[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?
