One of the joys of a long holiday weekend is the chance to pick up on things you either forgot or just didn’t have time to write about. Such is the case with an article in the WSJ that appeared around the end of July. Titled, “When Greed Can Be Bad” it’s an elegantly short little piece that nicely balances the issues to be faced in reregulating the financial markets.

The article points out that efficient allocation of capital in a financial system is driven by two factors-greed and fear. Greed being the desire to maximize risk adjusted returns and the fear of excess loss moderating greed. Normally the two are in balance but for some reason in the past decade fear took a holiday. The article posits four pretty good reasons for the absence of fear and the consequent debacle.

Previous bailouts. Whenever financial markets got into trouble — for example, after the Long-Term Capital Management crisis of 1998 or the bursting of the dot-com bubble that began in 2000 — the Federal Reserve slashed interest rates. The proposed bailouts of Fannie Mae and Freddie Mac will further the view that the U.S. government stands ready to socialize losses.

Skewed incentives. When markets boomed, many financiers made out like bandits. When markets tanked, well, most of the time it was mainly clients’ money that went down the drain.

Ill-conceived capital requirements. Regulators require banks to hold a certain amount of capital to cushion against losses. The problem is the way that formula is calculated. In boom times, it encourages them to pile on risk. When markets falter, the need to protect their capital forces them to withdraw credit. That is the wrong way round.

Failure to consider liquidity risk. In good times, most assets appear readily tradable. So financiers engaged in a large variety of “carry trades” — borrowing cheap short-term money and investing in long-term high-return assets, such as real estate. When the dancing stopped, investors found that these assets weren’t easily traded at all and could be offloaded only at huge losses.

The article also notes that there was gross incompetence at every level. Management of financial firms, employees of those same firms, investors and regulators were all asleep at the switch. Over reliance on rating agencies to put a stamp approval on securities in lieu of rigorous analysis by the purchasers of those securities also contributed to the problem.

The conclusion is pretty obvious. As the author notes, fear needs to be reintroduced into the equation. The parties who contributed to the problem need to suffer mightily. This includes not only management but the shareholders of the institutions that contributed to the problems. Compensation schemes need to be amended. Capital has to be increased and leverage reduced in conjunction with increased attention to the maintenance of liquidity.

While the author does not suggest it, I would add that prosecution and punishment of those at all levels who were demonstrably involved in illegal activities needs to occur. With good reason there is alive in the land the belief that even if caught with one’s hand in the cookie jar, the possibility of discipline beyond a light slap is remote. Fear of loss of freedom is much more potent than fear of loss of money. One can always be regained the other is a permanent.

Situations like the one we find ourselves in now will likely recur. It’s just part of the price we pay for a free market and society. The trick, as I see it, is to spot early on imbalances in motivations and bring them quickly back into line.    

Tom Lindmark 

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