“… capitalism requires the possibility of failure” (The Economist Special Report, 2009, The uneven contest). Our country was built on the idea that if you took a chance and ran for your dream it is possible you could make it. There was never a promise that you were guaranteed it though. The financial markets are a means for some to achieve their dream. However, as our lives have become intertwined with institutions and states our dreams have become intertwined. “When the financial system fails, everyone suffers” (The Economist Special Report, 2009, Greed – and fear). When the system fails there is always an outcry for regulation and to clamp down on those whose percieved incompetence caused the average person harm. While this has the over tones of a sense of justice, severe regulation results in stagnation and continued economic hardship. Take a look at the IMF regulations put on South Korea during the 1997 crisis, or Japan’s own internal regulations that led them to the “lost decade” where growth was non-existent. There is a middle ground however.
There are two places where governments and institutions can attack the problem of financial crisises. There is crisis mitigation where steps are taken to prevent a crisis, and crisis management where steps to taken to handle a crisis in progress. For mitigation we must realize that the financial markets are global and therefore require a global solution. This means that there needs to be agreement at the level of the World Bank or IMF for rules that are backed by international law. These rules need to allow for innovation and growth so they can’t really be focused on specific instruments and possibly institutions. An example of a rule that would likely help would be that the financial products be completely transparent. As Martin Wolf pointed out in his interveiw on Fixing Global Finance (2009), the CDO’s at the heart of the current crisis were opaque. While buyers knew that they were made up of mortgages across a wide variety of markets, there was little information about the distribution of mortgages across the traunches or how those mortgages were created. There was no information showing that many mortgages were made with no supporting documentation insuring income or ability to pay. Had this information been available buyers would have been better informed as to the risk they were taking. “The presumption should be for transparency” (The Economist Special Report, 2009, Fixing finance).
The second mitigation course I think should be done is that, in the interest of transparency, is that all assumptions about a product should be included in the documentation and a risk analysis of what would happen if these assumptions were to fail. This is not a novel concept. Businesses do this all the time when making decisions on what products to market and develop. It is a key part of the decision making process to understand completely where your risks are and how you will respond to them if they come true. Few people thought the housing market would fail and so they just ignored that it was an assumption and treated it as if it were law. That is when Mr. Soros term of “refexivity” comes in to play. “Once people come to believe that house prices never fall, they will buy too much property—and house prices will fall” (The Economist Special Report, 2009, When markets turn). It is key that it is legally required for companies to provide full disclosure of these assumptions and the make up of their product thus that they could be held responsible if they did not provide potential buyers with all critical material to make responsible decisions. When evaluating specific products the regulating body should be looking for those that are showing signs of increasing transaction volumes, with a very strong lense on the products that are touting “high returns with low risk”. That is always a big red flag.
In the area of crisis management we must get out of the knee-jerk reactions and panic decisions. This may lead to some quick relief, but it is usually at the cost of long term financial pain. “… regulators need to re-establish the idea that intervention is based on rules” (The Economist Special Report, 2009, The uneven contest). One thing countries can do is establish a “lender of last resort” for businesses within their borders. I am not talking about the bailouts that we have seen for the last two years. When the markets fail credit seizes up. Businesses in good health suddenly do not have access to the short term credit they need to innovate and grow. As a result they contract and lay off workers. This creates the cycle where less money goes into the system thus creating more uncertainty, even less credit, and more tightening. There needs to be a place where healthy businesses that were financially stable at the outset of the crisis, to be able to get credit when the private sector lenders are going through their period of shock. There needs to be a known planned process on how to feed cash into this lending institution in a predictable way so as not to increase inflation. This would help the private sector businesses whether the storm and keep jobs in place and dampen the viscious cycle of reducing demand.
While these are just some high level ideas on how we can deal with crisis moving forward the authors of our reading make two other important notes. “Time after time the market seems to have found ways to work around regulation” (The Economist Special Report, 2009, The uneven contest). This is the reason for more general rules that apply across the board. The more specific they are made the easier they will be to work around. Also, “Given the financial system’s fallibility, regulation is bound to be fallible too” (The Economist Special Report, 2009, The uneven contest). No one is perfect. And when you are dealing with products that are completely new there is the very real possibility that regulators will miss something. This is the reason that there will never be perfect mitigation and the need for planned management is required. Global finance is here to stay and it can be a hugely positive force in global development and personal wealth. But it can go astray and the mob hysteria around the so called “low risk, high return” products.
References and further reading:
Krugman, P. (2010, May 6). A Money To Far. Retrieved October 28, 2010, from New York Times Opinion: http://www.nytimes.com/2010/05/07/opinion/07krugman.html
Neuman, S. (2010, October 20). Could Drastic Euro-Style Spending Cuts Happen Here? Retrieved October 30, 2010, from NPR Business and Economy: http://www.npr.org/templates/story/story.php?storyId=130690626
Roubini, N. (2008). The Coming Financial Pandemic. Foreign Policy , 165, 44-48.
Stiglitz, J. E. (2009, November/December). Death Cometh for the Green Back. The National Interest .
The Economist Special Report. (2009, January 22). Fixing Finance. Retrieved October 28, 2010, from The Economist: http://www.economist.com/node/12957769
The Economist Special Report. (2009, January 22). Greed - and fear: The golden age of finaince collapsed under its own contradictions. Retrieved October 28, 2010, from The Economist: http://www.economist.com/node/12957709
The Economist Special Report. (2009, January 22). The uneven contest: Financial regulation is essential. That does not make it easy. Retrieved October 29, 2010, from The Economist: http://www.economist.com/node/12957717
The Economist Special Report. (2009, January 22). When markets turn. Retrieved October 28, 2010, from The Economist: http://www.economist.com/node/12957745
Vandewalle, D. (2006). A History of Modern Libya. Cambridge UK: Cambridge University Press.
Wolf, M. (2009, March 5). Fixing Global Finance. (N. Chandra, Interviewer) YaleGlobal.
Transparency is being oversold. It assumes that the buyers are wanting information that they are being denied. But if there is truly a demand for more information, the market would have already delivered. Maybe investors were buying CDOs in the dark, but if so, they were doing so willingly. I don't think more transparency would have changed much. How many day-traders buy stock on the open market everyday without bothering to look at the prospectus?
ReplyDeleteYou have a really good point there Rick. I can bet that most people did not actually read the paperwork on the mortgages they got that talked about what would happen after the initial teaser rate went out. When I actually read all my mortgage paperwork the people in the room were commenting about how no one ever did that. That said, where the CDO's were concerned the buyers didn't even have the option to read them. Hence why they are sueing the mortgage originators to give them their money back. If they had the option and didn't, then shame on them.
ReplyDeleteKristina
Transparency was only part of the problem. I'm not thinking of the general public here. I wonder how many of the financial institutions actually looked over all the records for those institutions that they acquired, or even how often they really knew about the loans that they were buying. Still, I'm not a fan of greater regulation per se (at least in America). The potential backlash - especially in the politically charged current climate - makes it a risky proposition. Often, new laws aren't necessary as much as increased awareness of the existing ones.
ReplyDeleteThat being said, the economic climate in Europe is not as different as it is here these days. In both cases, a too-pervasive lack of understanding about the interrelatedness of economies (and entities, in some cases) is part of what is fueling the discord. A global crisis is a GLOBAL crisis for a reason, and this one has impacted people who would not have previously been impacted. In some cases, they are not willing to recognize that. However, the recovery, though slow and painful, will also be global. There are practices that were not sustainable, and there were lessons that needed to be learned. The painful ones stick best, after all.
Incidentally, I read all my mortgage paperwork, too, but I still made some major mistakes. That is what I draw on: I knew better but got caught up in the excitement. Yeah, shame on me, I know. Low risk, high return is definitely a red flag - if it seems to be too good to be true, it probably is - but doing business with any institution which sells 100% of their loans within one year and who is willing to extend two mortgages to a borrower in order to avoid the borrower having to pay mortgage insurance is definitely another red flag. I also don't think I was alone in thinking "we'll refinance before the 15 year balloon payment comes due". It sucks to realize you've had your head in the sand... The banks that bought too many mortgages like this got a nasty lesson in how sometimes you get more than what you had planned on. Again, interrelatedness bites the economy.