Monday, October 13, 2008

Regulation in the financial markets

People (mostly economically uneducated and liberal) have been clamoring for more regulation in the financial markets. Unfortunately, this will hurt these (uneducated and liberal) people in the long run.

The cost of conforming with just the tax code approaches 5% of annual sales in some companies. Conforming with regulations at banks is also quite expensive. I worked at a bank, I know. Banks are forced by the government to spend millions of dollars on regulation training every year. Then their employees are forced to comply with government regulations by filling out mounds of paperwork, usually written by lawyers who have lobbyists that urge congress to pass more legislation so they can charge more fees to write out more regulations and paperwork.

Regulation is a huge cost in business and is also a barrier to entry for competition. The authors of much of the regulation in business are lawyers to the largest corporations and banks. These corporations and banks have lobbyists to urge congress to pass more legislation and paperwork to make it more expensive to enter a business and therefore stifle competition.

So who pays for this regulation? Of course its the consumer who has to pay higher prices and deal with poorer and poorer customer service.

Now with financial regulation I can see how there could be an argument for increased regulation. Companies are required to file financial statements with the SEC in accordance with guidelines set up by the Financial Accounting Standards Board (FASB). These accounting standards with banks are quite loose and in fact, the FASB loosened the standards even more due to the credit crunch. Currently there are Level 1-3 assets that are valued in accordance with availability of markets and models to value assets.

Level one assets are marked to market; that is they usually have an exchange traded value that is constantly adjusted. Level two assets are marked to model; these assets are priced according some ingeniously complex model that was created by a financial mathematics PhD at an investment bank with no concept of the real world. These are sold to investors at hedge funds and insurance companies who also have a financial mathematics PhD with a slightly lower concept of the real world than the investment bank. Level three assets are marked to nothing; These assets have no value other than the one an investment banking sales person can convince an institutional investor to buy.

Level three assets are scary because they have no market and no good model to price these assets. These can be mortgage backed securities, credit default swaps, total return swaps, etc. Investors have been conditioned to believe that markets have return distributions that are normal. Their stupidity should not be rewarded. In fact, they should be punished by the market. But, I digress.

How can more regulation help this problem? Well, it really can't because no matter what a regulator says, as long as there is not an official exchange for a security, there will be no tangible, measurable asset value. In a capitalist economy, people are paid to take risk. If a regulator applies some value to a security with no value, then people will take the value a regulator says as the truth because people generally are lazy and want to do the least amount of work to come up with a valuation. If people were actually to perform in depth due diligence, they would see certain assets and ask the bank how they value those assets. If the bank says we mark it to a complex theoretical model that our PhDs made up, then that represents risk to an investor. A light bulb goes off in the investors mind that says, "Sounds risky". The investment banker does his best to soothe the investors fear and attempts to explain how his PhDs are the best in the business. The investor somehow becomes convinced that the asset does have some value, but he now needs a higher rate of return to purchase the assets or the stock of the investment bank. Simply put, higher risk, higher reward. If the asset is worthless, shame on the investor for believing the investment banker. There was this thing called personal responsibility a while ago. It disappeared some time in the last 50 years.

The federal government has passed hundreds, if not thousands, of laws that pushed banks to lend to people who otherwise would not be able to afford a house. Community Reinvestment Acts, FHA loans, VA loans, etc. This causes demand of housing to increase beyond supply, therefore starting a housing price boom. Rational businesses see this price increase and therefore allocate more resources to build housing. Eventually supply exceeds demand and prices fall, but because people couldn't afford the housing before the boom started, the prices fall extremely fast as these people refinanced their houses at pre-bust days at values above their current home price. These people, rationally, just walk out on their mortgage because it will cost them more to keep it than to pay it. Foreclosures jump, banks lose money because they have to reclaim mortgages that are worth less than what they borrowed out. Capital depletes and cuts into the reserve requirements imposed by the Federal Reserve.

Banks are required by law to hold a certain amount of capital in excess of the amount of assets they buy. This is usually in the area of 10%. This is scary as well. If a bank makes a bunch of bad loans, the bank will become insolvent. If the bank starts to lose investors (depositors), the bank will become insolvent. Some banks live dangerously and hang out in the low end of the range set forth by the Fed. Smart, conservative banks hang out above the 10% requirement. These banks know that financial disasters are inevitable in the market controlled by the Federal Reserve. Boom and bust cycles caused by malinvestment create very unstable markets at times. But banks that hang out near the low end can make huge excess profits during the boom cycle because of the increased leverage allowed by law. Their executives get fat annual bonuses for not performing risk control. Then the bust cycle arrives. The super leveraged companies that made fat profits now are reporting billions of dollars in losses wiping out the shareholder equity. The executives get fat golden parachutes because they were smarter than the investing public, negotiating a big reward for blowing up a company before the public knew what was going to happen.

So the Federal Government, Federal Reserve, and the SEC incentivized risk taking that would ultimately become what has happened in the last year or so. They have also thrown out personal responsibility with the bailout of some of the worst offendors and have imposed even more regulation within the bill. Now they will attempt to reflate the economy with trillions of dollars of printed money. This will hurt savers and those on fixed incomes because purchasing power will decrease. Investors will have to require a higher rate of return due to the higher inflation. This is what we are seeing. Higher rates of return equate to lower valuations for financial assets. It's a very simple risk/return equation.

After reading this do you believe that the banks will give you a better rate on your loan or a worse one? Will the cost of obtaining credit rise or fall with time? How will you restructure your portfolio given the information I have provided. I have some suggestions that I will provide in a post tomorrow.

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