How could it all have happened – so vast, so disastrous – this subprime debacle?
We argue that advanced rulewriting in the form of one-size-fits-all (OSFA) deterministic regulatory metrics were mischaracterized as a proxy for stability. Policymakers were blind to attendant opportunities for ever smarter game-playing in the regulatory machinery. Much like marching soldiers breaking cadence when crossing a suspension bridge, complex systems needed to counteract fragility by breaking suppression of volatility. The failure to do so led to a catastrophic valuation uncoupling of the real goods and services sector of the economy from the financial sector of the economy that initially foiled, and eventually froze the pricing mechanism causing systemic failure.
What suggests the way to prevent the otherwise inevitable next economic crash is the understanding of the broad arch of randomness—the difference between predictable, risky, and uncertain underlying economic environments. For every product made in the real goods and service sector of the economy, there is a corresponding product created in the financial (“paper”) sector of the economy. Acknowledging randomness, the Parallel Paper Economy[i] provides a pathway for better governing of the reflexive price interrelationship between the real products and financial sectors of the economy.
The financial sector’s capital market difficulties persist and require analysis as to whether problems are the result of either:
- Ineffectiveness that requires doing things differently because of a dysfunctional market that failed to trade as in the subprime and 1987 crashes; and/or,
- Inefficiency that requires doing the same things better because of discontinuous pricing as in the S&L and Dot-comet crashes at the turn of the century.
Einstein said that “insanity was expecting different results from repeatedly doing the same thing.” Yet, policymakers have chosen to do more of the same with OSFA governance trying to overcome conceptual shortcomings by raising the legacy capital market standards from legality to morality by equating failure with fraud. [ii]
Throughout the policy spectrum many have advocated command-driven, governance based on a too-big-to-fail (TBTF) capital structure that enables regulatory scale to trump market forces. The TBTF financial sector strategy is a de facto subsidy because of the implicit government guarantee. But TBTF argues against itself as subsidies create excessive volume (market share) that feed industry giants and excessive complexity (over-engineered products) that beget uncertainty. Thus, the question remains as to how to govern uncertainty more effectively with OSFA deterministic metrics?
Financial sector ineffectiveness caused by OSFA deterministic regulation
Randomness is the range of variability of a complex adaptive system. In determining the degree of randomness, the component parameters of predictability and risk can be bounded whereas the component of uncertainty cannot be bounded with any degree of precision. But uncertainty must be considered. Ignoring uncertainty is done at one’s own peril (See: Beyond Rumsfeld).
The randomness matrix below illustrates how to differentiate risk from uncertainty for the financial sector of the economy. The matrix describes the functional domains of randomness in terms of predictable, risky, and uncertain underlying economic environments. The conceptual construct of financial cash flow and operational pricing is in the upper left corner of the matrix. Its matrix location is designated (A1) for column A, row 1. Binary benchmarks are made up of financial brightlines, (B1) and (C1); and, operational brightlines, (A2) and (A3), that define the boundaries of the determinate and indeterminate randomness.
Why use cash flow and mark valuations as brightline differentiators for indeterminate and determinate domains? They have established accounting precedents.
Investments supported by positive cash flow have greater control over their underlying economic environment. They can: buyback their stock or position their company as a takeover target, merge with or acquire a competitor to reach critical mass, use trade discounts to buy equipment to become a low-cost provider, explore distressed-sale opportunities, issue or increase their dividend, and reduce amount of debt and/or increase debt rating thereby lowering their cost of capital.[iii]
FASB 157 establishes guidelines for fair value accounting to assure objective, arms-length pricing. The statement holds that market participants should include their valuation assumptions. Randomness inherent in a particular valuation technique used to measure fair value should include inputs and assumptions as to the valuation technique.
Positive cash flow
Negative cash flow
· Predictable domain
· Knowable knowns
· US Treasuries
· Risky domain
· Unknowable knowns
· Initial public offerings
· Risky domain
· Knowable unknowns
· Merger & acquisitions
· Uncertain domain
· Unknowable unknowns
· NINJA MBSs
The binary benchmarks of the conceptual construct interact with each other to form brightline boundaries where risk ends and uncertainty begins. Binary benchmark having positive cash flow (B1) cross-referenced with binary benchmark for mark-to-market valuations (A2) enable the price of Treasury securities (B2) to be formulaically determined in a predictable domain (deepest and most liquid) of knowable, knowns. Prices are discovered in the risky domains of initial public offerings (IPOs) and mergers and acquisitions that have either mark-to-market valuations or positive cash flow but not both. Lastly, uncertain issues such as no-money down, NINJA MBSs[iv] have neither mark-to-market valuations nor positive cash flow from which to price investments.
Systemic dysfunctional pricing suggest the need for better organized information. We argue that one-size-fits-all governance needs to be segmented into predictable, risky, and uncertain domains. Unless and until uncertainty is recognized, the randomness of underlying economic condition is a recursive loop that produces in larger and more frequent economic boom-bust cycles.
Financial sector inefficiency caused by regulatory gaps, laps, and naps
Efficiency speaks to the capability to do things right by minimizing the functions of cost, effort, and time. This requires fixing capital market governance:
· Gaps: as in capital market governance omissions,
· Laps: as in governance that is redundant, conflicting, and/or differing, and
· Naps: as in regulatory policymakers not paying attention to market activity.
Gaps in capital market governance require fundamental change. If you want to change the capital markets system, you need to be willing to make real changes. Managing risk and managing uncertainty are conceptually different and require different approaches. With risk, one can insure (i.e. buying put options for portfolio insurance) and one can hedge (Ford and Exxon stocks in a portfolio). With uncertainty, one can insure against natural disasters, but cannot hedge (Ford and commodities). Uncertainty is not bounded.
Why? Determinate and indeterminate prices react to information differently. Without informational correlation, the less robust variance measure of randomness is used instead of the standard deviation. From an investment perspective, Nassim Taleb, hedge fund manager and author of “The Black Swan,” scorns any correlative association because past history can never prepare you for catastrophic failure. Taleb posits that relying on correlation is charlatanism. Similarly, we argue that investor protection is a state-sponsored, rent-seeking scheme where OSFA governance relies upon correlation.
Laps or overlaps create redundancies in jurisdictional responsibility. For example, credit-card products offered by Chase were overseen by one regulator with one set of governance standards, while a virtually identical product offered by a competitor would be overseen by a completely different regulator with different standards.[v] Furthermore, there is a fundamental need to differentiate regulation from rule-writing. Rules are codified best-practice procedures that define operational efficiency. Where were the best practices in SOX or Dodd-Frank? Rule-writing is the proscriptive description of an undesirable situation. It is ad hoc policymaking that Band-Aids over the current problem. It expects buy-in from society by describing the undesirable situation and prefacing it by saying “don’t do this.”
Naps as in policymakers not paying attention to market activity where financial intermediaries made the fundamental error in giving property rights to renters. This happened by extending credit to new home buyers through no-money down, NINJA mortgages. Or by existing home owners using their home equity line of credit as an ATM machine to borrow excessively without realizing that the integrity of their mortgage was being compromised. Mortgagors had no skin in the game. This regulatory “nap” was further compromised when regulators allowed financial intermediaries to raise their leverage ratio from 8:1 to 30-40:1. Such naps altered behavior, leaving regulators unprepared for the crash that was about to occur.
Uncertain MBSs (unknown cash flow and unknown market demand) were later securitized with an AAA-rating. How could uncertain securities receive an AAA-rating? Attempting to cross-manage non-correlative assets minimized the value of both resources (AAA-rated, uncertain MBSs, real estate, Fannie Mae etc.) as the reliability of price information is corrupted. This meant that you could neither cross-sell CDs and bonds as Citigroup tried to do in its financial supermarket, hedge tranches of MBS as financial engineers tried to do, nor regulate risk and uncertainty with one-size-fits-all governance metrics as policymakers have tried to do.
Like Agatha Christie’s mystery “Murder on the Orient Express,” there were no innocents in the subprime bubble. Investors, issuers, and intermediaries speculated and then scrambled to stay ahead of the impending tsunami of bad debt. Policymakers and rating agencies were blind to attendant opportunities for ever smarter game-playing in the regulatory machinery This was not so much the perfect economic storm as the search for the ultimate free ride. The act of giving property rights to renters via no-money down, NINJA mortgages was exacerbated by investment banks given regulatory impunity to become highly leveraged casinos. Societal subsidies such as the tax deductibility of mortgage interest that had been a form of forced savings became a form of forced speculation for teaser-rate mortgages that became wasting assets. Conflating risk and uncertainty enabled the financial contagion to be systemically spread by mischaracterized AAA-rated securities that had unknown cash flow and unknown mark-to-model valuations. What remains in the crash aftermath is deciding the timing and sequence of where to start—will ineffectiveness or inefficiency be the independent variable for restructuring or reform?
Stephen A. Boyko is the author of "We're All Screwed! How Toxic Regulation Will Crush the Free Market System" http://readingthemarkets.blogspot.com/2009/10/boyko-were-all-screwed.html . He has over forty years of financial services industry experience that include formulating regulatory policy for the National Association of Securities Dealers (now FINRA) and providing a practitioner's perspective for the privatization of the former Soviet Union in corporate governance and regulatory development of the Ukrainian Capital Market. Contact: email@example.com
Willard C. Rappleye Jr. has spent a lifetime as a financial journalist. He was the National Economic Correspondent for Time, Editor of American Banker, Founding Editor of Financier, the Journal of Private-Sector Policy, and Vice Chairman of FinancialWorld.
[ii] Note many policymakers are calling for another Pecora Commission. The Pecora Investigation was an inquiry begun on March 4, 1932 by the United States Senate Committee on Banking and Currency to investigate the causes of the Wall Street Crash of 1929. Ferdinand Pecora was the Chief Counsel to the U.S. Senate's Committee on Banking and Currency.
[iv] NINJA is an acronym for “No Income, No Job or Assets and MBSs is an acronym for Mortgage-Backed Securities.
[v] Dimon, Jamie, “A Unified Bank Regulator Is a Good Start,”
Wall Street Journal, OPINION, JUNE 27, 2009, p. A13.
I want to thank the authors for their excellent article for the Blog. They continue to publish articles and books of importance to the financial and regulatory sector. Steve published the book "We're all Screwed!" and has been on active speaking engagements. I am pleased to call him a friend and he has agreed to be an active contributor to the blog!You can follow Taffy Williams on Twitter by @twilli2861 and you can email him with questions at firstname.lastname@example.org. His company website is http://www.ColonialTDC.com and he writes for the local Examiner Paper. He is a member of the group Startup Group on Linkedin. The blog is now listed on Alltop®.