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February 14, 2010

Financial Companies Don’t Self-Regulate

Posted in: Financial Crisis,Oversight

photo: bitzcelt via Flickr

One of the myths you have to believe if you want to be taken seriously about financial matters is that the Lords of Finance are geniuses at risk management. The Cardinal of Rectitude, Alan Greenspan, taught this at every service he led. When he officiated at the rites of the convocation of the Futures Industry Association in 1999, he told the assembly that market players:

… continually reassess whether their risk management practices have kept pace with their own evolving activities and with changes in financial market dynamics and readjust accordingly…

Of course, he was forced to admit that it was all a lie when he testified before the House Committee on Oversight and Reform in October, 2008:

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.

You’d think that if the High Cardinal of the Church of the Perfect Market recanted, it would be a problem other true believers, like those at the University of Chicago. In fact, many economists there were stunned, as John Cassidy writes in the New Yorker. One of them is James Heckman, who won a portion of the Nobel Prize in economics in 2000:

Everybody here was blindsided by the magnitude of what happened…. But it wasn’t just here. The entire profession was blindsided.

Blindsided? Apparently the entire profession is stunned to learn that in an empirical test, their theory created a financial catastrophe. Even so, some cling to their theories with a blind passion. Cassidy talked to Eugene Fama, the prime mover behind the Efficient Market Hypothesis. This odd proposition is that markets use all information available to come up with the right price for assets. The efficient market hypothesis depends on market players acting rationally, which would include such things as risk management efforts, efforts to detect fraud, and reviewing mortgage loans. It was the justification for the big deregulation movement. Cassidy asked how Fama thought the EMH did in the Great Crash.

Fama says the EMH did just fine. He says the market was a victim of the recession, not a cause. The problem was the insistence of the federal government that Fanny Mae and Freddie Mac buy up subprime mortgages. This was a governmental failure, not a market failure. Fama doesn’t explain how his efficient markets fed Fannie and Freddie worthless, even fraudulent, mortgages.

Bolstered by the few remaining market fanatics, banks are instructing Congress what regulation they will accept. Jamie Dimon of JPMorgan Chase admits his company didn’t do a stress test on its portfolio that included the possibility that housing prices would fall. Blindsided, no doubt. Now he says he supports regulation and stronger enforcement of existing law. But return to Glass-Steagall? That’s a “quaint notion”, calling to mind another dismal failure, Alberto Gonzales. Lloyd Blankfein agrees that we must be very careful about regulating banks lest we choke off innovation.

Here is a perfect example of that innovation. CitiGroup has invented a derivative that pays out in the event of a financial crisis. Its creators say it tracks liquidity, and other market indicators like bid-ask spreads (of some unstated securities, probably derivatives), and trading volumes. It is based on something called the Sharpe Ratio, which is a simple ratio of historical data, so it offers a wonderful lack of reality in predicting the future. And best of all, it’s easy to trade. There are no upfront costs. This such a bad idea that Risk Magazine, which published the article, finds a scholar to explain the downside. Chris Rogers, chair of statistical science at Cambridge University, says:

This is basically a kind of insurance product. The main issue is: how good is the party issuing it? If it’s going to be paying out huge numbers in the event of a crisis, will it be able to meet it[s] obligations? Insurers can buy reinsurance for their liabilities, but the buck has to stop somewhere – there’s a limit to how much a private insurer can pay out. Only the government can cover unlimited losses ….

It is false that financial businesses will regulate themselves. In fact, they are planning to keep things just as they are, and to take explicit advantage of their size to create even more destructive derivatives. These are the people the President calls “savvy businessmen.”

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