April 22, 2010
The Problem With Financial Reform

Today President Obama addressed the titans of Wall Street and asked them to join hands and take preemptive measures to avoiding another financial collapse.  As usual, the delivery was eloquent and the message was clear; if you aren’t going to support this reform, then you must be doing something you don’t want regulators to see.

This fails to address the main concerns of many financial minds.  It isn’t that every bank is instituting wildly risky trading schemes or hedging their entire book value on the outcome of a Yankees game, and they don’t want regulators to know.  The issue is that regulation is rarely done well, and usually put into motion by people that don’t have the slightest idea what they are talking about.  For the purposes of this article, I want to discuss derivatives.

If Congress institutes sweeping financial reform it will most likely involve some sort of restriction on derivative creation and trading.  This could be in the form of more transparency, tighter valuation rules or limiting what derivatives can actually derive value from.  Some congressmen would have them banned altogether!  This is not in interest of maintaining efficient markets.  However, Congress believes that this is exactly what restricting derivatives will do.

On the contrary, derivatives provide very real benefits to markets in the form of efficient pricing, removing arbitrage opportunities and allowing parties to hedge risk.  The problem comes about when institutions and traders begin to layer their risk to such an extent that they cannot see what they are actually doing.  Is there a way to implement regulations that can let derivatives provide value to the market without removing most of their functionality?  I’m sure there are experienced derivatives traders who have excellent ideas about that.

Unfortunately, there is no incentive for intelligent minds to become the instigators of actual, material reform.  What incentive would an ambitious trader have to help Congress develop regulations that could potentially restrict his or his firm’s profits?  The money usually provides motivation for people to figure out how to beat the system.  So instead, we have politicians spewing partisan rhetoric at each other from both sides of the aisle.

Another issue is that regulation tends to swing wildly from one extreme to the next, and most financial institutions anticipate the pendelum swinging violently against them as a result of this reform.  This will lead them to be combative from the start.  Financial firms have had it good in the immediate past in terms of regulations being lifted and the markets generally being let loose.  The result, however, was not so beneficial to the world as a whole.  I anticipate that the initial financial reform put into place will be too restrictive for it’s own good, and end up strangling some of the functions of the financial system.

One of the quotes from President Obama is strangely applicable to both the financial collapse and process of over adding/removing regulations.  He said that “it is essential that we learn the lessons from this crisis, so we don’t doom ourselves to repeat it. And make no mistake. That is exactly what will happen.”  He should heed well those words as he begins to tackle the issue of financial reform, and make sure he does not implement changes too sweeping and broad to let the financial system operate at all.  If he does, we may find ourselves peeling the regulations back in ten years and fighting the same forces at work today.  Good luck, Mr. President.

12:50pm  |   URL: http://tmblr.co/ZsKgTyWFzVd
(Notes: 1)
  
Filed under: financial reform regulation obama economics regulatory reform reform finance derivatice incentive 
November 17, 2009
Bear Stearns: The Catalyst for Calamity

“There isn’t such a thing as reality when dealing with the global economy. There’s no vault under Madison Avenue. [Even if it was] adequately capitalized, that didn’t matter once the momentum began, the downward perception spiral became reality. It’s a classic run on the bank, via the Internet.” Although history will have the final say, the fall of Bear Stearns may have marked the beginning of one of the worst financial nightmares in history.  As it looks right now, this global recession rivals that of the Great Depression and even exceeds it in some measures.

Though few of the Wall Street’s gunslingers were around for the Great Depression, many draw comparisons between then and now. Bear was a respected financial institution with a theoretically sound balance sheet, by industry standards. Their fall demonstrates how easy it is for large companies to succumb to the pressures of leverage and short run profit fixation. What were the contributing factors in this downfall and how might it have been prevented?

Bear Stearns made the mistake of joining the MBS (mortgage backed security) party late, and it was a fatal misstep. Even as the presence of a housing bubble became evident to many analysts in early 2007, Bear continued to consume as many MBSs as they could. In the second quarter of 2007, both Bear Stearns and Lehman leapfrogged competition in underwriting mortgage backed securities (MBS). Lehman was first with 10.9% of the market, while Bear had 10.1% or $31.94 billion. As a multiplier to this, their portfolios had a strong coastal bias.

Even as Bear was becoming a larger player in the MBS market, they were cutting back on their other asset backed securities. While they moved up to second place in MBS market share, Bear was only tenth in ABS market share at 4.7%. Why would they do such a thing if? At this time, many analysts predicted a downturn in the housing sector. Even if Bear did not believe this, of course there would be some hedge in place to prevent total collapse should the housing sector become degraded.

As Bear Stearns revealed mounting losses in their MBS portfolios, credit markets began to seize up. The effect was viral, as lenders made several assumptions as a reaction to Bear Stearns. First, they assumed that Bear was insolvent and could not recover. Next, they associated banks with one another and assumed that many banks had toxic assets yet to be revealed. Credit stopped flowing, and many financial institutions were unable to meet short term liquidity requirements. Without creditors ceasing to provide short term lending to Stearns, they may have survived. As it stands, they helped instigate one of the more extreme periods of credit tightening in recent history.

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1:27pm  |   URL: http://tmblr.co/ZsKgTyEm5DX
(Notes: 2)
  
Filed under: bear stearns recession mbs securities finance economics banks financial institutions bank failure bear stearns failure investments asset backed securities