Thursday, September 18, 2008

The brain drain and the financial crisis

While almost every economic or financial blogger has given his opinion on the current financial troubles, I have resisted because I do not think the consequences of the crisis are a s large as the press suggests. Recent events seem to precipitate the financial crisis, which does not yet means this would lead to a recession. However, the current alarmist tone teases me to react.

First, at this point the economy is sound. The financial sector is a mess, but the rest of the economy is remarkably resilient to what is happening. This may not last as credit is the lifeblood of entrepreneurship, and if this situation lingers for another year or so, we may get into a Japan-like slump. But we are not there yet. And if there is a longer lasting credit crunch because the US banks cannot lend, there are plenty of others, in particular in the Middle-East, that are flush with cash.

Second, the problem is not a lack of oversight or regulation. The institutions that are in trouble are all regulated institutions. Those that are not regulated are doing fine, for example hedge funds. If there is a lack of something, it is that various federal agencies should be intervening, not the Federal Reserve.

Where I think I see a problem is in terms of misplaced human capital. There are bright people in the financial world, but also some not so bright ones. Among the latter are people who learned to work with recipes and pre-established rules and cannot adapt to new situations. The bright ones have gradually moved to where the money is: hedge funds. This leaves investment banks, banks and in particular regulators lacking. This explains the incredibly stupid decisions we have seen, like developing the sub-prime market, venturing into markets investors did not understand. For example, Lehman Brothers is currently not able to price some of securities it holds. It bought only because it could sell them further. Call that a bubble.

This crisis will thoroughly shake the financial industry. It is showing who is really competent. It is in times of war that the real leaders emerge. But clearly regulators are not emerging as leaders here. And one should not expect them to be. They do not have the resources to stay ahead of the financial institutions. The answer to the crisis is not to increase (poor and poorly enforced) regulation. Rather, give more liberties (with proper disclosures) to regulated institutions, thus letting them get better returns and attracting back talent that understands the business.


Anonymous said...

You are essentially right. I would add that the Bush Administration and Capitol Hill have been asleep at the wheel as well. This is why the Fed has to intervene in lieu of the true regulatory agenices.

hoopster56 said...

I have found it quite difficult to get real information on what is causing the actual problems. For example, when Bear Sterns failed, people talked about the stock taking. I could not see what that had to do with the firm going into backruptcy. Finally, months after, a Fortune article filled in the missing pieces. Bear had leveraged themselves about 35 to 1 and borrowed money in very short term increments. THe article indicted that over half of their capital was borrowed at periods of less than 1 week.

I assume that Lehman Brothers problems were similar, but I have not yet seen any clear data.

It is my understanding that all of these banks have some level 3 assets on their books. These kinds of assets may be unusual in the financial world, but have always been common in other areas. It is one of the flaws of the mark to market idea. For example, what is the value of some peice of commercial property? It will swing wildly depending on demand and supply. It is not that you should not have them, you just need to be sure that you don't have to sell in a valley.

It appears to me that Lehman's business model did not vary much from a hedge fund's.

Anonymous said...

Hoopster56: Lehman and hedge funds may have a similar business model. But Lehman is regulated and thus constrained in its actions. Your observation would mean Lehman was brought down because of regulation.

Anonymous said...

You are right, the economic basics are OK, in Europe and more or less in the States. What forses are behind the financial crisis? Who is the leader of all these developments?