Stein, like many of us, has pondered how the massively well-paid men and women of Wall Street could create such a catastrophe. How did some of the smartest, talented executives, Stein ruminates, generate such immense losses that "they made banks clam up on lending -- at great risk to the economy?"
Compelling questions
Stein asks: Where were the fail-safe devices? The government watchdogs? The ratings agencies? A speech by Greenlight Capital hedge fund manager David Einhorn at a Grant's Interest Rate Observer event, provided the answers -- the unfortunate truths of the recent housing/credit boom -- which Stein summarized:
-The investment banks have a strong incentive to maximize their assets and leverage themselves because their pay is a function of how much debt they can build.
-In addition to leveraging fairly safe assets, such as government agency debt, they also amassed exposure to derivatives, among other instruments, with stunning risk profiles and that can produce astounding losses in bad times.
-Underlying capital requirements to support these 'assets' were watered down as a result a 2004 rule promulgated by the Securities and Exchange Commission called the "Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities," which reduced the amount of required capital to engage in risky activities, Stein explained, citing Einhorn.
-Even more troubling, the SEC also allowed broker-dealers to determine their own valuation for assets and liabilities that were hard to value, and also allowed them to assign their own creditworthiness ratings to counterparties in complex derivatives.
In short, the SEC told Wall Street to police itself to save on regulatory costs, Stein explained, citing Einhorn.
What self-policing wrought
The result of the self-policing? A system that rewarded institutions when they succeed, but left the taxpayers with the bill if they failed, Stein explained, citing Einhorn. It's a system that took deregulation to the extreme, in Stein's interpretation
Don't misunderstand: Stein is an informed, consistent advocate of free markets, but those markets must have rules. Or as Stein put it, "deregulation... has been followed down so long and winding a road that it has led to an immense lie: that deregulation carried to an extreme will not lead to calamity."
Economic Analysis: Stein, always a good test of whether a behavior or business tactic makes financial common sense, demonstrates that financial common sense was sacrificed to other goals during the recent housing and credit market boom. And those other goals could not have been achieved in a classic regulated environment, hence the regulations were amended or eliminated, with predictable results. As noted earlier, the task for policy makers now is to determine: 1) which assets can be monetized, 2) what constitutes acceptable and unacceptable uses of debt/leverage and 3) which financial instruments enhance liquidity / limit risk and which are reckless / create systemic risk.
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Reader Comments (Page 1 of 1)
4-28-2008 @ 11:59PM
B. Harrison said...
Well,that just about sums up the case against Alan Greenspan's "sacred cow" for "industry self regulation", huh?
Self-regulation simply does NOT work. Period!
As proven by the subprime mortgage loan debacle, it simply doe not work; and does not have any "integrity" in it.
4-29-2008 @ 2:08AM
Petkov said...
"fail-safe devices"? "The government watchdogs"? "The ratings agencies"?
Oh please FINALLY get a clue!! It was ordinary human greed, pure and simple. Remember the saying: "Fish begins to rot from the head"? It was Greenspan who gave cheap credits to the banks, damn the consequences! I have been saying that for years, and now Starlitz has confirmed I was right all along and ALONE. I guess I don't need coollich or Harvard diploma to know what's going on. Al you need common sense and the ability to say the truth.
4-29-2008 @ 2:14AM
Petkov said...
here is the link for Starliz's interview:
http://www.reuters.com/article/telecomm/idUSL2719096320080428
4-29-2008 @ 7:37AM
Mike Sanders said...
Individuals can help by telling their money managers, "No derivitives!" Anything, which is so lacking in transparency, is bound to provide a breeeding ground for numerous diseases, molds and fungi. How many people have a good concept of what reasonable-risk is? Just as we have "Truth in Lending," there needs to be "Truth in Investment." Market risk is one thing, but when the mechanism itself, inflates that risk in order to overpay the middle man, it's time open the Black Box and see what's inside... Just be sure that you don a Haz-Mat suit, before you read the prospectus!
My worry is that the Mutual Fund industry, will be next... :(