28 April 2010

finance bill discussion

many people are adamantly espousing the need for greater financial regulation as included in the finance bill in order to prevent systemic meltdowns such as the one we are just trying to crawl out of.

i am not perfectly current on the specifics of the bill, as i believe there have been some concessions from the Democrats to the Republicans within the last hours to garner sufficient support to pass the bill in the Senate.

overall, i hear the cries for greater government oversight in the industry as only a half thought out solution.
everyone agrees there were bad investments that hurt a lot of people, but controlling every investment is a very costly, difficult, and not an assured way to prevent pandemics such as the recession of 2008.

a cooler solution is to stop the source (which may even stop itself) and definitely curtail the amplification mechanism that made the situation so severe.

i may have told this story before, but i'll tell it again because it's this simple. investment banks insure corporations cheaply by providing them hedge funds. they take a company's stock, and return a customized (like a trimmed hedge) fund that will pay the company back a smoother stream of profits than the original stock. cheap insurance, a hedge against a company's specific risk.

with so many companies (including home loan banks and even more standard insurance companies like AIG) now so well insured, there was moral hazard; these companies took riskier business practices than usual. Washington Mutual would lend to people they normally wouldn't. Why not, they were insured against losses?

not only were there some bad investments made by the moral hazard of cheap insurance, but they were made en masse because of a depressed fed interest rate that allowed the banks to borrow cheaply and leverage (amplify)these bad investments ~100x what they normally would have.

to me, there's a simpler and more desirable solution.

1) don't bailout investment banks that failed to recognize the moral hazard imparted by the insurance they provided, nor the companies that were not discriminating in their investments in the companies engaging in moral hazard. it was a costly mistake, and the lessons will be learned naturally, and the actions not repeated.

2) the greater problem is the momentum this somewhat minor problem was able to achieve via leverage. "systemic risk," the ability for this one problem to putrify the whole economy, was possible because of an artificially depressed fed-set interest rate. The artificially low rates that allowed the borrowing en masse (leveraging) turned a reasonable mistake (under-estimating moral hazard from proliferation of investment banks' hedge funds) into a systemic pandemic. Without fed depressed interest rates, money wouldn't have been as cheap to borrow and invest, investors would have been more discriminating, and there wouldn't have been such rampant and leveraged mal-investment.

what's kind of crazy is that the investment banks that were greedy (made the risky loans) lost big and went under. the investment banks that were smart/conservative and didn't make the risky investments and shorted the market, even though they may be despicable individuals, are now the ones being used (because of their character) to persuade the public to invoke change in the industry: regulation over investment practice specifics.

the solution i propose herein is simpler than the current proposed legislation, attacks the source of the meltdown, is less costly to implement, doesn't hamstring players in the banking industry, and doesn't hamper the overall finance market. essentially, it would be more effective and preserve a greater set of choices (liberty) in finance.