...for the past three decades financial engineers have been playing a game with unlimited upside reward and, thanks to the Federal Reserve and the White House, limited downside risk.
The new rules: A $45 trillion market in immensely complex derivative securities, with no regulation, no capital requirements, no transparency, and a Federal Reserve that is so terrified of the consequences of this market blowing up that it seems prepared to bail out the losers at almost any cost.The perfectly predictable result is a Wall Street willing to peddle increasingly dicey paper in return for the promise of ever-higher returns. Who wouldn't, especially with the Fed prepared to cover your bad bets? The phenomenon has been around long enough to have a name: moral hazard.
Just since the 1970s, we have gone through Michael Milken's junk bonds, the savings and loan crash, leveraged buyouts, Long-Term Capital Management and the hedge funds, venture firms and the dot-com bubble, the private equity craze, and the sub-prime mortgage mess. It's all a variation on the same theme -- smart guys take other people's money, leverage it by as much as they can get away with, buy stuff, securitize it, and then flip the paper for a huge profit.
Unfortunately, the deals get riskier and riskier and finally crater. Eventually, someone gets caught holding the bag. If that someone is big enough -- a bank or even an investment house -- the Fed steps in to bail them out. Even more troubling, the central bank continues to pump liquidity through the whole financial system to keep things afloat. So, to ease the consequences of the bursting dot-com bubble, the Fed made plenty of money available for the mortgage market. That not only kept home prices up, it set off a housing boom, sub-prime and no down-payment mortgages, and finally, kersplat, here we all are.
A handful of observers, such as the late Fed Governor Ned Gramlich, warned of the dangers of sub-prime lending. Sadly, they were largely drowned out by a curious combination of the Bush administration, which believed that a new "ownership society" would create fresh cadres of happy Republican voters, Fed Chairman Alan Greenspan, and some Democrats, who encouraged the expansion of sub-prime loans in a misguided attempt to aid low-income homebuyers.
More broadly, Greenspan believed that derivatives and the massive casino they created were good for the economy. Unregulated hedge funds and private equity firms would, he believed, be a more efficient mechanism for clearing market prices than traditional regulated securities firms. They were, until they weren't.
As a result, we seem to be reverting to an era where recessions are caused by financial busts rather than downturns in the real economy.... These Wall Street-driven busts used to happen all the time, until post-Depression regulation of commercial and investment banks leashed the speculators. In recent decades many of those rules were repealed, the Securities & Exchange Commission and other regulators were defenestrated, and financial rocket scientists invented securities that were beyond the law. Somewhere Jay Gould is looking down on derivatives traders and smiling.
We have created a system that privatizes profits but socializes losses. The rich get richer by taking ever bigger risks with other people's money, knowing that should they bet wrong the system they have built will deemed "too big to fail." But as Gleckam points out, this is nothing new. The mechanics of the system may have changed, but the underlying dynamic is no different than the ones that drove the bust-and-boom cycles of the early 20th century. We have been here before. We learned our lessons the hard way, and then we forgot them all.
Markets are not magical. They are not gifts from god, nor are they naturally occurring phenomenon. They exist because we humans create them, and they operate only because we agree to abide by a shared set of rules. As markets have grown more complex, so too have the rules that govern them. Without rules and regulations, markets cannot exist. Thus, the question is not if such rules will be created, but what these rules will be, who will write them, and how they will be enforced. Sometimes it will be government that acts, and other times it will be left to private citizens. But in the end, the rule-making is an inescapable part of markets, one without which they simply cannot exist.
In this case, it seems fairly simple to me. If your activities put our entire economy at risk, you have forfeited your right to demand self-regulation. When your failure creates externalities that are so great as to threaten the economic well-being of millions of uninvolved citizens, you cannot simply be left to do as you wish.
UPDATE: Looks like Kevin Drum and I were thinking about this issue at the same time:
It strikes me that the real problem is that in recent years markets have become so hyper-efficient that it's really hard to make lots of money from purely financial transactions. The competition is too good, spreads are too thin, computers are too powerful, and trading windows are too short. So what to do?
Two things. The first is to rely on absolute mountains of leverage. If a particular kind of hedge offers a potential spread of, say, 0.1%, then you need to invest a billion dollars to even begin to make any serious money. Obviously this makes the downside risk enormous if your bet turns out to be wrong.The second is.....what to call it? Not fraud, certainly. Not that. Perhaps hocus pocus? Agressive salesmanship? Exuberance? Whatever....
Of course, a mania for leverage is nothing new: the stock market crash of 1929, for example, was partly fueled by low margin requirements that caused investors to take huge losses when the market started to tank. (Margin requirements were eventually raised after the creation of the SEC in 1934.) More recently, the collapse of the hyper-leveraged hedge fund Long Term Capital Management in 1998 prompted the following warning from Alan Greenspan and Robert Rubin:
The events in global financial markets in the summer and fall of 1998 demonstrated that excessive leverage can greatly magnify the negative effects of any event or series of events on the financial system as a whole....Although LTCM is a hedge fund, this issue is not limited to hedge funds. Other financial institutions, including some banks and securities firms, are larger, and generally more highly leveraged, than hedge funds....The near collapse of LTCM illustrates the need for all participants in our financial system, not only hedge funds, to face constraints on the amount of leverage they assume.
As I said, all of this really is nothing new. We keep learning these lessons, and then we keep forgetting them. Sad, isn't it?
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