"The new financial system.... failed the test of the marketplace"

Once again, old Marty Wolf has written another awesome column in the FT. Here's the link, but unfortunately, you have to register to read the whole thing... So instead, I'll pull the good bits out, quoted of course, and comment on them...

He mentioned 7 facets of regulation that need to be improved in order to avoid another financial crisis like this last one (or the 5 year cycle we seem to be pretty good at going into).

"First, coverage. Perhaps the most obvious lesson is the dangers of regulatory arbitrage: if the rules required certain capital requirements, institutions shifted activities into off-balance-sheet vehicles; if rules operated restrictively in one jurisdiction, activities were shifted elsewhere; and if certain institutions were more tightly regulated, then activities shifted to others. Regulatory coverage must be complete. All leveraged institutions above a certain size must be inside the net."

This is a definite concern, but difficult to put into practice, as it really gets deep into the accounting and legal mumbo-jumbo and jibber-jabber. The principles-based GAAP the US will soon be adopting should help some, by ceasing the expensive-to-audit proliferation of rules designed to box in companies to restricted accounting practices. However, I imagine that this will continue to be a constant struggle between regulators and accounting/legal teams at CPA firms who are going to keep wriggling free (for competitive reasons - you have to convince customers to buy your services somehow). Just as there is no perfect contract, there is also no perfect accounting standard.

"Second, cushions. Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. If Bear Stearns had had larger equity capital, the authorities might not have needed to rescue it. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity."

We can probably put legal limits on how levered a company can be, can't we? This sounds like a good, old fashioned no-brainer.

"Third, commitment. The originate-and-distribute model has, it is now clear, a huge drawback: originators do not care sufficiently about the quality of loans they plan to offload on to others. They do not, in Warren Buffett’s phrase, have “skin in the game”. That makes for sloppy, if not irresponsible or even fraudulent lending. Originators should be required, therefore, to hold equity portions of securitised loans."

I personally see this at the biggest reason why everything went to hell in the first place. I heard a great NPR report on the drive home from school about mortgage lenders, and how these 'no documentation' loans kept getting fed to wall street in tranches because markets were so hungry for any type of asset backed security. If the jerks writing these loans had some skin in the game, things wouldn't have gotten so bad. This is another no-brainer for me.

Fourth, cyclicality. Existing rules are pro-cyclical. Capital evaporates in bad times, as a result of write-offs, thereby forcing contraction of lending, worsening the economic slowdown and further impairing assets. Mark-to-market accounting, though inherently desirable, has a similar effect. One solution could be to differentiate between target levels of capital and a lower minimum level. Institutions that have minimum capital in bad times would only be required to aim for the higher target level over an extended period.

Considering how psychological markets are, I doubt cyclicality can be conquered. Admittedly, I don't quite understand how Mr. Wolf's solution works, beyond trying to convince stakeholders that their efforts to increase their target level of capital is the acceptable... Any insights?

Fifth, clarity. Lack of information, asymmetric information and uncertainty are inherent in financial activities. These are why they are vulnerable to swings in collective mood. The transactions-orientated financial system is particularly vulnerable, because information has to flow freely across arms-length markets. So a big challenge is to generate as much clarity as is possible. One issue is the calamitous recent role of the rating agencies and the conflicts of interest under which they operate.

I don't know how Marty expects this to happen. Admittedly, much can be done to clean up 10ks and 10qs which "disclose" everything they have to, but go about in a very convoluted fashion, blending up information, and spreading it across dozens of pages and footnotes. Some things are just really tough to value, and nobody has a very good idea about how to best do this, aside from mark-to-market, which adds to volatility, and feeds issue #4: cyclicality, when markets devalue assets.

Sixth, complexity. Excessive complexity is a significant source of lack of clarity. It is particularly damaging, as we have seen, to the originate-and-distribute model, because markets in complex securitised products may, at times, seize up, forcing central banks to become “market makers of last resort”, with all the difficulties this entails. One possibility then is to insist that all derivatives be traded on exchanges.

The originate-and-distribute model is the practice of financially-inclined companies taking all of their income-generating financial assets (like car loans, credit card receivables, etc.) and selling it all to a Special Purpose Vehicle (aka an SPV, which is supposed to be a different company), which finances the purchase of these assets by selling bonds to other financial institutions (e.g. pension funds, banks, etc.). The assets that these SPVs buy off of the original company have varied levels of risk (they bought a car loan from a doctor and a homeless guy, say, so one will be more likely to pay back the car debt, and is therefore less risky). These assets, of varied risk, are smashed together and then chopped up into tranches and sold or re-tranched, making it very complicated to understand their risk, because of their complexity. I don't know how insisting that all derivatives should be traded on exchanges, though. How is a marketplace of people who probably don't understand them going to help? I don't think collective intelligence surpasses collective greed...

Seventh, compensation. On this I can do no better than quote Mr Volcker: “In the name of properly aligning incentives, there are enormous rewards for successful trades and for loan originators. The mantra of aligning incentives seems to be lost in the failure to impose symmetrical losses – or frequently any loss at all – when failures ensue.” Whether regulators can do anything effective is unclear. That this is a challenge is not.

'Nuff said.