The Irregular Blather Apr. 26, 1931

No Journal was published Sunday, Apr. 26, 1931. A lengthy blather on a matter of Some Considerable Importance.

Over the past week or so, the discussion of new financial regulation seems to have reached some sort of fever pitch. I of course feel compelled to weigh in on some of the more blatant errors I see, many by otherwise excellent writers, and even (gasp!) to put forth a modest proposal on the single thing that will decide whether we see a rerun of the 2008 fiasco.

One analysis that seems to be increasingly popular is that the big problem was the lack of personal risk assumed by the bankers (AKA moral hazard, AKA perverse incentives). Or as James Grant put it:
To the titans of finance go the upside. To we, the people, nowadays, goes the downside. How much better it would be if the bankers took the losses just as they do the profits.

This is also the argument made by Michael Lewis in The Big Short (p. 258):
No investment bank owned by its employees would have leveraged itself 35:1 ...

This analysis has the advantage of tapping into the prevailing (justified) anger at the insanity of spending public money to grant immense bonuses to bankers while the rest of the economy suffers. It also has the advantage of fitting into the still-prevailing view of market participants as mostly rational; the problem must simply be that they have the wrong incentives. And, I agree, by all means, it would be a fine thing to make bankers assume more of the consequences of their bets; the Brazilian system that Grant cites approvingly sounds fine to me:
In Brazil -- which learned a thing or two about frenzied finance during its many bouts with hyperinflation -- bank directors, senior bank officers and controlling bank stockholders know that they are personally responsible for the solvency of the institution with which they are associated. Let it fail, and their net worths are frozen for the duration of often-lengthy court proceedings.

The only problem I have is with the idea that this would prevent the next blowup. This is demonstrably false; to see this, look no further than Long-Term Capital. Meriweather and his Merry Band of extremely smart traders leveraged themselves up, not 35:1, but around 100:1 (not counting derivatives!). Did they do this because they offloaded the risk? Quite the contrary, they were so sure of themselves, they gave back the limited partners' capital (pissing many of them off in the process), so that they could make a more concentrated bet of their own money! And when the blowup came, they in fact lost the vast majority of their net worth. When traders are on a roll, it's the height of foolishness to expect them to be restrained by a sense of their own mortality.

Another thing that has me scratching my head is all the noise about too-big-to-fail and breaking up banks that get too big. For some reason this reminds me of those gambling books you see in the Las Vegas airport that advise you to manage your money by only taking a certain amount to each session. The problem is the crappy bets that were made, not the number of piles they were divided into! Or, in other words, if we had a bank with ten trillion dollars in assets, but all it did was use modest leverage and loan money to carefully checked borrowers, I don't think such a bank should cause regulators to lose a minute's sleep. On the other hand. having a bunch of small banks that all made dubious bets, as would tend to happen in a bubble, would be absolutely no improvement over the current system.

Yet another head-scratcher is the idea that more regulation and more regulators will prevent the next blowup. Again, I'm all in favor of trying to make regulators more effective. Regrettably, though, this seems to be a losing battle. While parts of the crisis can be laid to deregulation, others took place under the noses of regulators at the Fed, SEC, and OFHEO; depending on these same regulators to head off future crises seems like that old definition of insanity.

So, that said, let me argue for a single modest but iron-clad regulation that I believe would, while not preventing the next crisis, make it manageable rather than system-threatening. Let's consider past bubbles and economic crises, confining ourselves to the really infernal ones where the entire economic organism appears threatened. One pattern that clearly emerges is that the most severe crises always involve two idiocies acting in sequence. To loosely paraphrase Tolstoy, the first idiocy is always different but the second is always the same.

Examples of the first idiocy run the gamut of human imagination, from trading your house for a tulip bulb to giving out mortgages without checking on trivialities like the capacity of the recipients to fog a mirror. But, the second idiocy – the one that transforms an unpleasant but treatable illness into a metastatic disease that threatens the whole organism – the one the degree and type of which anticipates with uncanny accuracy the severity of the crisis – is, in a word, leverage, broadly defined to mean the total amount of obligations taken on by the actors on the economic stage divided by the amount of assets they own.

The problem with the regulatory reactions to past crises is that they usually are addressed to the first idiocy, being designed in ornate and exhaustive detail to prevent that exact same idiocy from recurring in the future. For example, in the case of Enron the problem was partly caused by executives giving misleading financial reports, so we got the pointless Sarbanes-Oxley ritual where executives must sign a statement saying that they really, really mean the financial reports this time. Doubtless in the current case, we'll get laws strictly requiring that all loan recipients be capable of fogging a mirror; for that matter, the tulip madness in Holland was probably followed by a law fixing the future maximum price on all bulbous plants.

Human ingenuity being what it is, however, it is inevitable that a new idiocy will be developed in short order that lies outside the set of laws painstakingly constructed to prevent past idiocies. It will gain momentum, and in an amazingly short time we'll be off to the races again.

A far more promising angle for preventing future financial catastrophes would be to attack the second idiocy. To do this, it would simply be necessary to restrict the leverage that all all entities can take on to some reasonable multiple of their assets. Simple, but not easy - this would have to be an ironclad rule applying to all, not one to be applied by friendly regulators at their discretion, and leverage would have to be broadly defined to include all obligations that might cause risk, whether it be loan, derivative, or contract written in monkey blood by the light of a full moon (which I understand from my recent reading is Goldman Sachs' preferred method).