Tuesday, September 23, 2008

It's a question of how to, not have to...

This weekend while out with friends, the conversation gravitated to the mess on Wall Street. Most conversations went something like this:

Friend: I don’t care if it lowers our GDP growth from 4% to 3% for ten years, we need more regulation to avoid this.

TBP: How are you going to regulate what just happened?

Friend: Well… I don’t know much about finance.

TBP: Exactly. What happened was a bunch of guys and girls who thought they were a lot smarter than everyone else, over exposed themselves, and they got nailed because of it. I’m not sure how you regulate that efficiently. And I’m not sure how you go back in time and regulate what happened.

Or to put it another way you can't regulate a computer model. That’s why anyone and everyone appeared to have been buying mortgages two or three years ago—the computer models that they had created showed something like a 5% default rate. After a little cost/benefit analysis companies started handing out mortgages to anyone who could breathe, sign a contract, and was over 18.

But then reality set in and default was something like 8% or 10%.

And now everything is fucked. Okay maybe I’m being a little melodramatic, but things aren’t good. Everyone, even John McCain, wants regulation. But it seems to me that there is too much reaction and not enough contemplation taking place.

Let's go back to part of the reason we're in this situation right now, the computer models were wrong—so now what? Obviously some sort of oversight is needed—this is blatantly clear with A.I.G. where things got way out of hand with little government oversight. But how about those computer models, how do we regulated those?

I think the answer is simple: you don’t. If people and investors want to use them, then they can at their own risk. If the computer model turns out to be ‘wrong’ then well, let them fail. This means more accountability to the leaders of such companies. Sadly, there has not been to much of that thus far in the fallout.

Some sort of oversight is probably needed in the mortgage industry, but instead of regulation, I’d prefer to see something like we see with the FDIC (Federal Deposit Insurance Corporation) and banks, which the government guarantees $100,000 that any individual has in a bank. So in a good standing mortgage, the government provides some sort of guarantee to the bank and the home buyer, but the government does not do the same on riskier mortgages. Those are given out at the mortgage/bank’s own risk.

Is this a perfect solution? Of course not and it would be a very expensive policy to undertake. But the current system failed us, mainly because the computer models that were cooked up failed the people who cooked them up. The result? The American tax payer may be stuck with a $700 billion bill, though some don't think it will happen. I can't believe it won't be passed after every Senator says "shame on you Wall Street" and then gladly signs off on the deal as the Wall Street types then donate money to their reelection campaigns.

ANYWAYS, once that dust settles, it’s time to put the policy wonks in a room with the bankers and other lenders and figure out just how to prevent this from happening at such a huge level again.

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