THE FUTURE OF FINANCE BLOG

Financial Collapse: It’s Only Natural

November 14, 2011

What does the collapse of MF Global, the Euro crisis, the sub-prime mortgage crisis, the collapse of Fannie Mae and Freddie Mac, and the 1998 collapse of Long Term Capital Management all have in common? Certainly these crises all shared the following characteristics: too much leverage, lack of transparency, inadequate regulatory oversight, agency problems of misaligned incentives, and failures of leadership at the very least. This is what we know, and we’re frustrated watching inadequate public and private sector responses to these problems. Viewed through a natural systems lens these debacles can be seen with a new clarity. We see a system architecture and accompanying ideology that is the cause of these repeated failures. Only by understanding systemic design failures rather than simply reacting to problems do we find the path to real solutions. As a paper by monetary expert Bernard Lietaer and natural systems scientists Dr. Robert Ulanowicz and Dr. Salley Goerner nicely details, a critical balance between efficiency and resiliency defines a sustainable natural system. We would be wise to look at the financial system, and the monetary system, through such a systems lens, as Andy Haldane of the Bank of England is increasingly doing. The important message is that a system can become “too efficient.” In the process, it becomes brittle and breaks. The financial system and monetary system architecture of today is woefully skewed toward efficiency. Why? Because the relentless drive toward “efficiency” is the prevailing ideology of our economic thinking. This ideology seeks to “optimize growth” at an aggregate level, and optimize profits at the micro level. Until it breaks. The conventional wisdom is that Long Term Capital Management failed because of a “black swan” event, a once in a thousand years flood that the brilliant academics and traders had no way to predict. Wrong. LTCM failed because it deployed a highly efficient capital structure (lots of leverage) to speculate on a series of supposedly “low risk” mean reverting trades. What it lacked was a resiliency-enhancing buffer in the form of significantly more equity capital, which would have rendered those trades marginally profitable at best. Such an approach would have been viewed as “inefficient” if the expected scenarios had played out, but the unexpected happened. Consequently, LTCM, devoid of resiliency, had to be rescued by a consortium of exposed banks. But unlike government bailouts, the banks virtually wiped out all the LTCM equity holders (and partners) in the process. Bailouts should not be pleasant. (Full disclosure: I represented JPMorgan on the Oversight Committee in charge of winding down the fund.) Similarly, Fannie Mae and Freddie Mac were models of “efficiency.” Centralizing and standardizing US mortgage-backed securities introduced tremendous efficiencies into the process of originating and distributing home mortgages. Higher growth of the real estate market and lower costs for borrowers were the result of this efficiency. However, when the market hit a shock, that same efficiency revealed a catastrophic lack of resiliency. “Less efficient” but more resilient home mortgage markets such as Canada’s and Germany’s were much better able to weather that shock. The securitization process itself, dangerously extended to the sub-prime market in the United States, is a perfect example of efficiency coming at the cost of resiliency. Today, the same “efficiency” that enabled the market to grow so spectacularly, enriching fraudulent bankers in the process, makes it virtually impossible to manage large-scale mortgage renegotiations because you literally can’t find the person to negotiate with. A more resilient system, where relationships remain between creditor and borrower, would be better able to recover from the shock that turned into collapse. Which brings us to MF Global. This still unfolding story is so appalling for so many obvious reasons, I’m not going to comment beyond pointing to the pursuit of “efficient” leveraged speculative profit at the expense of the resiliency that comes with a prudent balance sheet and segregated customer accounts. Thousands of employees are now on the streets while the problems continue to mount, while Corzine rightly becomes the new poster child for OWS, managing to take down a firm that traces its roots to 1783 in about a year and a half. Looked at through the natural systems lens, the Euro crisis looks even more sobering. The Euro was an experiment grounded in a blind faith in the supremacy of efficiency, in this case the “efficiency” of a common trading block and the free flow of goods and people across boarders in a unified Europe. Far too little thought was given to the system’s lost resiliency, the ability of exchange rates of “inefficient national currencies” to adjust to changing macro economic circumstances. The once unthinkable disintegration of the Euro zone now looks increasingly likely as Italy follows down the path of Greece, locked in a box with no way out. What are the lessons for financial system architecture? Build resiliency at the expense of efficiency. Promote decentralization over centralization. Break up the too big to save banks. Massive diversification must be encouraged among financial institutions, not within them. Buffers need to be materially increased, not incrementally as now proposed by Basel III—which means aggressive hikes in capital requirements, harder limits on funding mismatches, aggressive hikes in margin requirements on futures exchanges and on over-the-counter derivatives exposure, and a Financial Transactions Tax on securities trading. More not less currencies should be used to facilitate the essential feedback loops of our highly complex global economic system. In short, we need to turn 180 degrees from the path we have been on for 25 years. Here’s the rub: The financial sector in general will become smaller, more diverse, and less profitable in normal times, putting pressure on employment and compensation, shifting resources back into the productive real economy, and leaving the financial system more resilient in the process. It will be a system better able to recover from the economic shocks that undoubtedly still lie ahead. In short, finance must be returned to its true purpose: a sustainable system that serves the needs of the real economy rather than seeking to be master of it. Naturally.–John Fullerton, Founder and President, Capital Institute

Comment<Back