Solving the Financial Crisis: Looking Beyond Simple Solutions

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When presented with complex ideas about complicated events, the human tendency is to think in terms of Jungian archetypes: good guys and bad guys, heroes and villains. The more complicated the events, the more the human mind seeks to limit the number of variables it considers in unison in order to make sense of what it sees. The result is a tendency to describe events in the simplest black and white terms, ignoring the spectrum of colors in between.

This principle can be seen in the current explanation of the financial crisis. University of West Virginia Professor of Sociology Lawrence Nichols has developed what he calls the “landmark narrative” shaping how the public reacts to dramatic swings in financial cycles.

As Professor Nichols explains, the narrative described by the landmarks can be a contrived and even inaccurate version of history. By its nature, the shorthand narrative is often unable to describe the detailed reality of an occurrence. Much like an interstate highway, the landmark narrative takes the valley pass, avoiding the mountaintops from which the full view of history can be seen and understood. If we move away from the landmark narrative – beyond the highway for a view from the hilltop – we’ll see more of the landscape: enough to make sense of the complicated events that make up our financial environment.

There is real danger in limiting our view of events to what can be described by the landmark narrative. It’s like describing New Jersey from the I-95 Turnpike: funny enough for late night television but not particularly useful for problem solving. Basing our view of events on the landmark narrative can, and very well might, lead to “solutions” that could prove as dangerous – or worse – than doing nothing.

Specifically, reactions to the current financial crisis are making their way into popular consciousness, potentially becoming imbedded in unpredictable and usually indelible ways. In a democracy, our elected officials are bound to respond to these shifts in popular consciousness. The constant repetition of contrived and inaccurate versions of events eventually leads us to suffer what Nobel Laureate Merton Miller called “the unintended consequences [of] regulatory interventions.” Austrian Economist Ludwig von Mises, in fact, warned decades earlier that market data could be “falsified by the interference of the government,” with misleading results for businesses and consumers.

As Americans, we have repeatedly failed to learn this lesson. Throughout our history, Americans have had an irrational fear of finance. Deemed to be too complicated, the field of finance lends itself easily to description by landmark narrative. Quite possibly to our detriment, the rise of the financial sector has been tied to economic expansion throughout our modern business history. The more robust the flow of finance in capital markets, the more robust is economic activity. Our economy, our livelihood and our well-being are inextricably related to finance at home and around the world.

So what are the assumptions about finance we see today? It turns out many of the assumptions are often erroneous and usually dangerous. The problems on Wall Street, for example, did not stem from too few laws; rather, it resulted from not enforcing the laws we already have. When I talk to regulators and industry participants about problems with fails-to-deliver in bond and equity markets, they often respond that there is no rule against it. Indeed, there is no specific law that says that the seller of stock cannot fail to deliver the shares on the settlement date (usually 3 days after the trade); there is no specific punishment in place. Yet it seems clear that if someone takes your money and doesn’t give you what they promised, this is stealing and there are laws against it. Look at it this way: there is no specific law that says “it is a crime to hit a person on the head with a hammer.” Yet I assure you that if I hit you on the head with a hammer the police will arrest me for a crime. It will have some other name (like “assault with a deadly weapon”) instead of “the crime of hitting a person on the head with a hammer.” But I will be just as arrested. And it is just as much a crime.

So the real problem here is not a lack of laws, but a lack of enforcement of what already exists on the books. Our reluctance to act on this reality has serious consequences. First, we don’t focus on punishing the perpetrators. Our government says they don’t have time for “finger pointing” because they are too busy rushing rapidly to fix the problem – a problem they have yet to define. So we pour money into institutions, allow huge bonuses to be paid with public money, lavish retreats on insurance company executives – and then insist what we need is massive regulatory reform.

This has reached the level of absurdity. The House Financial Services Committee held hearings on January 5 to assess the alleged $50 billion investment fraud engineered by Mr. Bernard L. Madoff. The assumption is that somehow we don’t have the laws on the books to prevent Ponzi schemes; in fact those laws have been there for decades. A rash of new laws to prevent such occurrences is not necessary; we simply need to enforce what already exists.

Yet rewrite we will, and with what may well be reckless abandon. Opening the session, Congressman Paul E. Kanjorski (D-PA), the Chairman of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, called for Congress to “rebuild” the regulatory system and commence with “the most substantial rewrite of the laws governing the U.S. financial markets since the Great Depression.”

But this is the wrong approach. The real question isn’t new laws – although that may make good headlines for vote-seeking congressmen. The more basic question should be: where has the lawman been?

Hearings like this are an integral part of the “landmark narrative.” Unless we’ve learned our lesson, we will be in for a rash of new rules, regulations and legislation paving the path for a future round of financial turmoil while allowing the perpetrators who created the crisis to avoid prosecution. Remember Sarbanes-Oxley, the measure supposed to prevent ill-doing by Wall Street. Passed in 2002, it didn’t seem to do anything except keep accountants and lawyers busy. In fact, it had the unintended consequence of discouraging small businesses from going public because of the extra cost for the reporting it required. Need more examples? Here’s a speech by an SEC economist that explains how regulations designed “to reduce executive compensation could actually increase expected compensation.” I’ve written in the past about “regulatory chokeholds” that make the failures of financial institutions almost inevitable.

In 2009, we are presented with a new opportunity to display our capacity to evolve beyond the same old pattern of reaction and spurious law-writing. When dealing with violations of the law by respectable and powerful groups (like bankers), we need to consider using the laws already there; it’s simply time to find someone to enforce them.

Susanne Trimbath, Ph.D. is CEO and Chief Economist of STP Advisory Services. Her training in finance and economics began with editing briefing documents for the Economic Research Department of the Federal Reserve Bank of San Francisco. She worked in operations at depository trust and clearing corporations in San Francisco and New York, including Depository Trust Company, a subsidiary of DTCC; formerly, she was a Senior Research Economist studying capital markets at the Milken Institute. Her PhD in economics is from New York University. In addition to teaching economics and finance at New York University and University of Southern California (Marshall School of Business), Trimbath is co-author of Beyond Junk Bonds: Expanding High Yield Markets.



















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nice discussion

nice discussion

You cite 3 problems on Wall

You cite 3 problems on Wall Street: Fail to delivers in Treasury repos, executive compensation laws having the opposite of their intended effect, and how SOX made it harder for small businesses to go public.

Now all you have to do is explain how these problems have anything to do with the financial crisis we see today.

What's relevant

A lot of commentators point to borrowers and lenders who made foolish home loans as the cause of the financial crisis. However, this is a very small fraction of the problem. The lenders who pushed dumb loans then went on to re-sell those loans 15 times over – yes, they sold the same loans over and over as mortgage-backed securities. Then, they sold as much as 50 times that value in credit default swaps. The result was that the buyers of the default swaps stood to gain 50 times more when the mortgage defaulted than if it paid off. That set up the incentive to keep writing really bad loans and, as has been demonstrated in the case of Lehman Brothers, to refuse to take mortgage payments. It is as if someone bought $50 million worth of insurance on a house worth $1 million (even before the crash) – now they are burning down the house to collect on the insurance. And once they saw that this could work for home loans, they went on to do the same thing with other debt.

In addition to giving approval to that scheme, the Federal Reserve Bank and the Securities and Exchange Commission also permitted broker-dealers to sell more stocks and bonds than were ever issued. In the case of Treasury Bonds alone, they sold $2.5 trillion worth of bonds that could not be delivered to the buyers. (These are outright transactions, by the way, not repos.) This problem remains unaddressed even as the head of the FRB-NY became the head of the Treasury.

When sellers are allowed to create infinite supply by selling more than they can deliver, and no punishment is in place for this behavior, then prices are phony. That's where executive compensation comes into play -- perverse incentive structures made this bizarre behavior profitable.

SOX, in fact, is an example and not a cause. An example of what happens when "more regulation" is the solution offered up. My point is that enforcement of existing rules would get us a lot further.