Oct

10

Mr. Market, from Edward Talisse

October 10, 2008 |

skullI note with a certain degree of gallows humour that today's villains are highly regulated institutions like commercial banks, insurance companies and broker dealers. Ten years ago, the LTCM debacle had the wolves crying for greater regulation and transparency of fast money. Now the hedgefund community is relatively healthy and will attract huge inflows once the dust settles. The key is that most are not publicly traded (though some are) and have reasonabe lockup periods and few disclosure requirements. In short, they are nimble. The big boys lke GS, MS, JP etc… insist on being global banks and hence require massive amounts of capital accessed via the capital markets. I wonder what Mr. Market will think is the most appropriate market intermediation model 10 years from now?

Philip McDonnell adds:

Regulation is a dirty word to most free market fans. It always entails cost, both to the operating businesses and to the tax payer. After all running a regulator involves an expenditure of public dollars. Having said that some sort of independent oversight is necessary so that the con men and charlatans do not dominate the market place.

However a large part of the responsibility for the current financial crisis can also be attributed to the current regulatory environment. In particular FASB, the Financial Standards Accounting Board changed the rules in the middle of the game. FASB promulgated that the banks had to revalue their sub-prime assets this past summer. Particularly hard hit were the securities which had to active markets. The net result is that banks which were caught 'holding' found huge swaths cut out of their portfolios. This was true whether or not the underlying mortgages were performing or not.

Strictly speaking FASB is not a government entity but it is as least partly government funded. The directors include people from government and the private sector. Mainly they are accountants.

What is needed in the current environment is less restrictive regulation not more. If anything we need to undo the draconian measures which are killing bank asset valuations. To be fair FASB is now quietly revising its earlier directive of only 90 days ago. The original directive was undoubtedly intended to strengthen the banking system. Yet the proximate result was to topple the House of Morgan and WAMU and to bring the entire banking system to the precipice within 90 days. What were they thinking?

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008

Stefan Jovanovich responds:

The House of Morgan" would, by Morgan Sr. and Jr. and Mr. Peabody's calculation, be J.P. Morgan Chase, not Morgan Stanley. The idea of looking elsewhere for the funds to support your positions in the market would have seemed to them incredible; even as a market maker you always had to be in a net cash position. (The reason Ron Chernow's book on Morgan is good only for pulping, in spite of the author's extraordinary industry, is that he can only see the Morgan Bank with modern eyes. Whatever Morgan, Peabody and J.P. Morgan & Co. were, they were not a 19th century Bear Stearns with the added advantage of being Episcopalians.) The Morgans and their original partner would have found the Treasury's current rescue plans to be fundamentally wrong-headed. They would have wanted the Federal Reserve and the solvent member banks to buy the failing and failed banks' non-speculative liabilities - the savings and transaction deposits - and left the shareholders, derivative claimants and creditors to liquidate the assets on their own, with or without the help of the bankruptcy court. M Sr.,M Jr. & P would have scoffed at the idea that governments should, would or could reset asset prices in the midst of a panic by writing checks based on their ability to issue sovereign debt. That fantasy is one that only the 20th and 21st centuries have accepted as wisdom.


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