tag:blogger.com,1999:blog-706772597530050449.post101419729406329443..comments2024-02-19T12:04:56.080-05:00Comments on Reading the Markets: Redleaf and Vigilante, PanicBrenda Jubinhttp://www.blogger.com/profile/02587551531260863509noreply@blogger.comBlogger1125tag:blogger.com,1999:blog-706772597530050449.post-81595940843576956742010-05-13T10:03:15.217-04:002010-05-13T10:03:15.217-04:00In reading the May 11th post entitled “Redleaf and...In reading the May 11th post entitled “Redleaf and Vigilante, Panic,” I was intrigued by the prospect of combining in reverse order the May 10th (“Stochastic and epistemic uncertainty”) and May 11th posts. I believe that the combined-whole is more instructive than the parts for effective and efficient governance of complex, global markets.<br /><br />If there is complexity, there is uncertainty. To achieve real regulatory reform, policymakers have to move beyond risk management to randomness governance of both determinate and indeterminate underlying economic conditions. Trying to govern both risk and uncertainty with the legacy, one-size-fits-all deterministic regime is analogous to having one set of driving instructions for both the U.S. and U.K. <br /><br />Important as to randomness is the bright-line that divides determinate from indeterminate underlying economic environments. Structure matters — stochastic risk can be further delineated by firm and market economic structures. The market perspective of randomness is demarcated using FASB 157 as the bright-line where determinate investments are marked-to-market and indeterminate investments are marked-to-model. The firm perspective of randomness is demarcated using cash flow as the bright line where positive cash flow corporations are deterministic investments that strive to maximize value and negative cash flow enterprises are indeterminate investments that strive to minimize their burn rate.<br /><br />Why does structure matter? It provides better information correlation and transparency. In a world of financial innovation and bubbles, it is uncertainty — not risk — that should be the randomness component of focus. When the low hanging investment fruit of a boom period has been picked, bad information leads to flawed price discovery that creates vapor assets. The result is larger and more frequent boom-bust cycles.<br /><br />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? Shortly thereafter, “Dot Comets” that had their initial public offering priced at 200 percent of forecasted sales soon became financial road kill when their projections were not met. Collateralized debt obligations (CDOs) and credit derivative swaps were the subprime boom’s vapor assets where NINJA mortgagors were given property rights in order to enable questionable securitizations at even more questionable AAA-ratings prices to take place. But when the bubble burst, “questionable” became “improbable” as deterministic metrics lacked robustness to manage indeterminate investments.<br /><br />Distinguishing “stochastic” from “epistemic” uncertainty is relevant to the governance of today’s capital market. Is it more preferable to solve the “stochastic problems” of scale that is to-big-to-fail and scope that is too-random-to-regulate, or is it preferable to epistemically fix the “market” by segmenting the underlying economic condition in terms of predictable, probabilistic, and uncertain governance regimes. I argue in favor of the latter and believe it to be consistent with the essence of Senator Dodd’s proposal to provide market practitioners with better information.<br /><br />Thanks for a thought-provoking read. <br /><br /><br />Stephen A. Boyko<br /><br /><br />Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System” and a series of five SFO articles on capital market governance. <br /><br />http://w-apublishing.com/Shop/BookDetail.aspx?ID=D6575146-0B97-40A1-BFF7-1CD340424361Stephen A. boykonoreply@blogger.com