2008 Market Meltdown: Are We Headed for a Repeat?
Pundits say we edged within two days of a total meltdown in our financial markets during the fall of 2008. Can we now say with certainty what went wrong? Will the impact of regulatory reforms present future investment opportunities? Have we learned the right lessons or will misguided “solutions” only place our markets are risk once more?
On March 24, 2010 in Boston, at the Information Management Network’s Inaugural World Series of Indexing and ETFs, a panel headed by A. Seddik Meziani, Professor of Finance & Economics, Montclair State University address these issues during the seminar “Deconstructing the Crisis: Lessons Learned, Actions taken and Future Implication.” Panelists included Steve Cordasco, Senior Vice President – Financial Consultant, The Cordasco Group, RBC Wealth Management and Douglas A. Love, Chairman, Investment Policy Committee, New Jersey Investment Council. What follows is a summary of their delightful – and insightful – banter.
Some say that the sub-prime acted as a mere catalyst, but not the root of the crash of 2008. Cordasco agreed, citing greed from both Wall Street and Washington as the ultimate root. Love elaborated on this point by picturing a triangle. In one corner lay politics and ideology. He felt both ends of the political spectrum could share the fault. The right had too much confidence in the market’s ability to correct itself. He blamed the left for believing all people should have houses, whether or not they could afford them. In the second corner he placed regulation. He explained the inability to correctly classify; hence, regulate, Credit Default Swaps (CDSs) presented a major problem. Finally, the last corner of the triangle belongs to technology. Here, the industry relied too heavily on Modern Portfolio Theory (MPT). Love believes markets are more than just random, he feels they are “deeply random.” (The term comes from physics and describes a situation where no probability distribution exists that fits the data and remains stable.) From a financial engineering standpoint, MPT depended on normal distributions that don’t exist in the real world. Love contends the industry used the math because it was there, and the math was there simply because it could be done. In a deeply random environment, however, the math can never work. Meziani came to the defense of math, saying math performs as a tool, not as a means to the end. In other words, garbage in, garbage out.
Many feel part of the problem in 2008 occurred because of the difficulty in pricing illiquid assets. Love warned mark-to-market has very large political consequences. He said there’s no way to put a price on these very illiquid assets. Cordasco challenged that thought, saying you can always change the rules. “That’s what the government does if it wants to make things look better,” said Cordasco. He agreed mark-to-market fails to work for illiquid assets. Cordasco suggested we’ve got to break it down back to basics – if something is worthless it’s worthless. He concluded we have not learned our lesson.
In comprehensively reviewing the disaster of a couple of years ago, there are those who point a finger at agencies, both rating firms and government regulators. Meziani referred to people who say these agencies are not capable of rating complex derivative instruments. He described the ratings process as just an opinion. He added if the SEC were less dominating by lawyers, it would be more effective. Love explained there’s an unholy alliance between the rating agency and the banks. “If you go to work at the rating agency,” he said, “you keep your contacts on Wall Street and wait for a job.” He then offered what he called a “marvelous” idea for a new industry – consultants who can be used as an intermediary between the rating agency and the users of the rating agency. Cordasco simply said there needs to be more respect. He continues to see too much subjectivity. For example, small community banks are allowed to fail, but large banks aren’t. “Our whole economy has been built on the financial industry,” he says, “and Washington won’t allow it to fail.” Corsadasco contends things won’t get better until we allow the big banks to fail.
Meziani next asked the panel if they believed CDSs were underlying reason this crisis. Love said AIG committed a no-no in the options market – it wrote a naked option. Now, he says, New York State wants to intervene and declare CDSs as insurance products. To Love, the biggest question in the case of AIG remains the money flow of the TARP funds. The biggest portion of the government money went to pay Goldman Sachs par value on their CDSs (then valued at only $0.20). Cordasco felt AIG let the wolves in because Hank Greenberg wasn’t there. He said Goldman Sachs saw a huge amount of business and pitched a story that AIG bought.
The panel then mused as to what should be done with the SEC. Cordasco took on this topic alone, saying the SEC can’t keep up with the industry. He recalled when he went into the business, mutual funds contained 10% loads. This brought on the attention and the force from the SEC to protect the average investor and soon that 10% load went down to 5% and then to 1% until now where we have ETFs. They came at it with a fire hydrant to put out a mere flame. So Wall Street switched to research. Now the research has been replaced by the internet. As a result, Wall Street created these complex derivatives (CDSs), something no one – including the SEC – could figure out. Cordasco maintains the SEC will never be able to stay ahead of the greed and technology that creates the next revenue engine that’s going to drive the economy.
Not willing to give up, Meziani asked what kind of policies can the government come up with to fix the system? Love said we must bifurcate retail from institutional. “In effect,” he said, “banks have become a hedge fund.” He likes the Volcker Plan as it effectively reinstates Glass-Steagall. He admits banking will make less money, but he counters that it will become a much safer industry. Cordasco presented a more dire scenario. “There’s a mistake being made right now in Washington,” he said. “There’s fuzzy math. Right now, the regulators are missing it again. The administration has made a pact with the insurance industry. Annuities are the growth industry. The regulators are missing this one. Why? Because no major insurance company has gone belly up. The regulators are missing it with the insurance companies – they’re fighting with the SEC right now. The solution: cut the lobbying money.”
In summary Cordasco said the best explanation of what happened can be attributed to human nature. “It’s going to happen again,” he warned.