Most people reading this blog already know that what has happened last week and over the weekend with the bankruptcy of Bear Stearns and Lehman, bailouts of AIG, Freddie and Fannie, the sale of Merrill Lynch, and the capitulation of Goldman and Morgan Stanley as independent investment banks is the stuff of financial history legend. Students and academicians will be studying these events for the next hundred years, much in the way the Great Depression of the 1930's in the U.S. and other financial crises in other countries are still studied all over the world, looking for reasons and insights and more importantly how to NOT let them happen again.
The Wall Street Journal published an op-ed piece this morning by L. Gordon Crovitz that displayed a startlingly insightful, and yet simplistic, view into this that sliced right to the heart of the issue. And it sliced into the patient's heart from an angle that previously had not been used.
All of the stories that I've seen have reiterated the same general story of "lack of federal regulations led to unfettered corporate greed". There are offshoots to this story around "overly complex financial instruments" and "too big to fail" and other topics.
To me (and obviously to L. Gordon Crovitz), these are all secondary issues. The primary issue is that the global free market failed to properly account, over time, for the balance sheet risk in the stock and bond prices of the entities that held these mortgage-backed derivatives. It is BS that their risk was too complex for anyone to understand. If smart people could create these instruments then other smart people could decode them and understand their risks. Maybe not overnight after massive, inter-locking positions have been built up, but they certainly could have been understood over time as the positions were being built up over a multi-year period.
If the risk of these entities had been properly understood as the riskiness of their balance sheets increased over time, the free market would have driven their stock and bond prices appropriately lower over time, SMOOTHLY. The management of these companies would have reacted appropriately to their lowered market values, and would have reduced the riskiness of their balance sheets (again, slowly and smoothly over time) in order to bring their market values back up.
But this did not happen? Why not?
As Mr. Crovitz posits, it's because the Eliot Spitzer led charge against the Wall Street research analyst industry in 2000 removed a fundamental governor to the system. It is the job of the Wall Street research analyst to do "investigative reporting" into the health of public companies. In late 2000, several regulations were enacted that made it much harder, and much less attractive, for research analysts to perform high-quality investigative reporting on the public companies that they follow. This post is not to get into how, why or what these regulations were, but suffice it to say that while they may have been well-intended, we now see that they may have led to horrible unintended consequences.
In 2008 there are less than half the number of research analysts that were on Wall Street in 2000. The need for high-quality investigative reporting into public companies did not diminish, and the people that could do that job the best took jobs with hedge funds, but I'm sure that it slowed the number of smart, young people wanting to become research analysts to a trickle.
I'm also quite sure that many of the ex-research analysts turned hedge fund manager were pounding the table internally at their hedge funds (for months and probably years) screaming about how the stock and bond prices of these entities did not properly reflect the riskiness of their balance sheets, and pushing the fund to take huge short positions. Kudos to them because those that did take short positions collectively made their investors billions in profits in a few short weeks.
But those insights were concentrated into a small number of equity long/short hedge funds that focused on the financial services sector. Those insights were not widely dispersed to the general market; in fact the hedge funds are motivated to keep their proprietary information closely guarded and no matter how "right" they think they are they do not want to take too large a position because it could move the market and eliminate their ability to profit from the information disparity.
If high quality public company research had been done at the Wall Street investment banks, in effect creating more "table pounders" and keeping them at a (investment banking) platform that allowed, and encouraged, them to scream at all market participants in a very public way, the free market system may have functioned as it was designed, i.e. smoothly moving prices up and down and compelling management teams to take actions that properly align risk potential with return potential.
This gets to the title of Mr. Crovitz's op-ed piece: Information Haves and Have Nots. That is absolutely the right title for this concept. By chopping down the Wall Street research analyst function (causing it to be re-planted at the closed-information hedge funds), it created a smaller number and more concentrated set of "haves" containing information on the appropriate prices for the entities that held exposure to mortgage-backed derivative risk. The vast majority of market participants became information "have nots".
We will now pay the price for that information disparity for years and possibly decades.
Moral of this story: Be aware of the unintended side effects of even the best-intended regulations.
