September 3, 2011

Capital Markets Dysfunction

Here is what worries me about our financial markets. 

The public knows more about quantum mechanics than it knows about capital.  This is due, in part, to the way new discoveries are promulgated.  Advances in physics are made in universities, where newly acquired insights are quickly published for the entire world to absorb.  In contrast, new trading algorithms and hedging strategies are developed on Wall Street trading floors—often by physics and math PhDs—where the information is kept confidential and considered trade secrets.  Information, therefore, isn’t disseminated to people who can effect appropriate change.  Let me give you an example.  Remember how the Obama Administration introduced a loan modification program and hoped to prevent six million foreclosures with it?  People who understood how loans are aggregated and placed into CDOs knew it would do little good.  Why?  Because the owners of the loans—those who had the legal right to approve the modifications—were hedge funds that were now bankrupt!

Governments are ill-equipped to evaluate and regulate the investment industry.  This is because of two main factors.  First, as mentioned above, Wall Street deems its trading strategies as proprietary.  They report balance sheet positions in aggregate, but offer few explanations of how risks are mitigated.  Regulators monitor key metrics—such as overall leverage and credit quality—but in the end they can only assume the other risks are being managed well.  More importantly, however, if regulators could understand the complex strategies of the companies they monitored, they could make far more money trading.  In other words, those who can, do, and those who can’t work for the SEC.   

Many senior banking executives lack training in the management of key risks.  Just like a pediatrician may not know much about neurology, a salesperson on the commercial paper desk understands little about mortgage derivatives or other esoteric instruments.  This is a significant problem, because many proprietary traders—those who manage the largest and most problematic balance sheet exposures at investment banks—often leave to run their own hedge funds or eschew promotion to remain in their positions where they can demand compensation packages rivaling that of homerun hitters.  The executives who do get promoted, therefore, usually have little experience in managing complex risks.  That was true at Lehman Brothers, where the top executives had grown up together selling commercial paper.  This least complex of financial instruments is not a place to learn how to mitigate financial risks, and this showed in the management of the company.  I can recall, for example, a meeting with key Lehman executives during which I sought approval for a complex transaction.  By the questions I was asked it was clear the executives didn’t understand the trade, but they gave me approval anyway. 

What should be done?  Well, I believe many things ought to be done to enhance transparency and increase financial literacy, but the key to regulating the industry is to incentivize investment banks to do what is proper.  That isn’t to say they should, in all cases, be allowed to fail.  In fact, if all the recipients of TARP money had gone bankrupt, we’d be scrounging for food and guns to protect ourselves today.  (I’m not kidding.  It would be that bad).  What I suggest is that investment banks be allowed to book trading profits, ONLY after all the liabilities associated with such transactions are extinguished.  That’s how owners treat their businesses.  In fact, a good way to insure appropriate risk-taking is to make employees owners of the firms where they work, so that they’re exposed to both the long-term profits and adverse effects of their decisions.  

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