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How could this have happened?
What role did regulation (or delegation) play? What regulations should be enacted in the future? What other lessons are to be learned? Is this the end of capitalism as we know it?
posed the issue to several Colgate professors from a variety of disciplines, as well as alumni with expertise in various aspects of the financial industry, and asked them to share what’s on their minds.
An era of re-regulation?
Professor of Economics
Is this the end of capitalism that Karl Marx had
in mind? Not likely. But this historical moment does illustrate the thesis of a different Karl. In his 1944 classic, The Great Transformation, economic historian Karl Polanyi argues that markets of all types (goods, labor, and financial) generate destabilizing impulses that periodically require state-imposed limitations, often at the initiative of the entrenched business interests themselves. (It was serendipitous that my first-year seminar and I were reading this book just as the financial crisis erupted.) Partial nationalization of the banking sector initiated by a former CEO from Goldman Sachs would not surprise Polanyi, who might ask, “Are we entering a new era?”
This feels like the turning point between two eras. The Reagan-Thatcher era assertion that “there is no alternative” to the market no longer seems tenable; there must be an alternative. We are evidently entering an era of re-regulation, perhaps (I would hope) guided by the principle that the market is a good servant, but a bad master.
One potential victim of the current turmoil may well be the Greenspan doctrine that central banks have no business trying to contain speculative bubbles in stocks, housing, or other assets. Because they are the lenders of last resort, central banks will need to play a larger supervisory role in the financial system that goes beyond managing inflation. The Federal Reserve has been forced to restructure its balance sheet over the last year in breathtaking (well, maybe to an economist) ways, with nontraditional loans to broker-dealers, commercial banks, and even non-bank businesses replacing Treasury securities on its asset side. This is one measure of the depth of the crisis, and could foreshadow a redefined role for the Fed.
The immediate task, however, will be combining monetary and fiscal policies to address the danger that the global economy has fallen into the “liquidity trap” first envisioned by John Maynard Keynes. (In a liquidity trap, traditional central bank interest rate policies lose effectiveness, and need to be supplemented by fiscal policy and nontraditional monetary policies.) Beyond the broad generalization that we are entering an era that combines aspects of socialism and capitalism, it is too soon to say with any certainty what the world will look like on the other side of the current financial and economic turbulence.
— Michl is a member of the Economic Advisory Committee of the Fiscal Policy Institute in Albany, N.Y., and an associate of the Political Economy Research Institute at University of Massachusetts-Amherst. He teaches a course called Growth and Distribution, the topic of two of his books.
Finance as a dynamical system
Associate Professor of Mathematics
Two concepts from mathematics have direct
relevance to recent turmoil in the financial and insurance markets. One, from statistics, captures the “law of averages” that independent random fluctuations average out, but nonindependent ones don’t. The other, from dynamical systems, describes tipping points or bifurcations where small changes drastically affect long-term behavior. These concepts can guide regulation and intervention strategies.
Almost all prediction methods today rely on models of randomness. When random events are independent, they counteract each other. We can thus broadly predict the behavior of groups. For example, to predict life insurance claims, we assume that factors leading to death are largely independent from person to person. Thus, claims can be predicted and premiums set accordingly. This works so often, it is tempting to believe it always works; however, when factors are not independent (e.g., an earthquake), predictions fail. Models assuming independent mortgage foreclosures fail when people act in concert. When Secretary of the Treasury Henry Paulson and Chairman of the Federal Reserve Ben Bernanke were reported as “storming” Congress, demanding immediate action to save financial firms and credit markets, investors acted in concert to remove their money. Nonindependence destabilizes the markets.
Viewing the markets as a dynamical system obeying rules we don’t fully understand provides insight from the complex behavior of simple models. With as few as three variables, dynamical systems can generate chaotic solutions (unpredictable in detail beyond a short time horizon). With more variables, chaos becomes more likely. Simple models show how small changes can move systems toward completely different equilibriums by pushing them over a tipping or bifurcation point. Even in simple systems, long-term behaviors lie dangerously close to the boundary beyond which catastrophic motion drives us to a vastly different behavior. Because these situations arise frequently with simple systems, it is almost certain that they occur in complex systems like financial markets. Some bifurcation points have been identified for global warming, and we should expect them in financial markets, too.
The government is different from other market players because its motives go beyond making money. If the goal is stability and protection from catastrophes, regulation makes sense. It should move markets away from potential tipping points, perhaps by slowing market fear response by restricting short sales of stock. Unfortunately, identifying bifurcations is difficult at best, so funding financial research could be helpful here. Regulation could also encourage independence of events, discourage collective behavior, or intervene when nonindependent events occur. Just as regulation of the construction industry protects against earthquakes and hurricanes, regulation in financial services should help discourage “runs on the bank,” bursting (or building) bubbles, freezing or overflowing of the credit markets, etc. Safety nets could be put in place to reduce damage when nonindependent events do occur.
— Schult studies dynamical systems, pattern formation, and chaos through mathematical models of fire and disease spread. Prior to graduate school for mathematics, he earned bachelor’s and master’s degrees in economics, and he still watches the markets with interest.
Let markets work — for the most part
Associate Professor of Economics
Markets should be allowed to function with minimal government intervention. It is precisely this mantra that governed the oversight (or lack thereof) of the U.S. financial service industry leading up to the crisis that ensued last fall. Basic supply and demand theory would suggest that if markets work correctly, prices of financial assets would incorporate the potential risks and rewards associated with those assets; however, two problems arose with the basic model. First, the financial industry is essential for the world economy to operate, so the government could not let it fail. While the federal government certainly made examples of some (e.g., Lehman Brothers), the majority of financial institutions involved with the meltdown were not allowed to fail for fear of contagion throughout the U.S. and world economies. Second, I believe there was a complete lack of understanding — by consumers, traders, and regulators alike — about the complex ways in which assets were sold, split, and resold. Thus, various aspects of the financial world were connected in ways that were not clear to most participants, until the crisis began unraveling.
As a result of this crisis, the government is more directly involved with the banking industry. And this is unfortunate. If markets would have been allowed to work, by letting more banks fail, the industry may have learned from its mistakes, so that asset prices would better reflect the actual risks and rewards
that they potentially bear. Certainly, allowing more bank failures would have come at significant costs
to society, which was probably not worth it. Now,
the government must deal with the reality of interfering with these markets. Any new regulation should certainly control the extent to which banks are allowed to merge and become too big. The government should also require more transparency about how assets are sliced and diced across the various sectors of the economy. Hopefully, with a little government oversight, financial markets may be able to work again.
— Simpson, whose interests include fiscal policy and immigration, has studied the impact of fiscal initiatives — such as government education expenditures, the Earned Income Tax Credit, and public insurance — on economic growth and well-being.
Photo by Lorenzo Ciniglio
Look for regulated, centralized markets
Keith Goggin ’90
American Stock Exchange Specialist
A staunch advocate of free and open markets, I am therefore of the mindset that less regulation is generally preferable to more. Nonetheless, as a market maker and specialist on the American Stock Exchange for 12 years, I’ve operated successfully in one of the world’s most highly regulated trading environments and have come to appreciate the protections that an effective regulatory structure affords to its participants.
Clearly, additional regulations will spring forth in response to the near-total meltdown of the global financial system. Can we enact rules that are effective but still allow the financial system to be efficient and competitive?
In general, the Self-Regulatory Organizations and the central clearing houses that support and protect the listed markets have performed admirably during the recent turmoil. This is not surprising; these institutions have been tested before, most notably during the October 1987 stock market crash and the near-collapse of the Long-Term Capital Management hedge fund a decade later. Now, once again, the Depository Trust and Clearing Corporation, the Options Clearing Corporation, and CME Clearing have safeguarded the operations of the listed equity, options, and futures markets. Their structure is nothing new. Each is a central clearing organization, set up for use by all qualifying market participants and run both for profit and to protect the integrity of the markets, and their function has remained largely unchanged over time. In contrast, the Sarbanes-Oxley Act, the most significant piece of government regulation to come out of the last financial crisis — when WorldCom, Enron, Adelphia, and other large companies failed due to internal fraud — played virtually no role in preventing the current crisis, proving once again that knee-jerk reactions rarely have a positive long-term effect.
So, what new regulation is likely to, and should, come? Most certainly there will be copious legislative grandstanding and regulatory belt-and-suspendering, the vast majority of which will be misguided and ineffective, along the lines of Sarbanes-Oxley. For example, we have already seen an assault on short selling, a useful, long-standing, and largely market-neutral practice that most economists would argue generally adds to market efficiency and liquidity, but which, when prefaced with the loaded word “naked,” has provided a convenient boogeyman that both the government and the media has used to explain market-driven assaults on financially weak companies.
Another possible area of change could be to the different ways banks and insurance companies are required to value their portfolios for financial reporting purposes. Although the difference in the way these two market participants are permitted to “mark” the securities on their books is well beyond the scope of this commentary, it should be sufficient to point out that this discrepancy played a significant role in the collapse of insurer American International Group (AIG) in the biggest financial bailout to date.
While it would have been unthinkable just a year ago, consolidation of the market for credit default swaps under a common clearing house is also likely, and would be beneficial.
In my opinion, self-interested regulators, not regulation itself, will most effectively protect the interests of the markets and their participants.
— Goggin is a trader at OTA LLC and owner of STR Specialists in New York City. Previously, he was a market maker for the index-arbitrage firm STR Trading Partners and worked in AMEX’s Derivative Securities division. He got his start on Wall Street as a journalist.
Treat the financial system as a public utility
W. Bradford Wiley Professor of Economics
By providing sufficient liquidity, the Treasury’s and Federal Reserve’s combined efforts will be able to restore the functioning of the financial system. But these efforts must be joined with reforms that will reduce the likelihood of a similar financial meltdown in the future.
The financial system collects and mobilizes savings in order to deploy those resources to productive investments. By doing so, it facilitates economic growth and rising incomes. But it does no more than that, and, therefore, it should be thought of as providing a service whose function is to enhance the real economy of production and employment. Indeed, that precisely was the intent that motivated the creation of the Securities and Exchange Commission in 1934.
It is important for financial markets to be deep. Market depth encourages savers to make their funds available. But complexity can lead to dysfunction. The problems that arose when subprime mortgages were securitized did not emerge because those loans were packaged together for sale. The real difficulty was that investors (driven by herd behavior), bought them, although many contained terms and obligations that were literally unintelligible. Government regulators allowed this to go on in the name of enhancing financial market depth and size.
But this — literally — was too much of a good thing. Too many complex instruments encouraged too much risk taking. What occurred boiled down to system-threatening bets being made without sufficient knowledge of the private and public interests at stake.
If in future reforms, the financial system were considered as a public utility, government regulators would examine markets not simply with regard to their traditional concerns of transparency and arms-length deal making. As well, they would intervene when the level of complexity of transactions makes it unlikely that a reasonable assessment of risk can be made. When that threshold is reached, they should aggressively act to remove such securities from the market.
Doing this would mean that financial markets would be constrained to a level below their growth potential. But in doing so, and in treating the financial system as a public utility at the service of the rest of the economy, regulators will reduce the risk that the financial tail will wag the economic dog of the future.
— Mandle, whose interests include economic globalization and the contemporary U.S. economy, writes a monthly editorial column, “Money On My Mind,” that explores the role of private money in politics. His latest book is Democracy, America, and the Age of Globalization.
Restore free credit markets
Michael T. Hayes
Professor of Political Science
Free markets are the most efficient way to allocate scarce resources, including credit. Genuinely free markets are extremely rare, however. What “fails,” in instances like the current financial crisis, are mixed markets featuring a large governmental presence.
As the late Austrian economist Ludwig von Mises observed, government intervention distorts markets, inevitably creating political pressure for more intervention. For example, we have not had a free market in health care for a very long time. The effects of government intervention are not confined to the existence of Medicare and Medicaid, two huge programs. Equally important is the fact that the tax code encourages employers to spend marginal compensation dollars on untaxed benefits like health insurance because a large portion of any money paid to employees goes to the government in the form of taxes. So, the tax code fosters a system in which most private insurance is provided through employers rather than purchased on an individual basis.
Almost no one in either party thinks that this system is working. Many Democrats want some form of single-payer program that covers everyone. While (as of press time), President-elect Obama says he does not want that (yet), he certainly favors action by the federal government to expand coverage. Whatever plan ultimately emerges, the trend is toward more government intervention rather than less, conforming to Mises’s law.
The same thing is happening in the credit markets now. Two government-sponsored enterprises, Freddie Mac and Fannie Mae, have substantially expanded the secondary mortgage market (distortion 1). Government regulators and elected officials have also encouraged the relaxation of normal standards of credit worthiness in order to encourage home ownership (distortion 2). All this takes place within a larger environment in which the Federal Reserve is expected to influence interest rates (the price of credit), and elected officials routinely generate enormous budget deficits, further affecting interest rates through massive government borrowing.
Although some form of government intervention is warranted now to keep the system from imploding, we need to restore free credit markets, not undermine them. While we should do this very carefully and gradually, genuinely free credit markets should be the ultimate aim of our policy. Whatever we do, we should understand that the free market is not what is failing here.
— Hayes, an author of three books who specializes in American politics and public policy, and studies interest groups, incrementalism and policy making, and effects of public opinion on the legislative process, teaches a course called Government and the Economy. He will lead the Washington, D.C., Study Group next spring.
Photo by Lorenzo Ciniglio
Don’t make hedge funds the scapegoat
Dan Gluck ’00
Hedge Fund Manager
Based on what materialized in the markets in 2008, and the resulting often-unfavorable spotlight on hedge funds, many lawmakers have begun to call for more regulation of this “misunderstood” industry. This is not the first time hedge funds have been used as scapegoats and such threats have been issued. In 1998, after the failure of Long-Term Capital Management, representatives of the hedge fund industry were forced to testify in front of Congress. Then, between 2000 and 2002, hedge funds were often blamed for the steep declines in the NASDAQ, and a similar process ensued; however, it was inconclusive that hedge funds posed real systematic risks to the financial markets, and there was little change on the part of government intervention.
What did change was oversight by investors. Before 1998, this relatively new and unregulated industry reported little in terms of numbers, and there was zero transparency. Afterward, although not required by law, most hedge funds started to provide investors with information on holdings, exposure, and returns. So, there was little real regulation, but plenty of self-regulation.
This time around, the current endorsement is of a different and more serious order of magnitude — and government regulation is more likely to result. Politicians and investors are looking for answers (and scapegoats) to explain one of the largest financial crises in history, and the hedge fund industry is ripe for a severe regulatory crackdown. While it is unclear what form of legislation or other regulatory measures will be developed, the likely area of focus will be on trading activity (specifically, short selling), portfolio transparency, taxation of managers, and general compliance and oversight.
While I often lean toward a more laissez-faire approach to economic policy, as a hedge fund manager, I welcome a modicum of government regulation, such as reinstating the uptick rule, stricter enforcement of the ban on naked short selling, requiring hedge funds to register with the U.S. Securities and Exchange Commission, and the reporting of positions on a confidential basis to a regulator. The aforementioned cautionary policies will establish
a more formal protocol for the industry and will
appease policy makers, but will not retard the true spirit of hedge funds — capitalism!
It is essential to remember that companies such as Bear Stearns, Washington Mutual, and Lehman Brothers went under because of poor internal risk management, not because of machinations of hedge funds. Bank shares went down because of over-levered balance sheets and a lack of investment discipline and acumen, not because of hedge fund manipulation. The financial crisis and ensuing company bankruptcies are part of the natural cycle of capitalism, not the product of hedge funds.
— Partner and portfolio manager at Weiss Multi-Strategy Partners, Gluck manages the firm’s $1 billion long/short global real estate securities fund. Previously, he was senior analyst for Weiss’s U.S.-focused real estate fund, which he helped start in 2001, and a capital markets
analyst at the Carson Group, a New York financial consulting firm.
Defaulting for degrees
Assistant Professor of Sociology
The lack of meaningful regulation of the financial industry is clearly a major factor in the country’s economic woes. And, while I believe more governmental oversight is needed, here I will point to other social problems related to this crisis that must be addressed with vigor and imagination once the economy stabilizes.
One clear example is the state of America’s educational system. Much of the attention to the financial crisis has focused on credit markets, specifically the subprime arena, where many bad home mortgages originated. Home ownership has a strong connection to education. Where you live and the value of your home can determine the experiences and opportunities your children may or may not
receive. Disparities in the quality of education within our public schools have produced a situation where Americans scramble to live in what I call “blue chip” neighborhoods — homes with high values and strong infrastructures such as public schools. High demand for these finite neighborhoods raises the access fee, or selling price, and many Americans have been willing to do whatever it takes, including accepting mortgages they cannot handle, to acquire entry.
The resulting waves of foreclosures take a large toll on the public in a variety of ways. Americans who have lost their homes lose a major wealth asset; neighborhoods with more foreclosed homes see wealth draining out as property values of occupied homes spiral downward; then, because property taxes are still the main source of public education funding, less revenue comes into the school system. As the costs of higher education continue to rise, more Americans are stretching themselves even thinner to provide their children a leg up in our ultra-competitive global economy, taking out home equity loans or second mortgages to pay for tuition in order to lessen their reliance on student loans.
One important lesson, then, is the need to support the concept of the public good. Those fortunate enough to send their children to college without incurring major debt, or who live in a “blue chip” neighborhood, have just as much at stake in working toward making higher education more affordable and reducing the gap in the quality of public education. If we fail as a nation to see what our collective responsibility is to each other, then we are more than likely to repeat the mistakes that brought us to our current state.
— Prisock, who specializes in race and ethnicity, as well as political, urban, and economic sociology, has studied the participation of African Americans in conservative social, political, and intellectual movements, and black suburbanization. He teaches a course called Sociology of Money and Markets.
Photo by Timothy D. Sofranko
Tell it like it is
Leslie French Seidman ’84
Board Member, Financial Accounting Standards Board
Don’t shoot the messenger.” It’s safe to say that the Bard did not have an accountant in mind when he penned those words. But just as wartime messengers cringed upon delivering bad news, today’s accountants are trying to deliver a difficult message during a financial crisis. For years, U.S. accounting standards have required that impaired loans and securities be written down to fair value. Yet some organizations have called for the temporary suspension of these standards during these extremely volatile times. They suggest that if they could ignore the current depressed values, and report assets at what they’ll be worth in the future, investors will regain confidence and the markets will recover.
In my view, suspending standards is a short-sighted strategy that would backfire. Japan tried this approach in the 1990s, when the government made a policy decision to postpone the write-down of bad loans. Many economists believe that practice kept investors in the dark and prolonged the stagnation under which Japan suffered. More recently, the London-based International Accounting Standards Board, under pressure from the European Commission, softened the accounting for impaired loans and securities. The few European banks who took advantage of the change were sullied in the financial press. Investors quickly saw through the accounting gimmick and chastised the standard setter. Investors are aware that losses exist: the best way to restore confidence is for the companies who have losses to report them clearly and in a timely fashion.
These previous episodes both involved political influence in the standard-setting process. In the United States, the Securities and Exchange Commission has statutory authority to determine accounting methods for public companies, but for decades it has delegated that responsibility to the Financial Accounting Standards Board (FASB), which is a nongovernmental agency. Having an independent standard setter is important to investors, so that the markets receive consistent, objective information, even when administrations and their policy agendas change. As the U.S. financial crisis emerged last fall, the Securities and Exchange Commission urged FASB to enhance any standards that weren’t providing useful information to investors, such as disclosures about complex derivatives and securitizations. This form of governmental oversight is appropriate, and distinctly different from pressure to change rules in order to achieve a desired outcome. However, it is likely that special interests will suggest, through the Treasury blueprint for regulatory reform in the United States and the G-20 Summit discussions, that accounting standards should be set by the government, rather than an independent agency such as FASB. The investing public should be wary of allowing politicians, who are potentially influenced by powerful lobbies, to decide how financial information should be presented to the capital markets. For the markets to function effectively, we need the messengers to tell it like it is, not tell us what they think we want
[The views expressed in this article are my own and do not represent positions of FASB. Positions of FASB are arrived at only after extensive due process and deliberations.]
— Seidman was appointed to FASB in 2003. Previously, she was a financial reporting consultant, and a vice president of accounting policy at J.P. Morgan. She started her career as an auditor with Arthur Young & Co.
All photos by Andrew Daddio unless otherwise noted
Economics professor Nicole Simpson discusses more of her thoughts about the financial
crisis in the Colgate Conversations series at
What regulations, if any, do you think are
needed to restore the economy? Discuss at