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A Firewall for Wall Street

When death-defying daredevilry goes awry

What happens when you neglect an engine that is long overdue for an overhaul? Answer: It breaks down, perhaps bringing an aircraft crashing down to earth.

And in recent days Wall Street, the engine of the world financial economy, has sadly shown that it is far from immune to the banal real-world constraints that the rest of the world is routinely accustomed to living with.

Owing to a heady and overpowering mixture of high expectations and sheer exuberance, many financial industry players were convinced they could defy the mundane aspects of the real world, such as gravity. But magic wands and pixie dust did turn out to be the stuff of fairy tales, after all.

As I wrote 18 months ago in The Long Arm of the Laws of Economics, risk in world financial markets has been underpriced by hiding it away, using increasingly arcane, complex and innovative instruments* such as Credit Default Swaps and Collateralized Debt Obligations. As I wrote,

"While underpriced (Cheap) risk is good for borrowers in the short term, in the long term it can undermine  the health of the entire financial system. Thus there are good grounds for apprehension as to the robustness of the world's financial markets."

In fact, the financial media including the Economist and BusinessWeek had been carrying admonitions to this effect this for some time. So if the fragility of the financial system was widely known 18 months ago, it’s a fair bet that the wise and wizened wizards who run the world of finance knew it too. But regulators largely looked on benignly, as did most everyone else. Sure enough, when the risk came home to roost, what resulted was the carnage on Wall Street and its reverberations around the world that we have witnessed in the past 10 days.

I also wrote in another piece, that despite all these excesses, the financial economy is still likely to have a soft landing.  This statement was, alas, based on the assumption that the same wise and wizened wizards would not allow things to reach the pass that they have in the past two weeks. Yet what has happened thus far may still be characterized as a relatively soft landing - only events over the next year will tell if this observation was correct.

Very hearteningly, regulators have responded with alacrity and appropriate measures to contain the contagion on Wall Street. One key and very correct consideration that has driven the US Treasury’s actions over the past week has been to prevent the ripple effects from spreading beyond the affected institutions to the broader US financial system, and from spreading beyond US shores to engulf world markets.

Be that as it may, it is now very important that we do not go overboard on the other side, and become overly alarmist. In particular, there are two myths now sought to be propagated by scaremongers of various hues that I think should be jettisoned:

1. Myth:The free market system is fundamentally flawed”. There are voices emerging which suggest that the current upheavals indicate that the financial industry was always “evil”, and that the US Federal government’s moves last week to strengthen regulation are “proof” that leftist, anti-free market ideology was always correct. This is worse than an over-reaction – it is pure muddle-headed thinking.

The financial industry, led by Wall Street has done an admirable job of supporting the capitalist system in producing ever more goods and services that have improved our daily lives. There were excesses as I have noted earlier, but these were partly a result of regulation reaching a low point, turning a half-blind eye to risk. With regulation rebounding to stronger levels, the outlook is much better.

2. Myth: “Innovation is dangerous”. It is true another reason for the excesses was runaway innovation that produced the increasingly ingenious financial instruments that Warren Buffet has called “Weapons of financial mass destruction”.

However, this is far from sufficient evidence against innovation itself. If we were to shoot down any system or practice on the grounds that it resulted in some excesses, no human enterprise would be possible.

And so, in an enactment of the circle of life, the financial markets will become hale again, perhaps to commit the same excesses at some (hopefully) distant point in future. What is certainly worth keeping in mind however is that if you defy the laws of economics, you may just find the law of gravity catching up with you.



*These complex financial instruments also created a veil of opacity that hid the true extent of risk, and thereby acted as a “levee” that eventually came crashing down.




In my view, financial innovation and capitalism go beyond Wall Street crisis. We have seen the contribution of capitalistic business model in human growth as well as the flexibility financial innovations brought to economy.

However, the weak-link is human error, judgement:

- Mortgage crisis is a grave dug by human mind. Service providers very well knew the risk, but they had scant respect on derisking the downside. Besides, Mr Regulator was more watching the footstep of lobbyist than watching the market. All human errors.

- CDO, CLOs in their core form are fantastic instruments. But, while using them we never dent the risk they are carrying. The pricing & profitability management should have taken ample judgement on the downsides before masquerading them to global market. Blind-folded belief in rating agencies and pricing philosophy having little consideration to sensitive loopholes, are all mis-direction of human mind, human error.

Capitalism and financial innovation will be there to stay, what needs to change is the culture of execution. Financial business is cyclic and executors should understand ups & downs before pressing "approved" button.

I would like to take your observation about innovation with a pinch of salt.

Creation of financial instruments such as derivatives on top of derivatives
can't be called innovation. An analogy would help bolster my argument.

Joe goes to the track and bets $2 on a horse.

Two guys standing nearby get into a discussion and Fred says to Sam,
"I'll bet you $5 that Joe wins his bet."

Two other guys get in discussion and bet $50 on Fred.

Suddenly, you see $2 + $5 + $50 = $57 riding on the horse.

In the banking collapse, the only person who invested was the home buyer.

The rest were speculators and they can't be called innovators.

This article leaves me confused. We all know what has happened, and the author is simply reiterating a high-level narration of what happened. Where is the service provider's insight? No amount of regulation or oversight could have stopped this, not even the overweight Sarbannes-Oxley.

Suvendu, I agree with your observation - the key participants in the financial markets were oblivious to the risks and ended up being blindsided.

Nav, the view that innovation in financial products led to the crisis is widespread. See, for example, Paul Krugman writing in the New York Times:
"The bottom line is that policy makers left the financial industry free to innovate — and what it did was to innovate itself, and the rest of us, into a big, nasty mess. "

However the myth that needs to be debunked is that this is evidence that innovation is in itself somehow dangerous and needs to be drastically reined in. Innovation always entails risk, and that risk needs to be explicitly managed - by extensive testing, using iterative approaches, pooling the risk to ensure that no single entity suffers unduly, quantifying the risk, etc. And if that risk is not managed well, the outcome is failure of the kind that we're witnessing.

Sanjay, the possibility of the health of world financial markets being undermined by inadequate risk management was fairly well-known and commented upon by various observers for months before the Sep 2008 collapse. As noted above, I have myself written a warning to that effect in March 2007. Yet the response from regulators was remarkably understated - even sanguine. What this shows is that those who refuse to learn will be forced to learn the hard way - thru failure. And those who refuse to learn even then are doomed to repeat their failures. A situation of this kind may well happen again but that does not absolve us from doing our collective best to ensure that it doesn't.

I would find the notion that regulators were helpless to prevent the collapse highly discouraging. Luckily, that's not the case. The Chairman of the SEC has conceded on Sep. 26th that flaws in regulatory oversight fueled the collapse. French President Sarkozy has called under-regulation a "folly" that led to the crisis, and suggested an overhaul of the regulatory system. Leaders cutting a wide swathe across the spectrum from German Chancelor Angela Merkel and British PM Brown to Sen. McCain and Sen. Obama, and the IMF Chief have echoed the need for increased regulatory oversight. In fact, in my view the pendulum is now swinging toward the other extreme - of over-regulation - and it is necessary for us to guard against that.

Very Nice discussion.
I have one very philosophical argument in favor of the article. Any instrument (however complex) is designed by the market players only. Any design can be transformed into a systematic risk framework to measure a)true value b)health/origination of underlying asset c)risk profile of underlying asset d)bubble up to show the exposure of the firm as a whole.

In all the discussions so far on the crisis, the innocence displayed by the large financial services firms (including the disgraced Bear Stearns and Lehman) is hard to digest. I believe it was intentional to avoid the systemic risk and the folks should be investigated for possible scam than given bail out package.

I totally stand by the fact that the mess can be avoided in future with a "simple" technology enablement. It's simple when you understand what you are getting into!!

Anil, I agree that there was probably an element of disingenuity in many of the financial institutions' apparent underestimation of the risk they were carrying.

Alan Greenspan has admitted as much in yesterday's testimony to Congress, where he said that expecting the institutions to "self-regulate" the amount of risk they took on was a mistake, and that the present crisis is a direct outcome of regulators allowing such self-regulation.

Could I make Few Comments :

1. The root cause of the current financial crisis is excess credit by central bank.

2. Excess credit would always find a way to create a Bubble / Hype over the period.

3. History is evidence for that. Take Cotton Boom, Railroad Hype,..... DotCom Bubble, and Now Subprime; the focus is excess credit and related investments/production/consumption.

4. Financial players are acting as distributors for this excess credit.

The question is how to regulate the credit/leverage in the economy for sustainable and stable growth.

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