ship-capsizing.thumbnail.jpgSo you’re in a boat, and it starts taking on water. You grab a bucket and start bailing. What do you tell the rest of the crew?

"Find the hole, and plug it."

All the running around, screaming and arm waving in Washington right now is about organizing a bucket brigade, but I don’t see anyone talking about finding the hole and plugging it up. Right now financial institutions are still engaging in the many of the same practices that caused this crisis. Everyone bandies about "subprime" as if that’s the key to the problem. It’s not. First of all, the problem extends far beyond subprime even when it comes to mortgages, diving deep into what’s known as Alt-A and even into prime territory. Second, this housing downturn while bad wouldn’t be causing all these troubles if it had happened 20 years ago. The default rate is high, but it’s not catastrophically high. We’d be looking at a nasty recession, but it wouldn’t be a financial crisis.

What is making this crisis so bad, in two words, are leverage and complexity. It has been entirely possible to leverage up to multiples in the hundreds, where for every dollar you’ve bet you’re controlling hundreds of dollars. That’s how you make money in this game. If an underlying asset makes a 1% profit – i.e., one cent, that’s not much. But if you’re leveraged 500 times, unltimately, hey you just made 50% return. Sweet! Of course, if it loses a cent, or two cents—or worse, 3 cents, well, you could have problem.

Just tightening up mortgage requirements, then is not enough. Financial institutions and investors of all kinds, including hedge funds, need to be forced to reduce their leverage ratios to something reasonable. This needs to be total leverage – the problem now is that you may leverage 5 to one when you first borrow money. You put that in a brokerage account, and then you leverage that 10/1. You’re up to 50/1. You buy a heavily leveraged security, say 10/1, and hey, you’re at 500/1. That has to end. Leverage has to be end to end. Make it 10 to 1 max. If you don’t, financial institutions can just keep growing flooding the boat damn near infinitely.

The second problem is complexity. The securities created in this mess weren’t just highly leveraged in many cases, they were very complex. A single mortgage might be sliced in multiple ways, the simplest of which being selling the revenue stream and also selling the default risk (if it defaults, you get the proceeds from the sale of the house.) Fraud was instrinsic to this model, because the face on the default risk, for example, was often overstated. If a large number of people who are very good risks start all going belly up and losing their houses all at once, you probably aren’t going to get the $800,000 sale price the house was worth during the bubble, are you? Yet the security would be sold at that value.

But the complexity goes far beyond that. Simply put, these things are so complex that no one knows how much they are worth. No one can really value them. We don’t really know what the default risk is. We don’t really know what the returns are. We don’t really know what the property is worth. Even if there had been no fraud, we wouldn’t be entirely sure about these things because no one really agrees on what future property trends are going to be. To value these things you have to make estimates. Bluntly, the financial industry’s track record at making these estimates hasn’t just been bad, it has been catastrophic. They never got it right. (Which, again, suggests fraud. Even fools sometimes luck into getting things right.)

So, if you don’t stop financial institutions from making bets they don’t really understand, based on favourable assumptions they can’t back up, they’ll keep doing so. Add in massive leverage and you’re looking at a gusher. The ship keeps taking on water.

If you don’t close the hole, if you don’t make it impossible for financiers to keep flooding the boat with water, they will keep doing so. As with gamblers who are down, they will stay at the table trying to get their money back. Worse, because they know that the government is making what amounts to an open ended commitment to buy toxic crap at a price more than it’s worth, why shouldn’t they play? Heads they win, tails the taxpayers bail them out.

If you don’t patch the hull, if you don’t make significant regulatory changes at the same time as you are creating a bailout bill, you’re just buying time. The ship may stay afloat as long as you don’t stop ferrying buckets of money to the financial sector, but it’s still got a massive hole in the hull and it’s still taking on water.

Any bailout bill that does not have significant regulatory changes will not solve the problem. It will, at best, kick it down the road for as long as taxpayers are willing to fork over a hundred billion a month or so to keep it from exploding. It may even make the problem worse because of moral hazard—heads the financier who makes a bet wins, tails the government bails him out.

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