Bouncy Castle Finance

A year ago, the fall of Lehman Brothers marked the end of Wall Street. Fundamental reform was just around the corner. … Or so we thought. One year later, Wall Street has been reconstituted, refinanced, and refurbished. The biggest bull rally in history has followed swiftly on the heels of its greatest collapse. Top traders are still pulling in nine-figure salaries, and top banks are back to record-breaking profits. Why?

Part of the answer is that we went from a world in which regulators and politicians refused to see systemic risk to one where all they see is systemic risk. As a consequence, the lesson of Lehman was that not only are some banks "too big to fail" — we also found out that the system as a whole is "too big to bail." This subtle change lies at the heart of our current regulatory climb-down.

Since Lehman’s collapse, rather than making the world safe from financial firms, we’ve made the world safer for them by socializing the risk and privatizing the profits. Governments in highly financialized economies like the United States and Britain prioritized shoring up financial firms rather than regulating them, turning Wall Street into something like a big inflatable bouncy castle for the kids — where they can bounce higher and harder than ever before, with the guarantee that the government will keep the whole thing inflated. How did we get here?

Part of the blame rests with the influence of three persistent, flawed ideas about markets. First is the "microfoundations critique": Truths about aggregates must be ground in truths about individuals. As such, the financial system has no identity apart from the sum of its parts. Second is the "efficient-market hypothesis": Prices of publicly traded assets like stocks reflect all known information — a theory mistakenly treated as a rule. Third is the proposition that investors have "rational expectations": That is, investors use information efficiently so that while individual investors may make mistakes, the market as a whole tends to an optimum. Thus, the market price is by definition right.

These ideas, taken together, managed to convince governments and financial firms that regulation was part of the problem rather than part of the solution. Everyone believed that self-interested actors in a transparent environment made optimal trading decisions based on their own risk-reward trade-offs. The people holding an asset best managed its risk, risk that is divisible down to a single stock or bond or collateralized debt obligation. The only thing regulators needed to avoid was moral hazard. If individual institutions made bad bets and went bust, bailing them out would just encourage other firms to assume that they would be bailed out, too.

In short, risk is individual; regulation is best left to those with "skin in the game"; bailouts should be avoided at all costs. This was the thinking behind letting Lehman Brothers go under. Doing so was supposed to stop the rot. But it failed spectacularly.

The problem with this view of the world was that its focus on the microrational completely ignored the possibility of systemic risk. We now know the interlinking of market agents’ positions leads to a form of risk that is neither reducible to the sum of individual positions, nor knowable a priori because what matters is how these positions are interlinked when market risk as a whole changes. That lesson had to be learned the hard way, with the death of Lehman Brothers and the discovery (by the rest of the world) of things like collateralized debt obligations.

Why couldn’t we see — or even conceptualize — systemic risk until Sept. 15, 2008? First, because we did not recognize that the conceptual framework governed by the hypotheses of microfoundations, efficient markets, and rational actors was, well, just conceptual. Another related problem lay in allowing banks to regulate themselves by relying on internal risk-assessment models based, in part, on these ideas.

Before Lehman collapsed, microprudential regulation ruled. Each bank used a variety of internal risk models to measure exposure and obeyed requirements to keep a certain amount of capital on hand to cover losses. At the end of each day, each bank thus calculated its "value at risk" and hedged. The problem was that the banks used similar models, meaning they produced common positions with common hedges across enormous, disparate portfolios. So though any one bank was diversified, the system as a whole was not — exposing the whole system to far greater risk than anyone could have foreseen when staring at their own models.

We had built a system around the assumption that if you look after the micro then there is no macro to worry about. A year ago, that world ended. The U.S. government had to guarantee payrolls a week after Lehman collapsed. Iceland, an OECD country, went bust. Asian exports collapsed. The doctrines of Keynes replaced the doctrine of "there is no alternative." The collapse of a single financial firm led to the shrinking of global GDP for the first time since World War II. Surely, given all this, fundamental financial reforms must be in the cards. Beyond the furor over bonuses, Wall Street couldn’t be allowed to do this again now that we all know about systemic risk? Could they? Well, basically, yes they can.

Let’s look at the actual financial reforms made in the United States in the past year. The government turned the Federal Reserve into a big "bad bank," chock full of bad assets (check its balance sheet). It added as much liquidity as possible to the system, to wash away remaining troublesome assets with the Troubled Asset Relief Program (TARP) and similar initiatives. When the banks sought to give TARP money back because it might limit their bonuses — tantamount to extortion, as doing so deliberately increases systemic risk by reducing liquidity — the government folded.

The Treasury Department delayed administering "stress tests" for as long as possible. Just before it performed them, regulators decided to withdraw a "mark-to-market" rule that would have required banks to value assets in a manner consistent with reality. The banks are now free to use "mark to model" — read: inflated — prices as inputs on the same old risk models. Even before performing the stress tests, the Treasury Department announced that no bank would fail. Treasury Secretary Timothy Geithner promised and delivered Goldilocks results — not dire enough to cause a panic, not rosy enough to beggar belief. In short order, Wall Street firms raised $100 billion in new capital.

A year out, the banks are doing fine, even if — or, more accurately, precisely because — the U.S. taxpayer continues to prop them up. Today, President Barack Obama promised regulatory reform and chastened any banks agitating against it, promising to look at micro and macro risk. But thus far, neither he nor any regulatory agency has said how it will identify systemic risks and then require banks to unravel positions — positions that may or may not be innocuous. In the meantime, a Treasury Department report released this morning promises indefinite support for the sector. Washington continues with bailouts, loan guarantees, capital infusions, and massive repo programs. The message streaming from Washington remains that a big bank will never be allowed to fail.

A year ago we discovered that there was more to life than moral hazard: There was systemic risk. This acknowledgment led to the conclusion that ad hoc policy interventions would not work and that "systemically important" institutions had to be supported — hence the bailouts of Fannie Mae, Freddie Mac, AIG, and others. But we have in fact moved from "too big to fail" to "too big to bail." That is, the system as a whole generates more risk, via complexity and leverage, than the economy supporting it has capacity to hold.

At this point, regulation stops being about reform. It’s about moral hazard — and this time, on a truly systemic scale. We have turned moral hazard into a systemic property whose externalities will never be internalized by the banks themselves. Now, when the state steps in to support firms that are part of a "too big to bail" system, it effectively gives the same guarantee to that firm’s senior debt that it does to U.S. sovereign debt — only with a much greater potential for growth and a guarantee that there is no downside to holding it.

Thus, the stock market recovery — despite the complete lack of real-world economic recovery — makes a lot of sense. The banks have zero incentives to cooperate on issues of fundamental reform. Despite calls for smaller bonuses, transactions taxes, lower leverage, simpler instruments, and financial product safety commissions, what is actually emerging from the meltdown is not a smaller, fitter, and safer financial system, but a giant inflatable bouncy castle for finance to go play in harder than ever.