Tuesday, November 17, 2009

Reflections on the crisis

Here is an interesting take on the financial crisis - a paper from William Sahlman called Management and the Financial Crisis (We have met the enemy and he is us …). It's a broad overview with some unique perspectives. It points out for example how everyone is a "Monday morning quarterback" when it comes to the financial crisis (apologies to our non-US readers for this US style jargon - it just fits).

There have been fabulous new articles about why, for example, ratings on mortgage‐backed securities were flawed. These articles might have been more useful before the crisis rather than after. Academics have also poked holes in various widely accepted measures like Value‐at‐Risk. Again, a little foresight would have been helpful.

This of course is not entirely true, as there were some who sounded the warning bells. This article from the WSJ pointed out how correlation models broke down in 2005 when GM got downgraded. This brought out the dangers in the widespread reliance on models, particular when it comes to structured credit. A publication by Ed Grebeck in Euromoney in 2006 called "Why should Institutions Invest in CDOs at all?" was another warning sign. But the rest - both academia and practitioners alike - were just along for a ride.

William Sahlman points to the fact that regulatory proposals, even sensible ones are not necessarily going to solve the problem in the long run.

Take a simple example of a positive improvement in regulatory policy that would involve imposing higher permanent capital minimums on systemically important financial firms. Those requirements might even be contra‐cyclical – higher reserves required when asset prices are high and lower when times are tough. Increasing the buffer between an implicit Federal guarantee and private responsibility is a good idea – it may lower the likelihood of a panic and of forcing the government to step in. History reveals, however, that increasing the buffer will not stop clever people from figuring out ways to bypass regulated structures and, in the end, put the system back at risk. The rules and regulations become a point of departure for finding unfettered ways to make money and use leverage.

A number of other interesting observations are in this working paper - some a bit controversial. Enjoy.


Hat tip Ed, Bill

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