Shining Light on Our Financial Markets
It's so crazy it just might work...
The great Peruvian economist Hernando de Soto has argued that the financial crisis originated in a failure of markets to do their work: refining price information into clear usable form.
Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of everyone's property. ...
Property is much more than a body of norms. It is also a huge information system that processes raw data until it is transformed into facts that can be tested for truth, and thereby destroys the main catalysts of recessions and panics -- ambiguity and opacity. ...
The only paper representing an asset that is not centrally recorded, standardized and easily tracked are derivatives.
Writer Richard Vigilante and mortgage trader Andrew Redleaf have written a powerful, accessible, witty book about the mortgage crisis that develops de Soto's idea from the perspective of market users: Panic: The Betrayal of Capitalism by Wall Street and Washington.
I assigned the book to review to a friend of mine here in the Washington area who writes and trades mortgages for a living. Here's what he had to say about Panic:
[W]hat made this latest crisis catastrophic and inevitable, the authors argue, is that the regulators (and ratings agencies) all believed the same assumptions. Innovation of financial instruments and corresponding accounting practices outpaced the regulatory frameworks in place to monitor and prevent systemic failure. The result was that regulators (and most Wall Street analysts) reached the same conclusion as the banks themselves – that risk was sufficiently spread around to accommodate any major shocks. We know that to be true because the models said so.
In the Corner today, Vigilante and Redleaf offer an amendment to the current financial reform package that would go far to address the central flaw diagnosed by themselves and de Soto. They urge: require banks to publish every trade and every position after a short lag, say 5 days. That's enough time to protect them from having their ideas stolen by competitors, but it would enable market outsiders to assess the banks' and investment houses' solvency independently - and to sell short right any the stock of any company that even begins to acquire excess risk.
[T]he way to get better markets is to give them better information. Markets failed two years ago because for many years, markets were denied the information they needed to make good decisions, to separate good mortgages from bad, good banks from bad, and shift capital accordingly.
For too long, American banks have operated in the shadows, their inner workings hidden not from regulators (who have an invincible legal right to examine every line in the banks’ books) but from citizens and investors. That’s why we have proposed the one truly radical reform that would have prevented the both the mortgage crisis and the crash and would do far more to prevent future catastrophes: Require every significant financial institution in U.S., every firm managing other people’s money, to disclose every investment position, every asset, and every liability every week, between market close on Friday and market open on Monday morning.
We don’t mean mere accountants’ summaries. We mean the raw data. Every stock, every bond, every long, every short, every hedge, every swap. All of it. Collectively millions and millions of lines of data.
At first it would be too much data even to be useful. But as the short sellers and curmudgeons, the rag-and-bone shops of the financial world, gradually absorbed the data and constituted massive parallel-processing systems over months and years, we bet the result would be an early-warning system that would run rings around the regulators and do far more to keep the banks on the straight and narrow than any grand high council or regulatory poo-bahs.
This is a good and important idea - and I hope the gathering fog of disrepute that is accumulating over NRO will not blind the larger value to the good things that do sometimes appear in that space.