As some of you may know, I'm not an economist by trade (B.S. in Chemistry, PhD in Linguistics, JD, and LLM in Taxation). I'm married to one, however, who holds a PhD in Economics from Chicago, no less, having studied with Milt Friedman and F. Hayek. (He thinks Hayek is misread quite frequently....) So we've been talking about this economic crisis and the behavior of the big banks. They supposedly have proprietary computer models for assessing risk, and use these models to hedge their risks on a daily basis. They mark to market their assets, so that any time they know whether they are doing good or their assets are turning sour. Yet the subprime/mortgage-backed security crisis has hit them like an iceberg slicing the Titanic. Why?
Mark Thoma has collected a couple of interesting explanations (including Greenspan's), at this link. I suspect it has a lot to do with the fact that the future can't be predicted from the past, no matter how sophisticated the computer programming that attempts to extract trends from points or how successful it may appear to be at times. Here's what Avinash Persaud, linked on Thoma's blog, has to say about risk.
.....When a market participant’s risk model detects a rise in risk in his portfolio, perhaps because of some random rise in volatility, and he tries to reduce his exposure, many others are trying to do the same thing at the same time with the same assets. A vicious cycle ensues of vertical price falls prompting further selling. Liquidity vanishes down a black hole. The degree to which this occurs is less to do with the precise financial instruments, but more with the depth of diversity of investor behaviour. Paradoxically, the observation of areas of safety in risk models, creates risks and the observation of risk, creates safety......
If the purpose of regulation is to avoid market failures, we cannot use as the instruments of financial regulation, risk-models that rely on market prices, or any other instrument derived from market prices such as mark-to-market accounting. Market prices cannot save us from market failures. Yet, this is the thrust of modern financial regulation, which calls for more transparency on prices, more price-sensitive risk models and more price-sensitive prudential controls. These tools are like seat belts that stop working whenever you press hard on the accelerator....
Meanwhile, Paulson at Treasury is trying to preempt congressional action to regulate the huge investment banks that are "too big to fail", leading the Fed to come to their rescue. Here's the text of his remarks, the Blueprint for a Modernized Financial Regulatory Structure , a fact sheet and news release. But the Bush administration plan for revamping the regulation of financial institutions seems too little, too late, and maybe even intended to eviscerate the ability of the states to regulate banks. In other words, like most things coming out of this administration, it is done more with the eye of aiding and abetting the mighty than with the eye of curbing their appetite for risk in favor of supporting a more sustainable economy that lifts all boats. As Floyd Norris writes for the New York Times--Market Plunges, Fed Acts --appearing to give Wall Street whatever it wants.
And here's what Nelson Schwartz and Floyd Norris, In Treasury Plan, a Reluctant Eye on Wall Street, New York Times had to say about Paulson's plan for revamping the financial system yesterday (3/30/08).
Although the proposal would impose the first regulation of hedge funds and private equity funds, that oversight would have a light touch, enabling the government to do little beyond collecting information — except in times of crisis.
The regulatory umbrella created in the 1930s would grow wider, with power concentrated in fewer agencies. But that authority would be limited, doing virtually nothing to regulate the many new financial products whose unwise use has been a culprit in the current financial crisis.
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Mr. Paulson is clearly taking a stand against critics who support even stricter regulations, while rejecting any notion that the crisis in financial markets or the collapse of Bear Stearns can be laid at the administration’s doorstep.
I'm not convinced that a plan hatched in the desire to help banks be "competitive" (Bush administration jargon for "make money without sharing any of it with the Federal government") has any place in the reforms we need to develop. I wonder if we don't need to rebuild the Glass-Steagal wall, or at least some part of it. When you let banks get too big to fail, that means that there will come a time when you really can't prevent it after all. Now is not the time to go "light" so banks can continue their reckless and risky run for the money. It's time to be reasonable and thoughtful-- to move with all due deliberation towards a revamped system of bank oversight that subjects investment banks to real supervision and takes a very hard look at their exotic derivatives, especially the credit default swap speculation and the collateralized debt obligations.