Tuesday, October 20, 2015

The Rules and the Game

We are winding our way towards another insufferable presidential election cycle. Financial regulation is always one of the topics under discussion. Expect to hear a lot of simplistic nonsense from our candidates. However, there will be another crisis sometime in the future, perhaps the equal of the slow motion train wreck that started with the housing bubble and subprime crisis in 2006 and ended in the crash of 2008-2009. Then Congress will pass some sort of financial reform package to avoid the mistakes of the past. Inevitably the new law will contain the seeds of the next crisis.

We, the American people, ultimately elect the committees that make the rules. Then the market plays the game. Sometimes the outcome is unexpected and undesirable. It isn’t the market’s fault.

It didn’t make the rules.

Consider the National Football League. Without a rules committee overseeing professional football, my favorite game would quickly turn into a blood sport that would be promptly outlawed. The owners want continued and increasing profits. The players want a game that is profitable and reasonably safe. The fans want a game that is fun to watch. To achieve these ends, the competition committee, a blue ribbon panel of respected managers and coaches are constantly watching the games and tweaking the rules. They know the fans want to see touchdowns, particularly passing touchdowns, but not a game without defense, like professional basketball. The fans and the owners don’t want to see their favorite players recovering from injuries during the season. Every time a rule is modified it changes the game, sometimes in unexpected ways.

Human ingenuity is quite remarkable.

“Why both Clinton and Sanders are Wrong About How to Fix Wall Street,” an article written by David Dayen, explores some options that could lead to a simpler, less coupled financial system starting with the reinstatement of the Glass Stegall law that put a firewall between investment banking and commercial banking. Many believe that the repeal of this law contributed to the liquidity crisis of 2008 that almost brought down the world’s banking system. The author considers this a good idea, but certainly not a fix to an enormously complex and interrelated problem. He prefers ideas found in a book entitled Other People’s Money written by John Kay a professor at the London School of Economics that borrows concepts from systems engineering.

Consider the electo-mechanical switch that controlled your old wall phone. Banks of these switches, one for each phone number, were once housed in little brick windowless buildings located in every town and neighborhood throughout our land. By the early 1990s these switches had been replaced by complex computer systems that could simultaneously control tens of millions of phones all over the country. The new system was faster, more reliable, and less expensive to operate. However, when it failed, it failed spectacularly. One of these “computer switches” failed, wiping out all long distance service in the Eastern United States for about twelve hours. If one electro-mechanical switch fails only one phone is affected.

Computer trading has been a godsend for the average investor, lowering the cost of buying and selling stocks from over $100 per transaction to just a few dollars per transaction. It has also created a monster, high frequency trading, a parasitical practice that buys and sells shares on minuscule movements allowing the computer program to skim tiny amounts, sometimes less than a penny a share off the profits of “real buyers and sellers” by holding those shares for only a few seconds.

In the most recent housing crisis, the Government pressured the banks to make loans to low income households that could not reasonably be expected to ever be repaid. The Government also provided funding and guarantees to encourage this activity. The banks bundled up these loans into “synthetic” packages that included a certain number of mortgages that could be best described as toxic waste. The Government controls the number of rating agencies tasked with grading these kinds of securities. These companies were charging banks higher rates to receive higher ratings on their securities, essentially a bribe. These “bonds” were then sold to unsuspecting customers who actually believed they were buying a AAA security. It gets worse. Insurance companies were selling policies on European bonds to people who didn’t own the underlying securities. Imagine if some stranger could buy an insurance policy on your life? The insurance companies were even selling insurance policies on these insurance policies, ad infinitum.

When the whole mess came unraveled, the bankruptcy courts couldn’t determine who owed what to whom. In many foreclosures, it wasn’t at all clear who owned the mortgage. Basically, while staring into the maw of abyss, the world’s central banks started printing money to buy up all this toxic waste and inject liquidity back into the system. The taxpayer and his grandchildren’s children are ultimately on the hook for their actions.

The “too big to fail” banks were saved by the taxpayer. The poor lost their homes. Their credit ratings now reflect these foreclosures. It is unlikely they will ever be able to buy another home. For the first time ever, large investment houses bought up large numbers of single family homes for rental properties. In some netherworld of the damned reserved for famous film villains, Henry Potter is smiling.

What if “too big to fail” banks were broken up into their component pieces, allowing them to continue doing business as separate, unconnected financial entities? What if local banks were expected to hold the mortgages they write for the entire term of the loan instead of packaging and selling them as secondary financial products? What if these banks could only buy insurance on mortgages they actually hold? What if our tax code was simplified? What if we removed perverse incentives from our corporate tax code that rewards bad behavior? Excreta. Excreta.

All these topics should be discussed by mathematicians, game theory experts, system analysts, economic professors, and the men and women who actually play the game. Simplistic sound bites offered by manipulative politicians preaching blood and soil to energize their base isn’t enough to address these very important issues.

Remember, the rules will determine how the game is to be played.

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