The Fallacy of Regulating Wall Street

[Updated:  One of the readers of this post referenced a related article that has some interesting ideas on how to solve the problem addressed below:  Maybe regulating Wall Street more effectively isn’t a fallacy.  I still contend that the wiz kids will get to work right away to figure out how to manipulate whatever requirements they are presented with whether they are successful or not.]

In December of 2008 I wrote the first of two posts on the Sub-Prime Crisis and have delivered a presentation on the Credit Crisis in 10 cities around the Southeast over the past year and a half.  Preparing for both involved many hours of research and interviewing experts.  “Experts” may be a bit of a stretch, which I’ll explain below, and is one of the reasons for the title of this post.

A frequent question relates to how we can regulate financial markets in order to avoid future crises and my answer is that we can’t which, sadly, I really do believe.  That is not to say that we shouldn’t try to take every step possible to limit market abuses like the ones that led to the credit crisis that started in 2007* but I really don’t think it is practically possible.  In order to effectively regulate abuses out of the market, three elements must be present:  an informed regulating & legislating community that understands the issues, a willingness on their part to make effective changes, and a relatively static market environment (i.e. rapid changes to structure or business practices are not possible).

[*Note regarding the issues that led to the credit crisis:  It can be argued that governmental requirements on banks and mortgage companies created an environment in which banks felt the need to bundle certain “toxic” assets with other assets and sell them to remove them from their balance sheets.  There is certainly some truth to that claim but there was nowhere near enough of this type of activity to cause the credit crisis.  The real culprit was the ridiculous amount of synthetic derivatives that caused the markets to expand and then burst — see previous posts Sub-Prime Primer 1 & 2 for more explanation.]

Back to the three elements……..the first one, an informed regulating & legislating community that understands the issues, is the most critical and without this there is no hope of establishing effective regulation.  If you read Sub-Prime Primer 1&2 and articles like The End by Michael Lewis and books like The Greatest Trade Ever you will quickly realize the dazzling complexity of financial derivatives that were created and the enormity of the market for these derivatives.

When I was first researching the topic I contacted several people who were either at or close to the top of mega-investment firms as well as individuals that had sold synthetic derivatives before the crash to inquire about a few basic questions.  At the time I didn’t know they were so basic because I was just learning about it myself but, in retrospect, these were indeed basic questions and not one of these individuals had any idea what I was even asking nor did they know who to send me to in order to get the answers.  That is not to say that the answers are simple because they are not.  In fact, the mechanics are fairly complex but somewhere I should have been able to find somebody to give at least a modest amount of guidance since these were such huge markets.

I ended up pouring through charts, documents, papers, and other literature to find the answers and when I found them I was again dumbfounded.  Again, these are complicated issues but somebody should have known these answers.  In reading books on the subject later, I came across the same thing again and again — very, very few people actually understood the mechanics and issues involved in a market that generated tens of trillions (that’s Trillion with a “T”) worth of these derivatives……..not the people at the tops of the investment houses and not the people that were selling the derivatives.

If only a handful of people in the world actually understood all of the inner-workings of these derivatives, can we really expect that these issues could be understood by regulators.  And can we really expect that these issues could have been explained to Representatives or Senators in a way that  would allow them to craft effective legislation to limit abuses?  I really don’t think so.

Take the Bernie Madoff case for example which was a relatively straight-forward ponzi scheme.  Some of Madoff’s competitors had reasonably good indications years before his arrest that he was indeed running a giant ponzi scheme and provided regulators with a trail of evidence.  If it took regulators that long to come to the conclusion that Madoff was a criminal how much longer would it take for them to understand much more complex issues like the relationship between synthetic collateralized debt obligations and credit default swaps?

And, again, understanding the issues is just the first step.  The real test is trying to craft regulations or legislation to limit the abuses, which is even more complex.  Even if they had the political will to regulate or legislate the abuses out of the market, it is difficult to envision a situation in which this could happen.  For example, would a legislative bill that on the surface looked like a hindrance to the growth of the housing market be very popular?

As if these first two elements wouldn’t have stopped any attempt to regulate abuses in its tracks, the third element, a relatively static market, would have crushed any attempt.  The fact is that regulatory efforts or legislation take time and Wall Street is far too nimble and creative to stand still while a lucrative market is taken away from them.  They would begin with intense lobbying against any such regulation and even if that didn’t work they would simply innovate and adapt to the new environment.  Effectively, they would just create another world of lucrative opportunities that were yet to be regulated or legislated away and the game would continue.  It is sort of like a game of cops & robbers where the cops are not very effective……..every time they think they have the robbers nabbed they are frustrated to learn that they are already 500 miles down the road and nowhere to be found.

I believe that the lawmakers in Washington that recently recommended limiting Wall Street compensation already know all of this.  I believe they know that they will always be 500 miles behind and that the only hope they have is to limit compensation to the point where the real whiz kids of Wall Street will lose the incentive to take major risks in order to have a chance at millions or billions in profits.

And now Wall Street is hiring “quants” at a greater rate than ever before.  Quants are quantitative types (math whizzes) that are focused solely on numbers & trends.  They really don’t care about creating lasting value or even if the value of an investment goes up or down — they just want to calculate the odds and get on the right side of the trade, whether it is rising or falling.  On the surface, this is nothing new since this type of activity has been going on to some degree since markets were created.

The difference is that instead of the credit crisis sobering up Wall Street and helping it return to fundamentals and sound investing principles, it has done the opposite.  There is a new level of greed that has been created by stories of individuals like John Paulson who bet against the housing market and personally netted $4 Billion and made over $20 Billion for his clients.  The new Wall Street wants to emulate John Paulson and others like him to make their fortune and they are ignoring the fact that many more lost huge fortunes in the last cycle seeking the same thing.  And the game continues……….

As I said in the beginning of this post, the regulating & legislating community has to keep trying to do their best to limit abuses but in reality it is becoming more difficult to do so.  For the every-day investor like most of us, this means we need to stay on our toes more than ever.

As you manage your investments (or manage those that manage your investments), keep an eye on markets that seem to be overheated and avoid the temptation to either buy the “hot” investments or fail to sell certain investments that have had a good run.  Personally, I also maintain a higher level of cash than in the past to limit the downside and to be able to take advantage of future market dips.  Of course, this also limits the upside in a rising market but, with the market volatility of the past couple of years combined with the apparently ineffective regulatory community, I sleep better that way.

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