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A Fateful Day
Posted by: Lance on Friday, October 03, 2008

The New York Times treats us to a multimedia look at the day that the S.E.C. decided to allow the five largest US investment banks to substitute advanced mathematical risk models for traditional capital requirements that I have discussed before.

From there leverage and risk exploded:

http://www.nytimes.com/interactive/2008/09/28/business/20080928-SEC-multimedia/index.html

Here are two quotes from the accompanying article::

"We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”

“I’m very happy to support it,” said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: “And I keep my fingers crossed for the future.”
Okay, let us call this a major mistake. I have huge problems with financial risk models, but experience with them was lacking. The problem is how clueless the SEC was long after it should have been clear what a disaster they were overseeing.
“We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.
On March 11th?

Also:
The 2004 decision also reflected a faith that Wall Street’s financial interests coincided with Washington’s regulatory interests.

“We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,” said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).

“Letting the firms police themselves made sense to me because I didn’t think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We’ve all learned a terrible lesson,” he added.
From someone who could have been an anonymous hero had he made any difference:

“With the stroke of a pen, capital requirements are removed!” the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. “Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?”

He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.
In my opinion hedge funds (most of which are less risky than traditional investing) get a very misleading treatment in the press, but Mr. Bole has made a very good point. One type of hedge fund scares the heck out of me, and that is the leveraged debt funds, of which Long Term Capital was for a while the most successful version.

Where do the traders for these funds come from? The trading desks of Wall Street's behemoths. What were they doing there? Operating massive leveraged debt funds disguised as investment banks.

Fannie and Freddie (who also use elaborate mathematical risk models) ply a similar trade. We not only didn't learn from Long Term Capital's meltdown, we institutionalized the types of models they used to profit and control for risk throughout our financial system.

That is what we allowed our financial system to become, a regulated version of a levered debt fund.

Of course the article spends a lot of time making the case for more regulation, and enforcing those regulations. It also complains that maybe the plan would have worked if Cox had actually used the power to monitor the banks that the deal to allow them to use the models gave them:
Mr. Cox has said that the 2004 program was flawed from its inception. But former officials as well as the inspector general’s report have suggested that a major reason for its failure was Mr. Cox’s use of it.

“In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the S.E.C. didn’t oversee well enough,” Mr. Goldschmid said in an interview. He and Mr. Donaldson left the commission in 2005.
I see it somewhat differently. Intrusive regulation and monitoring of firms as complex as these will not work. Instead you use simple rules that do not require near as much supervision or competency, but limit risk. That is what capital requirements do, they should have never given them up.

The complete audio of the 55 minute meeting where this was decided can be found here.
 
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"I have huge problems with financial risk models"

I have a problem with misusing any models. That is why is the real world they build pilot projects and prototypes to check out the models before they go into full scale production. And even then unanticipated problems come up.


"We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,"

Foolish, stupid, and ignorant. Firms don’t have culture, people have culture. I am sure the executives did have a strong culture of self-preservation, which is why ’golden parachutes’ are so common. Responsibility and discipline? Give me a break. responsible and disciplined executives do not take their staff and their spouses on all expense paid ’retreats’ at resorts and order cases of $70/bottle wine for dinner.

"I foolishly thought the market would impose its own self-discipline"

This clown is an expert on accounting? Perhaps he missed the classes where they explained the reasons for all the accounting procedures and FASB rules.
 
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