The Economist

"Greed - and fear", The Economist, 1.24.2009, special feature

Financial transactions are a series of promises. You hand your money to a bank, which promises to pay it back when you ask; you invest in a company, which promises you a share of its future profits. Money itself is just a collective agreement that a piece of paper can always be exchanged for goods or services. [4]
Reform is certainly needed, yet, for all the excesses and instability of finance, a complete clampdown would be a mistake. For one thing, remember the remarkable prosperity of the past 25 years. Finance deserves some of the credit for that. Note, too, that finance has always been plagued by crises, whether the system is open or closed, simple or sophisticated. Attempts to regulate finance to make it safe often lead to dangerous distortions as clever financiers work around the rules. If there were a simple way to prevent crises altogether, it would already be the foundation stone of financial regulation. [4]
[ignorant, Milton Friedman sychophant, economist idiots!]

"Wild-animal spirits", The Economist, 1.24.2009, special feature

These are bets, remember: if the punters are down, the bookies are up by the same amount. In the jargon, the claims 'net to zero'. That sounds safe enough. Yet the winners and losers behave differently. The winners' extra spending may not offset the losers' retrenchment. And the losers may not be able to afford to pay out, either because they do not have the money - they are insolvent - or because they cannot easily raise the money - they are illiquid. This 'counterparty risk', which grows with the volume of bets, has been the outstanding feature of this crisis. [6]
The more efficient the financial system, the faster fear will spread. [8]
In the booming American housing market mortgage originators were happy to accept no security at all, lending 100% of the value of the house - partly because they though house prices woudl continue to rise, and partly because they assumed the market would be liquid enough for them to palm the mortgages off on other investors. As it happened, the mortgage originators were wrong and the loans that were stuck on their books helped destroy their businesses. [8]
[they had a huge financial incentive to risk being wrong, especially when liability for bankruptcy does not pass to owners]
If it is hard to stop booms once they are in full swing, it is no easier to prevent them from starting in the first place. Hyman Minsky, an unconventional economist who made it his life's work to study crises, was convinced that they arose spontaneously. Financial stability itself creates confidence and risk-taking eventually leading to recklessness and instability. After the bust, stability will return and the cycle will begin again. Similarly, David Roche and Bob McKee, of Independent Strategy, an investment consultancy, among others, think credit started flowing more easily in teh 1980s because the rich economies conquered inflation and the large emerging markets embraced globalisation. [10]

"In Plato's cave", The Economist, 1.24.2009, special feature

Modern finance may well be making the tails fatter, says Daron Acemoglu, an economist at MIT. When you trade away all sorts of specific risk, in foreign exchange, interest rates and so forth, you make your portfolio seem safer. But you are in fact swapping everyday risk for the exceptional risk that the worst will happen and your insurer will fail - as AIG did. Even as the predictable centre of the distribution appears less risky, the unobserved tail risk has grown. Your traders and managers will look as if they are earning good returns on lower risk when part of the true risk is hidden. They will want to be paid for their skill when in fact their risk-weighted returns may have fallen. [14]
[fatter tails = hidden risk = shuttered costs = profitability : bailout = socialized cost]

"How to play chicken and lose", The Economist, 1.24.2009, special feature

Financial services will always be a tug-of-war between two contradictory promises: 'Your money is safe with us' and 'We will earn you higher returns.' The disturbing truth behind Charles Prince, former CEO of Citigroup,'s words is that bit by bit a boom kills off those who tend toward safety. The survivors, meanwhile, go for returns, because as long as the sky is clear financial-services companies grow by earning money. [14]
In 1970 Goldman Sachs had about 1,300 people. At the end of last year it had roughly 30,000. In 1971 Morgan Stanley had about 3,500 people; at the peak, in 2006, it had 55,000. Although boutiques such as Perella Weinberg have sprung up in the intervening period, the story of commercial and investment banking has been broadly one of consolidation.
Roy Smith, a finance professor at NYU Stern School of Business in Manhattan, has counted no fewer than 28 takeovers of once-important commercial and investment banks since 1977. Kuhn Loeb, White Weld and Donaldson, Lufkin & Jenrette have all disappeared, as have Soloman Brothers, First Boston and Kidder Peabody. Firms also built up their capacity to trade in the secondary market, at first so they could make markets and later to earn profits on their own account. As the demand for capital grew, the partnerships were tempted to list their shares. The old Wall Street was lost. [16]
Rather than being victims, shareholders may well have driven managers on. Hans-Werner Sinn, the head of Ifo, an economic research institute in Munich, argues that limited liability gives them a reason to flirt with disaster. The creditors of a failed firm have no claim on the personal assets of its shareholders. So if the bank takes big risks that promise big profits, its shareholders stand to enjoy the full gains but to bear only part of the losses. By contrast the shareholders of low-risk, low-return banks that never collapse have to bear all the losses. [17]
George Gilbert Williams, long-time head of Chemical Bank in New York in the 19th century, once explained that his success was founded on 'the fear of God.' But as a boom takes its course, fear is supplanted in what a senior quant at an American bank calls the 'Cassandra effect'. The more you warn your colleagues about the tail risks - the rare but devastating events that can bring the bank down - the more they roll their eyes, give a yawn and change the subject. This eventually leads to self-censorship. 'The system', he says, 'filters out the thoughtful and replaces them with the faithful.' [17]
To paraphrase Keynes, if you work in finance the market can stay irrational longer than you can stay in your job. As managers built financial conglomerates and sought to push them even harder, the quality of earnings in their industry was deteriorating. [17]

"The uneven contest", The Economist, 1.24.2009, special feature

In a fight, the regulators have the legal power. But the financiers have the political power, at least when there is no financial crisis in progress. The industry stands to make or lose large sums if the rules are changed, whereas everyone else has got better things to worry about than financial regulation. The wealthy and well-connected people on Wall Street, fine citizens and generous donors, usually get their way. [18]
The problem was not so much deregulation but regulation's failure to evolve with the so-called 'shadow banking system.' [18]
If the market for auction-rate securities had been a bank, you would have said that it had suffered a run. Yet auction-rate securities were not regulated like banks. Time after time the market seems to have found ways to work around regulation. Banks paid insurers such as AIG to take on the risk that their assets would default, which saved them having to put capital aside as the regulations required. This neatly converted lower-rated securities into AAA ones - except that AIG almost went bust. [20]
capitalism requires the possibility of failure. Investors must pay for their mistakes. [20]

"Fixing finance", The Economist, 1.24.2009, special feature

At the same time the financial-services industry is condemned to suffer a horrible contraction. In America the industry's share of total corporate profits climbed from 10% in the early 1980s to 40% at its peak in 2007. Its share of the stockmarket's value grew from 6% to 23%, according to Martin Barnes of BCA Research. It is hard to believe that financial services create enough value to command such pre-eminence in the economy. At the peak, the industry accounted for only 14% of America's GDP and a mere 5% of private-sector jobs. [20]
In America, for instance the insurance industry is regulated by the states; AIG's capital-markets group which lost all the money insuring CDOs for foreign banks, fell between stools. [21]
The rules need to be able to evolve along with the financial services themselves. That means regulating by function rather than by institution: if something looks like a bank, it should be treated like one. If a hedge fund or any other type of fund looks large enough to threaten the system, it will need watching. [21]
Centuries of boom and bust show that you cannot avoid financial crises altogether, but you can exercise some choice over what kind of crisis you get. Charles Wyplosz, professor of economics at the Graduate Institute in Geneva, envisages a spectrum, with an innovative, lightly regulated but crisis-prone financial system at one extreme and a stable, heavily regulated but stodgy one at the other. Depression-era America tried to tame finance's most dangerous traits by moving towards safety. Gradually, modern finance has reversed that shift, creeping towards innovation and light regulation. There will no be strong calls to restore some of the old values. Is that the best balance to strike? [21]


The Economist

"Law v common sense", The Economist, 1.17.2009, 38.

The direct costs of lawsuits are only one of the drawbacks of an over-legalistic society. Too many rules squeeze the joy out of life. Doctors who inflict dozens of unnecessary tests on patients to fend off lawsuits take less pride in their work. And although the legal system is supposed to be neutral, the scales are tilted in favour of whoever is in the wrong. Because the process is so expensive and juries are so unpredictable, blameless people often settle baseless claims to make them go away. The law is supposed to protect individuals from the state, but it often allows selfish individuals to harness the state's power to settle private scores.

"Not playing", The Economist, 1.17.2009, 64.

Rumours of an impending closure caused suppliers to pull back deliveries and workers to demand salaries in advance. 'I learnt that without confidence, a business is dead,' says Smart Union's founder, Tony Wu. The firm essentially shut down in September, despite having a heavy backlog of orders.

"Growing insecurities", The Economist, 1.17.2009, 73.

Mr. Obama has talked about the need for regulatory consolidation. Mary Schapiro, who is due to succeed Mr. Cox at the SEC later this month, pending Senate approval, has publicly advocated merging the two agencies. This would require a doctrinal ruling, since the Commodity Futures Trading Commission's approach is far more principles-based than that of the SEC, which cleaves to hard rules. It would also call for some deft politics, since they are overseen by separate congressional committees, for whose members disbandment would mean an end to juicy campaign contributions from financial firms.

[congress is no more eager to regulate business than business]


The Economist

"Writ Large", The Economist, 1.10.2009, 53.

Groups that investigate government misbehaviour say their efforts are now being hampered by English libel law. 'London has become a magnet for spurious cases. This is a terrifying prospect to most NGOs because of legal costs alone,' says Dinah PoKemper, general counsel at the New York - based Human Rights Watch. It recently received a complaint from lawyers acting for a foreign national named in a report on an incident of mass murder. 'We were required to spend thousands of pounds in defending ourselves against the prospect of a libel suit, when we had full confidence in the accuracy of our report,' she says.

The problem is not just money. Under English libel law, a plaintiff must prove only that material is defamatory; the defendant then has to justify it, usually on grounds of truth or fairness. That places a big burden on human-rights groups that compile reports from confidential informants - usually a necessity when dealing with violent and repressive regimes.

"Indefensible", The Economist, 1.10.2009, 66.

Rather than driving good Asian companies and managers from Hong Kong, closing such a loophole that allows companies to report earnings up to 3 months after the end of the fiscal period while directors and managers can still trade shares would instil greater confidence in minority investors. That should lower the cost of capital for companies and enhance returns - exactly what executives should want, if they are really working for all owners, that is.

[transparency -> trust -> investment]

[Law used to stifle dissent, opposition or competition]