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November 16, 2008
David Warsh, Proprietor


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The Crash Next Time

When five of the richest and most powerful US hedge fund proprietors gave sworn testimony before the House Committee on Oversight and Government Reform last week, the theatrical opportunities were as rich as the witnesses’ themselves.  The billionaires included:

The legendary George Soros, his latest book on reflexivity and financial crises on display on the table in front of him;

 

James Simons, the former math professor who turned $29 billion Renaissance Technologies into one of the most success hedge funds in the world;

 

John Paulson, of Paulson & Co., whose spectacularly well-timed bet against the housing market (his single best fund gained 600 percent) made him the highest earner in the business last year ($3.7 billion), according to Alpha magazine;

 

Philip Falcone, of Harbinger Capital, who told the committee about having been born the youngest of nine children in a three-bedroom house in the iron-mining town of Chisholm, Minnesota (today his $20 billion fund’s holdings include a sufficiently big chunk of the non-voting stock of The New York Times to be able to place two directors on its board);

 

Kenneth Griffin, of Citadel Investment Group, who reminded the committee that “We haven’t seen hedge funds as a focal point of the carnage in this financial tsunami” and noted that the greatest failures had occurred in regulated industries.

Rep. Henry Waxman, Democrat of California, the committee’s chair, acknowledged that hedge funds played no very big role in the present crisis, but expressed concern over tax law provisions that permit managers to treat most of their salaries as capital gains, paying as little as 15 percent on portions of them. “That’s a lower tax rate than many schoolteachers, firefighters and even some plumbers pay,” he observed, according to the Financial Times. And when Falcone’s testimony about his rise from poverty (his electricity was shut off as recently as 1994) touched off a dramatic ovation in the hearing room, Waxman demonstrated, with his gavel and his gift for sarcasm, why money definitely isn’t everything – as described in this vivid account on New York magazine’s Website (a somewhat cumbersome video of the hearings themselves can be found on Rep. Waxman’s site).

 

But the star of the show was probably a low-key finance professor named Andrew W. Lo, of the Sloan School of Management of the Massachusetts Institute of Technology.  A leading expert on the industrial organization and regulation of the financial system, Lo not only offered a glimpse of the experts’ broad program of regulatory reform in thirty- four pages of testimony , but zeroed in on a single indispensable measure with which to begin.

 

What is needed immediately, Lo said, perhaps even before Congress tackles the system itself, is an independent investigatory agency patterned on the National Transportation Safety Board, which has investigated air crashes and other transportation disasters since 1967, with considerable success in inspiring public confidence. Standard operating procedure for the NTSB is well-established after forty years – seasoned teams, immediate responses, on-site command-posts (ordinarily a hotel), twice-a-day press briefings and reporter pools designed to communicate preliminary findings quickly and completely to an anxious public.  The same kind of immediate investigation is needed when a financial institution “blows up.”

  

Such a “Capital Markets Safety Board” would consist of dedicated teams of forensic accountants, securities lawyers, tax attorneys and financial engineers working together on a regular basis, and charged with examining the circumstances of every failed financial institution, communicating their broad outlines quickly to the public, and then producing a report documenting the details, analyzing the failure, and suggesting ways to avoid such explosions in the future.

 

Moreover, a CMSB might prove to be a suitable collector of information on the so-called shadow-banking system, hedge-funds, private partnerships, sovereign wealth funds and the like. Many other financial regulatory agencies inevitably would be involved, Lo said. But if a single agency were responsible for managing data related to systemic risk, creating high-level analytics, including an overall map of the financial network and its asset flows, it would be far easier to keep track of the overall risks.

 

Creating a CMSB won’t be cheap, Lo acknowledged.  Government agencies must be prepared to compete against the hedge funds themselves to attract – and keep – highly qualified experts. The typical investigator can be expected to make certain sacrifices in the name of civic duty, he noted, but “it would be unrealistic to build an organization on altruism alone.”

 

Then again, one substantial success presumably would pay for itself many times over. If an operational CMSB equipped with a proper network map could have correctly forecast and prevented the disaster which followed permitting Lehman Brothers to fail, the savings would have been sufficient to fund the agency for the next fifty years.

  

 Lo made his original suggestion in 2004, in “Sifting Through the Wreckage: Lessons from Recent Hedge-Fund Liquidations,” a paper with Mila Getmansky Sherman, of the University of Massachusetts at Amherst, and Shauna X. Mei, of the Sloan School, in the Journal of Investment Management.  Since then the proposal has circulated widely among risk managers and financial engineers, and today probably commands fairly widespread support.

 

Last week’s testimony on the CMSB was just a debut; Rep. Waxman’s Committee on Oversight has no responsibility for financial markets. But soon other legislators will become involved.  Plans for the CMSB probably will go forward. After all, the emergency response precedent is well-established in other technologically complex fields — not just the Transportation Safety Board, but the Centers for Disease Control as well.  It’s unthinkable that the American financial system should go into the next explosion without a public agency charged with learning from its mistakes.

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