Is William Cohan Right That Wall Street "Regulation" Has To First And Foremost Curb Greed?
Now that the world is covered in at least $707 trillion in assorted unregulated Over the Counter derivatives (as of June 30, the most recent number is easily tens of trillions greater) and with at least one JPMorgan prop|non-prop trader exposed to having a ~$100 billion notional position in some IG-related index trade, pundits, always eager to score political brownie points, are starting to ruminate over ways to put the half alive/half dead derivative cat back into the box. Unfortunately they are about 20 years too late: with the world literally covered in various levered bets all of which demand hundreds of billions in variation margin on a daily basis, the second the one bank at the nexus of the derivative bubble (ahem $70 trillion JPMorgan) starts keeling over, it will once again be "the end of the world as we know it" unless said bank is immediately bailed out. Again.
As a result William Cohan, in a half-right narrative, suggests that instead of trying to curb derivatives this late in the game, which is a lost cause by definition as the JPMs of the world will simply change the rules to abuse the regulatory loopholes, says that regulation should be geared toward capping the potential of infinite greed to generate next to infinite losses. His suggestion is not to curb financial innovation, but to make "traders and bankers once again financially liable for what they are selling. If that were the case -- as it was when Wall Street was a series of private partnerships -- financial innovation would once again be revered and help to restore the luster of America’s capital markets." So far so good. The problem is that even in a private arrangement, those who become TBTF, whether with clawbacks or not, would still abuse the system? Anyone remember all too private LTCM, and how its legal team was frantically begging the Fed and Wall Street to bail them out, in essence launching the modern equivalent of TBTF? The truth is that modern Wall Street does have too much innovation, whose only purpose is to extract as much cash flow from increasingly worthless assets. And once the assets are completely depleted, to create synthetic assets which generate all too real cash flows out of parties close to the Fed.
Ah, I can hear you scream, didn’t Milken’s junk-bond monsters bring about the stock market crash of 1987, when the Dow Jones Industrial Average lost 22.6 percent in one day, leading to the credit crunch that engulfed the economy from 1989 to 1993? And didn’t Ranieri’s little devils lead to the current financial crisis when one mortgage-backed security after another went into a tailspin? Wouldn’t an FDA-type agency, like the “pre-cogs” in the 2002 movie “Minority Report,” have seen these two train wrecks coming and prevented them?
This is beyond ridiculous, for the simple reason that there is no way to deconstruct a financial product before it goes to market to determine whether it will end up doing more harm than good. Yes, the excesses in Milken’s junk-bond market helped cause the speculation in the stock market that led to the Crash of 1987. But both before the crash and most certainly for the last 25 years the junk-bond market has been robust and vital, allowing thousands of companies access to capital while also providing investors with the sorts of risk-adjusted yields they most certainly cannot find in the overinflated Treasury market.
Much the same can be said for the securitization market, which worked brilliantly for more than 20 years before credit standards deteriorated miserably in the middle part of the last decade, sending the mortgages tied to them and the entire housing market spiraling downward. Chances are good that as we emerge from the downturn, securitization of mortgages will again be a viable and important market.
The problem on Wall Street is not financial innovation per se or the risks tied to untested products. Rather, it is a terribly outmoded incentive system that rewards -- with big bonuses -- the Wall Street armies who generate revenue by selling the array of new products without any accountability.
The key to Wall Street reform is to make Wall Street executives, traders and bankers once again financially liable for what they are selling. If that were the case -- as it was when Wall Street was a series of private partnerships -- financial innovation would once again be revered and help to restore the luster of America’s capital markets.
Alas, while superficially correct, this merely a case of revisionist history of a story that has ended well. For now. Yes: it took $20 trillion in backstops, cash infusions and guarantees from the central planners to stabilizie the system, but what happens next? What happens when the central bankers themselves need bailing out. After all none other than that modern day champion for all things right, Austan Goolsbee himself was a strong advocate of, get this, subprime back in March 2007. Just read the following sheer idiocy from a man who was Obama's economic advisor:
When Senator Christopher J. Dodd, Democrat of Connecticut, gave his opening statement last week at the hearings lambasting the rise of “risky exotic and subprime mortgages,” he was actually tapping into a very old vein of suspicion against innovations in the mortgage market.
Almost every new form of mortgage lending — from adjustable-rate mortgages to home equity lines of credit to no-money-down mortgages — has tended to expand the pool of people who qualify but has also been greeted by a large number of people saying that it harms consumers and will fool people into thinking they can afford homes that they cannot.
A study conducted by Kristopher Gerardi and Paul S. Willen from the Federal Reserve Bank of Boston and Harvey S. Rosen of Princeton, Do Households Benefit from Financial Deregulation and Innovation? The Case of the Mortgage Market (National Bureau of Economic Research Working Paper 12967), shows that the three decades from 1970 to 2000 witnessed an incredible flowering of new types of home loans. These innovations mainly served to give people power to make their own decisions about housing, and they ended up being quite sensible with their newfound access to capital.
These economists followed thousands of people over their lives and examined the evidence for whether mortgage markets have become more efficient over time. Lost in the current discussion about borrowers’ income levels in the subprime market is the fact that someone with a low income now but who stands to earn much more in the future would, in a perfect market, be able to borrow from a bank to buy a house. That is how economists view the efficiency of a capital market: people’s decisions unrestricted by the amount of money they have right now.
And this study shows that measured this way, the mortgage market has become more perfect, not more irresponsible. People tend to make good decisions about their own economic prospects. As Professor Rosen said in an interview, “Our findings suggest that people make sensible housing decisions in that the size of house they buy today relates to their future income, not just their current income and that the innovations in mortgages over 30 years gave many people the opportunity to own a home that they would not have otherwise had, just because they didn’t have enough assets in the bank at the moment they needed the house.”
And this man shaped US policy two years later? Is it any wonder America's is progressively collapsing into the worst Depression in history despite optical gimmicks that fool increasingly less of the people, all of the time?
While we agree with Cowan on one part of his analysis, we disagree that financial innovation is reasonable going forward, as all it does is take flawed exit assumptions (yes, the securitization market did work for 20 years but only because it was a hyper-levered bet on one very wrong assumption: that markets and home prices can only go up, and that the cost of money will always go down). And yet it is precisely the flaw embedded in Goolsbee's simpletonian argument that has also fooled Cowan, and all those other sophisticates on Wall Street: the ability to predict cash flow. Alas, that is now impossible, because the very cash flows depend on the level of future innovation! Yes, there may be a greater fool if even more greater fools pay Facebook $10 billion to buy companies with 13 employees which make photo filters, at a valuation that is about 50 times greater than reasonable. But one day the greater fools run out of money, courtesy of their own capital misallocation decisions. And as shown here before (read How The Fed's Visible Hand Is Forcing Corporate Cash Mismanagement), it is none other than the Fed which is now the ultimate driver of capital misallocation across the US corporate sector. When predicting the future depends entirely on reading the mind of the central planners at every given moment, what can possibly go wrong?
Well, everything.... as history teaches us over and over. And which lessons humanity, in the pursuit of its own selfish infinite greed interests, always ignores.