It’s our choice: How far have we come since 1/24/09? My notes, from This 14 page special report.
1. Page 6: Animal Spirits; the possible causes of the “great bubble”: Barely legal mortgage underwriters, overpaid Bankers and the intoxication of easy credit. Cupidity, fraud and delusion were part of the big bubble and bust. In the words of Willem Buiter, of The London School of Economics, ” finance is a scary, inherently unstable, essential activity”.
2. Aside: People act irrationally; they buy in an up market and panic in a down market. Everyone loves to participate in a boom, but when investors lose confidence that other people will honor their promises, that undermines the market. Liquidity and credit suddenly become scarce and a devastating value destroying uncertainty takes hold. That characterizes “the bust”.
3. Page 10 Plato’s Cave. Mathematical models are a powerful way of predicting financial markets. But they are fallible.
In 1973 The Chicago Board Options Exchange traded 911 derivative contracts, this was one month before Black-Scholes appeared in print. (For the uninformed, there were 3 partners (Myron Scholes, Robert Merton & Black), from the MIT Sloan School of Management, they explained how to use share prices to calculate derivatives. In 1983 Robert Rubin Hired Fischer Black from MIT. In 1998 Long Term Capital Management was run by John Merriweather and his team from Salmon Brothers along with Merton and Scholes. Their Hedge Fund almost brought down the market when Russia defaulted on it’s loan. Their collapse was the credit crunch in miniature and should have served as a warning going forward.)
In 2007, the CBOE’s volume in contracts reached almost 1 trillion.
4. Page 13 To sum up, the Trillion Dollar bet on mortgages went disastrously wrong. Almost as damaging is the hash the Banks have made of “value at risk” (VAR) calculations, a measure of the potential losses of a portfolio. This is supposed to show, whether banks and other financial outfits are being safely run. Regulators use VAR calculations to work out how much capital banks need to put aside for a rainy day. But the calculations are flawed.
5. page 18 The Uneven Contest: Financial regulation is essential. That does not make it easy. The case for Regulation is financiers make mistakes and everyone else has to pay for them.
6. The Economist postulates: Fixing Finance. The world has a chance to make finance work better. It should tread carefully. It is worth quoting James Tobin (page 22) The advantages of liquidity and negotiability of financial instruments come at a cost of facilitating nth degree speculation which is short sighted and inefficient.
In summary, if you believe this point of view, you may want a core of regulated banks, that cannot blithely create credit, take on leverage or secrete assets off their balance sheets. If hedge funds continue to exist, then limit their access to capital.
The presumption should be for transparency. That favours market based accounting. CDO’s which trade in huge volumes should pass through clearing houses. That would have the added benefit of limiting the damage from a collapse, since the default would pass to the clearing house too. The system can be made more robust in other ways. Senior financiers could take more of their pay in equity; and hand some back if the Bank does badly.
Whatever happens, the choice hinges on the interests of the economy as a whole. After all, it’s taxpayers and savers who pay for financial crises. Centuries of boom and bust have taught us that financial crisis occur, but you can exercise some choice over what kind of crisis you get. (page 21)