Long post by Mark Thoma, but important in understanding what's going on in the financial markets right now. He begins with a quote from Fred Block on how Reaganomics led to today's crisis. Essentially, Reagan reduced financial regulation and cut taxes for the wealthy (and if that seems familiar, George W. Reagan Jr. has continued this process). The rich took a lot of this new big money and put it in investments with big returns, the most famous of which are hedge funds (unregulated investment companies that are restricted to big-ticket investors, are mostly housed offshore as a tax dodge, and pay their CEOs remarkably well, as much as $1.5 - 2 billion dollars a year).
Now, we had some warning that hedge funds do not inevitably work, as we saw in 1998 when Long-Term Capital Management lost more than $4 billion in four months. Nonetheless, other financial institutions got jealous and wanted to get in on the act; two things happened, some institutions invested in these funds, others set up their own. Understand, the risk of these things is huge, and there is no regulatory body insisting on any kind of transparency or oversight. So when your pension fund invests in a hedge fund, it's taking your future and putting it on the roulette wheel in Reno.
One problem with a hedge fund is that it needs a constant expansion of markets in order to compete. If one hedge fund discovers that trading in Kazakh uranium futures can generate high returns, it doesn't take long for other hedge funds to spill into Kazakhstan looking for their cut, and the returns drop. (This is analogous to what happened in commercial banking in the 1980s. I was working in the industry then, and I saw envious commercial bankers try to emulate the investment banks by jumping into complicated swaps and the like. Of course, they didn't have quite the expertise, and everyone did the same thing, so they got nothing like the high margins they were expecting. That was one of the reasons for the bad results for banks in the late '80s.)
So someone had the bright idea of using subprime mortgages as an investment vehicle. These are mortgages that are given to people who really can't afford them but are willing to pay a high interest rate. And there's no risk to the lender, because house prices rise infinitely, meaning the worst that can happen is that it will end up with a high-value house in the portfolio instead of the mortgage.
But housing prices don't rise infinitely, and the securities that were based on these mortgages turned out to have very little value after all (you see, the hedge funds and investment banks don't buy mortgages, they buy bundled mortgages, packets of high-risk mortgages that magically become low-risk after bundling - no one knows exactly how). As Block says, "The right-wing experiment with free market orthodoxy has been a complete and total failure."
There is, thus, talk of regulating these currently unregulated investment companies, but very little confidence that will happen effectively. The Bush administration still seems reluctant to support any structural changes (it's easier just to roll out short-term programs that sound good). Thoma:
There is an Econ 101 foolishness to our executive branch, believing that tax cuts always bring more government revenues and that the above quote is wrong. Of course regulations hamper the working of the market, all the business leaders tell us so. Managers of regulated mutual funds do OK, but they don't make anywhere close to the income of even a mediocre hedge fund manager. And in a world in which wealth is taken as a proxy for wisdom and public-mindedness, the incentive is to let the geniuses do what they want.
Thoma goes on to talk about the kind of regulations that would improve financial markets: increasing available information, increasing capital requirements, basically "rethink[ing] the whole operation." He then provides a couple more quotes on how regulation might prevent the capital markets from freezing in the way they apparently have now.
However, until we understand politically how to create a true level playing field, which we'll do only when we stop allowing large institutions to write our laws, we're unlikely to achieve the results Prof. Thoma and the others quoted here believe are possible. Do you really trust the Bush administration to do a 180, start believing in regulation, and implement public-friendly policies? Or will they allow industry insiders to create regulations that seem like action, but will perpetuate, if not enhance, existing inequities? I know how I'd bet.
Now, we had some warning that hedge funds do not inevitably work, as we saw in 1998 when Long-Term Capital Management lost more than $4 billion in four months. Nonetheless, other financial institutions got jealous and wanted to get in on the act; two things happened, some institutions invested in these funds, others set up their own. Understand, the risk of these things is huge, and there is no regulatory body insisting on any kind of transparency or oversight. So when your pension fund invests in a hedge fund, it's taking your future and putting it on the roulette wheel in Reno.
One problem with a hedge fund is that it needs a constant expansion of markets in order to compete. If one hedge fund discovers that trading in Kazakh uranium futures can generate high returns, it doesn't take long for other hedge funds to spill into Kazakhstan looking for their cut, and the returns drop. (This is analogous to what happened in commercial banking in the 1980s. I was working in the industry then, and I saw envious commercial bankers try to emulate the investment banks by jumping into complicated swaps and the like. Of course, they didn't have quite the expertise, and everyone did the same thing, so they got nothing like the high margins they were expecting. That was one of the reasons for the bad results for banks in the late '80s.)
So someone had the bright idea of using subprime mortgages as an investment vehicle. These are mortgages that are given to people who really can't afford them but are willing to pay a high interest rate. And there's no risk to the lender, because house prices rise infinitely, meaning the worst that can happen is that it will end up with a high-value house in the portfolio instead of the mortgage.
But housing prices don't rise infinitely, and the securities that were based on these mortgages turned out to have very little value after all (you see, the hedge funds and investment banks don't buy mortgages, they buy bundled mortgages, packets of high-risk mortgages that magically become low-risk after bundling - no one knows exactly how). As Block says, "The right-wing experiment with free market orthodoxy has been a complete and total failure."
There is, thus, talk of regulating these currently unregulated investment companies, but very little confidence that will happen effectively. The Bush administration still seems reluctant to support any structural changes (it's easier just to roll out short-term programs that sound good). Thoma:
Regulations can make markets work better, so it's not clear to me why those who believe in the power of markets have such a knee jerk reaction against any kind of regulatory oversight.It may not be clear to Professor Thoma, but, to anyone who has watched the Bush administration for eight years, it is all too obvious. Simplistic ideas have ruled this president and his people, whether it be in foreign policy ("we will be greeted as liberators") or in domestic policy.
There is an Econ 101 foolishness to our executive branch, believing that tax cuts always bring more government revenues and that the above quote is wrong. Of course regulations hamper the working of the market, all the business leaders tell us so. Managers of regulated mutual funds do OK, but they don't make anywhere close to the income of even a mediocre hedge fund manager. And in a world in which wealth is taken as a proxy for wisdom and public-mindedness, the incentive is to let the geniuses do what they want.
Thoma goes on to talk about the kind of regulations that would improve financial markets: increasing available information, increasing capital requirements, basically "rethink[ing] the whole operation." He then provides a couple more quotes on how regulation might prevent the capital markets from freezing in the way they apparently have now.
However, until we understand politically how to create a true level playing field, which we'll do only when we stop allowing large institutions to write our laws, we're unlikely to achieve the results Prof. Thoma and the others quoted here believe are possible. Do you really trust the Bush administration to do a 180, start believing in regulation, and implement public-friendly policies? Or will they allow industry insiders to create regulations that seem like action, but will perpetuate, if not enhance, existing inequities? I know how I'd bet.
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