Cleaning Up the Mess Wall Street Made

03/27/2008 12:00 am EST

Focus: MARKETS

Howard Gold

Founder & President, GoldenEgg Investing

Now that the immediate danger of financial calamity posed by the collapse of Bear Stearns has passed, pundits and policymakers have begun to ask how we can prevent this from happening again.

On Wednesday, Treasury Secretary Henry M. Paulson Jr. declared that since investment banks had access to emergency funding through the Federal Reserve’s discount window, they should come under increasing scrutiny from the central bank, at least temporarily.

That reverses decades of regulatory practice and lays the groundwork for a fundamental change in the way the major investment banks are supervised. It’s about time.

As I’ve argued here, the giant investment firms of Wall Street (and Switzerland and the City of  London) have shown themselves incapable of managing the risk of the new financial instruments they created. With few exceptions, they have been reckless with their shareholders’ money and indifferent to the impact of their actions on the rest of us.

Clearly changes are needed. But despite my strong desire for many of these people to get their comeuppance, I believe we need to act thoughtfully and judiciously to craft a new financial regulatory system for the 21st century.

Why regulate at all? Shouldn’t the free market sort out these problems without the heavy hand of government interference? And by inviting the government in, aren’t we setting the stage for more meddling and unintended consequences later?

All legitimate questions. But I would argue that there’s a stronger case for increased regulation, because of the nature of this crisis, its potential consequences, and the role the government has already played in rescuing the financial system.

First of all, free markets are clearly the best way to make economic decisions, but they’re not perfect, and there are cases of market failure. It’s safe to say this is one of them. In an astounding statement, Josef Ackermann, chief executive officer of Deutsche Bank, one of the world’s largest investment firms, recently declared: “I no longer believe in the market’s self-healing power.” 

Huge chunks of the debt markets are frozen, and the leading financial institutions can’t determine the value of billions, even trillions, of dollars of securities and derivatives. And the Masters of the Universe who as recently as 2005 smugly argued that there was little danger of a financial crisis have been manifestly unable to save themselves from this one. 

The reason? Financial instruments have become so complex that they almost guarantee market meltdowns, as Richard Bookstaber argues in his prescient 2007 book, A Demon of Our Own Design.

Bookstaber, a PhD from MIT who now works at a hedge fund, helped design quantitative trading systems and handled risk management for Morgan Stanley, Salomon Brothers, and Citigroup. He contends that the financial system’s complexity and what he calls “tight coupling” (close links between many instruments and parties) “is a formula for disaster.”

“Things will go bad, and when they do, they will quickly move from bad to worse before the cascade can be stopped,” he writes.

And as we have seen, the unwinding of a complex, tightly coupled market can have a huge impact on everyone. Warren Buffett foresaw the danger several years ago when he called derivatives potential “weapons of mass destruction.”

Finally, the government already has put taxpayer money at risk by agreeing to cover nearly $30 billion of Bear Stearns’ liabilities when JP Morgan Chase takes over the moribund investment bank. And the Fed has opened its discount window to investment banks for the first time, in effect guaranteeing billions of dollars of their paper.

That was Treasury Secretary Paulson’s rationale for greater Fed oversight. I believe it should be made permanent. Only the Fed has the sophistication to understand the complex new financial products that Wall Street’s wizards have created, and only it has the necessary resources to keep a crisis from becoming a catastrophe.

The giant publicly traded investment banks now have as big an impact on the economy as the big commercial banks do, although they don’t hold federally insured deposits. Aside from that, it’s hard to distinguish a JPMorgan from a Morgan Stanley or a Citigroup from a Merrill Lynch. All should be under the Fed’s purview.

The Securities and Exchange Commission, which currently regulates investment firms, has shown itself yet again to be behind the curve. It should be relieved of this responsibility and focus on what it does best: bringing cases after alleged violations occur.

Here are some other things that should be done:

1. Investment banks should have the same capital requirements as commercial banks. Citigroup’s new management has taken great pains to stay above its target capital ratios. That won’t prevent if from taking further write downs, but at least it provides a benchmark for regulators and investors to measure. Why shouldn’t Lehman Brothers or Goldman Sachs do the same?

2. Require greater disclosure of off-balance-sheet liabilities and limit banks’ exposure. This whole crisis stemmed from a systematic effort by financial institutions to keep liabilities off their own balance sheets and make them disappear into the ether. Investors had to dig deep into the fine print of financial statement footnotes to get even an inkling of how much banks had at risk.

By contrast, the Bank of Spain didn’t allow Spanish banks to hold structured investment vehicles off their balance sheets without setting aside enough capital. So, even though Spain has had a housing bubble and bust that’s the equivalent of ours, its banks have remained relatively unscathed by mortgage- and subprime-related debt problems.

3. Overhaul Wall Street’s compensation structure.  The major firms reward short-term (successful) risk taking and don’t penalize long-term destruction of shareholder value. Some firms like Merrill are beginning to tie annual bonuses more tightly to the firm’s overall performance, pay out more in stock and phase in awards over many years. By the way, this is an issue for shareholders, not regulators, to deal with.

Will these measures prevent the next crisis? I don’t know. But it’s clear we need to fix a broken system. We can’t go back to the “good old days” before derivatives and other exotic financial instruments any more than we can put the nuclear genie back in the bottle. We simply have to learn to understand and manage their risks better.

After the collapse of Bear Stearns, the Financial Times’ economic columnist Martin Wolf wrote: “Once upon a time, I had hoped that securitization would shift a substantial part of the risk-bearing outside the regulated banking system, where governments would no longer need to intervene. That has proved a delusion.”

He’s not the only one who’s lost his innocence in these crazy, tumultuous times.

Howard R. Gold is executive editor of MoneyShow.com. The opinions expressed here are his own and do not necessarily reflect the views of InterShow.  

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