Hedge fund Elliott Management founder and CEO Paul Singer in today's WSJ, in part:
Reform must begin with a regulatory regime focused on "behavior" instead of "systemically important institutions." Today, even small entities that trade complex instruments or are granted sufficient leverage can threaten the global financial system.
It's true that monetary policy was too lax for too long, and the government encouraged lending to people who were unlikely to repay their loans. But this crisis was primarily caused by managements and individuals throughout the financial system who exercised extremely poor judgment. The private sector, not the public sector, is where the biggest mistakes were made.
In the past decade, most global financial institutions built highly leveraged balance sheets -- sometimes as high as 30 to 1 -- that were stuffed with risky assets. These institutions also bought on a large scale for their own accounts the same securities they sold to their customers. Our anachronistic regulatory framework didn't catch the problems, and warped incentives and compensation schemes fueled the risk-control failures that eventually brought on the crisis we face today.
Now we must create a new regulatory infrastructure that will meet three fundamental tests. First, it must assess and measure risks accurately, including the compounded risks of herding (traders being similarly situated and forced to unwind simultaneously). Second, it must impose significant margin requirements on all exposures. And finally, it must bring all investors and traders -- regardless of whether the risk holder is a hedge fund, bank, private equity fund, individual or government agency -- under the regulatory umbrella. These three measures will diminish volatility and reduce the likelihood of a future financial collapse.
Creating a regulatory system that reflects the modern-day realities of financial markets is not as difficult as it may appear. The financial structures that destabilized our markets have definable characteristics. [...]
It is critical that any new regulatory initiative have a global mandate and contain mechanisms to prevent “risk infection” by countries that try to dodge risk controls. There are legitimate concerns about the time needed to devise a global risk-management system and staff it with individuals with the requisite sophistication and experience. But there are relatively simple solutions.
The premise that we need "some" regulation ignores the mountain that exists. I think Singer is far off the mark, as I detail with the following...
There is one huge problem with Mr. Singer's prescription: a global mandate. This puts us all in the same boat--we sink or swim together, so to speak. And it is based upon a faulty assumption: this time "we" get it right. Under Mr. Singer's construct, the problem is simple ("Creating a regulatory system that reflects the modern-day realities of financial markets is not as difficult as it may appear."), therefore, the solution is simple.
This is hubris.
The factors cited as contributors (or as answers) to the financial collapse: leverage, margin, risk, and concentration, were already regulated and under the purview of the SEC, the Fed, other bank, state, market, or other regulators.
Capital controls, margin requirements, internal risk control systems, disclosure (transparency) requirements, audit standards, compliance regulations, performance (market) expectations, access to capital (public and private) markets, are mere details that make up the foundation of the financial system. Simple, this is not. And this foundational/regulatory complexity spawns so-called loopholes, much like our legal and tax system--if it is not explicitly forbidden, then it is allowed (and perhaps, required).
Our rules-based system attempts to remove human judgment, and therefore ill-judged (usually, after-the-fact) mistakes, from of the workings of the financial system. Moral and ethical judgment regarding right and wrong are proscribed--supplanted by this rules-based system of do's and don'ts.
And still, it was a fundamental judgment--an assumption--that led to this calamity. And that assumption was home prices would inexorably continue to rise--and in this rise was a cushion of safety upon which our foundation would rest.
While pointing fingers can be politically satisfying, I think the record is pretty clear--mistakes were made regarding the constancy of rise in home prices, and all our institutions--legislative, executive, regulatory, and financial markets--contributed.
While no one factor triggered the meltdown, the totality of the commitment (and reinforcing feedback loops) to this assumption is pretty impressive: the CRA; "affordability" mortgages; low (negative real) interest rates from the Fed; Fannie Mae and Freddie Mac morphing into trillion dollar, hedge fund-like institutions with, essentially, one-way bets on interest rates and home prices; rating agencies rating securities lacking transparency (CDOs, CDO-squared, et al.); over-the-counter derivatives, e.g. CDSs, with its inherent counter-party risk, rather than exchange-traded that reduces such risk; bank capital requirements advantaging AAA mortgage securities; risk models based on Gaussian "normal" distribution when financial market disruption is anything but normal; tax treatment of mortgage interest and home re-sale capital gains; and on and on and on. While lengthy, the list is not exhaustive of the contributors.
Markets are messy. They require rules and procedures. There is no way around this fact-of-life. Tackle each of the issues and factors individually in the appropriate venue. It will require hard work and effort from many quarters. There is no omniscient (or centralized) body that can “know” how to get each of these issues right.
I am not suggesting we throw our hands up in frustration and futility because it will be difficult, but unlike Mr. Singer, I do not see a silver-bullet answer–-passing the responsibility off onto another layer of regulation and regulators, be it a global framework, foundation, umbrella, or mandate, and hope they get it right.
Besides, hope is not a plan, it is a prayer.
