Thursday, October 23, 2008

US: The Financial Crisis Is Not That Complicated


For the last month, the press has been raging about how insanely complex the current financial crisis is. So complicated that financial wizards are still reeling to understand what happened. So complex that even mighty titans of finance like Greenspan and Paulson don't know how to fix it.

At the risk of hubris, I disagree. The problem seems pretty simple, really.

Here's what happened. About a decade ago, the financial community dreamed up something called Credit Default Swaps (CDS). These financial tools are basically an insurance policy against something going bankrupt. The "something" could be anything, like a corporate bond or a sub-prime mortgage. So if I sell you a CDS, you pay me a certain amount of money each year, like an insurance premium, and if the mortgage goes bust, I give you a big payout. Just like having car insurance: your insurance company pays you if your car gets creamed.

Here's the catch: "insurance" is regulated. "Swaps" aren't. This means that the Wall St guys don't have to have financial reserves in case they actually have to make the CDS payouts to someone. That's like if I sold all my friends car insurance, took their premiums, and hoped that no one crashes their car. If a bunch of my clients do happen to have car crashes -- especially at the same time -- then everyone is screwed. I can't make the payments, and the car owners suddenly don't have insurance. That's what happened this fall, except that it was mortgages that crashed, not cars.

The heart of the problem is that regulators were convinced by financial lobbyists that they didn't have to regulate CDS because they were called "swaps" instead of "insurance." That's just idiotic. But there you have it: highly-paid Washington lobbyists influenced legislation for special interests, to the detriment of the Joe Taxpayer. Joe Taxpayer just got screwed.

Greenspan admits now that he thought banks would have the self-discipline to hold sufficient financial reserves to back the CDS's even in the absence of regulation. Even without the benefit of hindsight, that's a staggering assumption: it should not be surprising that banks wanted to trade these enormously profitable CDS's while they could, and knowing that if the system collapsed, the government would have to pick up the pieces. The financial system of the US really is too big to fail.

Admittedly, the solution to this problem is not simple. But I think it has to start with the recognition that this is a classic, recurring problem: the financial wizards on Wall St will always be one step ahead of the regulators, and they will always try to hire high-priced lobbyists to create loopholes in regulations. This isn't new: the Savings and Loans crisis in the 1980s was created in much the same way. It almost certainly won't be the last time.

So it seems to me that if we know this is a recurring problem in the financial industry, we ought to structure long-term solutions around that principle. It's true that the exact form and timing of these crises are unpredictable, but the fact that they will happen is entirely predictable. Instead of letting them take everyone by surprise and the cost being passed on to taxpayers, why not find ways to ensure that the fat cats on Wall St foot the bill when financial collapses occur?

3 comments:

Kevin said...

As far as the 'span man is concerned, I believe that every person eligible for public office should be asked "Do you think Ayn Rand has an interesting and inspiring philosophy, or is she a tiresome hack? If they don't say "hack" and they aren't fifteen years old, they should be banned from public office, permanently.
That would have weeded out Greenspan.

Mr. Hennessey said...

Must we always blame the lobbyists?

Nikhil said...

I'm also wondering whether it's really fair to draw this dichotomy between "Wall Street fat cats" and "Joe the Taxpayer." First of all, it doesn't seem to me that "average Americans" would be any more likely to restrain their profit-making impulses were they in a position to make a lot of money due to lack of regulation - just seems that Joe doesn't usually have the opportunity to do this, so we don't see his greed manifested. Second of all, didn't "Joe" benefit here just as Wall Street types did from getting cheaper mortgages because of the investment insurance available? The only difference is that Joe doesn't get to avoid responsibility for this risky behavior in the end, while investment bankers do. But this isn't a difference in greed, or a difference in how much folks benefited from the lax regulation while the going was good. Intelligent regulation may be the answer, but I'm not sure drawing distinctions between Americans as to culpability is the right course.