Mittwoch, Oktober 01, 2008

Subprime Solutions...

We've had an interesting couple of days, to put it mildly.

When the House rejected the rescue plan - I'm still digesting that one and will comment on that later - the markets went south in a hurry. That's exactly what I expected, but I didn't expect the day after.

The markets went back up.

Market liquidity is not the problem (as it had been in The Great Crash: leverage there was so high that when margin calls were placed, the system convulsed).

The political commentary has been poor: even such sages as Martin Wolf continue to say "We are watching the disintegration of the financial system".

I say: balderdash.

What we are seeing is a market correction. Companies that made investment errors - Lehman Brothers and others - are being sanctioned and punished for losing sight of why you do risk management: not to be in the way of investments and profits, but rather to learn what the market risks actually are and to make a decision that is based not purely on the bottom line, but one that also includes real risks.

This is the problem when you have accountants and lawyers making investment decisions: over time, the only thing that matters is the bottom line.

You need good economists and right and proper investment advisers - above all: independent - to make those decisions based not merely on the bottom line, but also in the risks involved. Dismissing risks because they don't happen at first is foolish at best and criminal at worst, because, given the kinds of investments made, having the worst-case scenario come true once will destroy you.

But this post is on subprime solutions.

There are four things that need to be done in the wake of this crisis that will help ensure that it does not arise again (and failing to ensure that is sheer stupidity):

1) repeal the CRA and eliminate all additional subprime loans immediately. If you want to do some social engineering, then subsidize directly, not by gaming the system;

2) closing of Fannie Mae and Freddie Mac over a 10-year period. These institutions cannot, effectively, be reformed, but have a mind set that has proven to be toxic;

3) government guarantees may not be politically influence If such a guarantee is given to some sort of follow-on mortgage guarantee trust, that organization's leadership may not be chosen politically, but rather solely on the basis of technical competence. This needs to be written into the bylaws of whatever legislation is proposed, and the head of such an organization must be chosen much like the Fed Chairman is chosen;

4) no government-approved rating agencies. These agencies bear an enormous responsibility for the mis-allocation of capital based on fundamentally erroneous ratings, and part of the problem was that they operate as an oligarchy, without adequate competition.

This is, obviously, not comprehensive, nor does it address any sort of loss compensation for the banks or investors.

Nor should it: risk has to be resurrected for what it is. You can insure against risk: that's what insurance companies do. You pay for this. You cannot, however, remove risk: that is what at least some of the derivatives claimed to be able to do, and there is a simple rule that can be learned here: You Cannot Remove Risk.

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