Tuesday, July 27, 2010

Dodd-Frank: A fine alphabet soup appetizer, but where’s the beef?

Today I am turning over the blog to a guest poster, Steve Boyko, whose book I reviewed some time back. Although we are not cut from the same political cloth and aren’t impassioned by the same issues, we share an interest in analyzing the weaknesses of standard risk models. Steve looks at these weaknesses at the regulatory level; I go at them from the perspective of the trader. But enough blathering; here’s his contribution. He welcomes comments.

Consider the way in which the politics of capital market governance provide for interesting legislative “calls to action.” The Dodd-Frank Wall Street Reform and Consumer Protection Act went from lofty legislative intentions at the inception of the Financial Crisis Commission when Senator Dodd stated that it was his

hope that this commission will provide valuable insights that will help us to continue our efforts to ensure economic security for American families.”

Then later to:

"We can’t legislate wisdom or passion. We can’t legislate competency.”

Like the World War II French Generals who built the Maginot Line’s fixed fortifications in reaction to World War I tactics, Dodd and Frank proposed legislation in response to the most recent crash. Their response focuses on scale, Too-Big-To-Fail (“TBTF”), rather than the economic randomness of predictable, probabilistic, and uncertain valuations which is Too-Random-To-Regulate (“TRTR”). Our “financial generals” have unfortunately conflated risk and uncertainty in deterministic, one-size-fits-all governance metric that almost certainly will result in a dysfunctional price discovery mechanism leading to increasingly more frequent and larger economic dislocations.

The perfect financial storm

The subprime housing crash has been called the perfect financial storm. It, like most recent crashes, was the perfect blend of financial innovation and congressional interference that enabled financial opportunism to take place when low-hanging opportunities were exhausted. There were no innocents—not unqualified home-buyers, not banks, not Government Sponsored Enterprises (“GSEs”), not regulatory agencies. Financial alchemists marketed the hole-in-the-donut to naive opportunists whose faulty due diligence suggested that cheap was well-bought and that well-bought would soon become profitably well-sold.

Recall the S&L meltdown, where the indeterminate “asset” on the books of many insolvent S&Ls was “regulatory goodwill” – the regulator’s reward for acquiring an even more insolvent thrift. Who could have foreseen the Resolution Trust Corporation’s (RTC) liquidations that occurred when minimum reserve requirements became illusory in a setting where capital consisted of vapor assets?

Likewise with the subprime crash, Dr. Stanley Liebowitz of the University of Texas posited that the single most important factor in home foreclosures was negative equity. No-money-down, liar loans effectively gave property rights to renters. This created a moral hazard where investor rights exceeded their responsibilities. Liebowitz demonstrated that the presence of such loans also misdirected policymakers’ focus toward the wrong variables for controlling the adverse consequences of the subprime crash.

Governing randomness

In a world of financial innovation, it is uncertainty — not risk — that should be the randomness component of focus. Uncertainty is different from, rather than a higher degree of, risk. This distinction was made famous by economist Frank H. Knight in his seminal book, “Risk, Uncertainty, and Profit” (1921). Risk refers to situations in which the outcome of an event is unknown, but the decision maker knows the range of possible outcomes and the probabilities of each. Uncertainty, by contrast, characterizes situations in which the range of possible outcomes, let alone the relevant probabilities, is unknown.

If there is complexity, there is uncertainty. For example, software iteration 2.1 was written because of unforeseen circumstances experienced with version 2.0. As there are innate complexities in the capital markets, the element of uncertainty always will be a part of complex adaptive systems.

Difficulties arise when risk is conflated with uncertainty under deterministic, one-size-fits-all governance metrics that frustrate the market’s price discovery function. We can insure (put options) and hedge (Ford and Exxon) risk. We can insure (natural disaster insurance) uncertainty, but we cannot hedge (Ford and pork bellies) uncertainty. If we cannot hedge, we cannot regulate risk and uncertainty in a one-size-fits-all regime due to non-correlative information. It is similar to having a single thermostat regulate temperature for H2O conditions of ice, water, and steam.

Investments that lack cash flow and are valued on a mark-to-model basis are uncertain. Credit default swaps (CDSs) are uncertain derivatives that required constant hedging by dealers. This activity resulted in cost with very little benefit. Absent randomness segmentation, indeterminate information cannot be processed effectively and efficiently by determinate metrics.

The Dodd-Frank financial reform was brought about by a troubling trend of more frequent and larger economic crashes. In undertaking a complex reform, sequence and timing are critical. Policymakers had to determine whether the capital market needed reform by amending the existing deterministic, one-size-fits-all system; or, whether the capital market system was broken and required fundamental structural repair.

  • If the former, what is new or innovative in the 2,000-plus pages of Dodd-Frank?
  • If the latter, which proposals introduce REAL structural change?
The solution for Dodd-Frank-type legislation with one-size-fits-all deterministic regulatory metrics is to segment randomness into: predictable (money market investments), probable (positive cash low, earnings-driven, NYSE and NASDAQ issuers that are marked-to-the-market) and uncertain (negative cash low, event-driven issuers that are marked-to-the-model) regimes.

Stephen A. Boyko is the Chairman and CEO of N2K Ecosystems, Inc. — a business development consultancy providing market-based solutions for entrepreneurial wealthfare. He has over forty years of financial services industry experience that include formulating regulatory policy for the National Association of Securities Dealers ("NASD"), managing regional brokerage operations for retail, institutional, and corporate clients, and providing a practitioner's perspective for the privatization of the former Soviet Union in the areas of corporate governance and regulatory development of the Ukrainian Capital Market. Mr. Boyko holds a BA in history from Bates College and an MBA in finance from American University. He is conversant in French, Russian, and Ukrainian and serves on the Advisory Board of Yorktown University. Mr. Boyko is the Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System” http://www.traderspress.com/detail.php?PKey=671. He can be reached at n2keco@bellsouth.net.

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