new country will be called.