Sonenshine on Financial Crisis and Reform

About a month ago Marshall Sonenshine delivered prepared remarks at the Harvard Law School Leadership Conference. Below are excerpts of Marshall’s words, all of which I agree with and believe deserve a wide audience and discussion.

As an introduction to Marshall’s text, and so everyone has full transparency and disclosure, I think it is important to reveal that despite having the same last name (yes, that’s right, my last name if spelled correctly is “Sonenshine”), Marshall and I are not related and I am not agreeing with him because he is a family member.

OK, it is true that Marshall and I have the same last name, look a little alike, have some of the same mannerisms and speech “tics” and are both focused and driven. But, we aren’t related.

And anyway, if we were related, I would be known as funnier, more athletic and more modest, even though “Mom” probably would have liked him better.

So, without further introduction, below are Marshall’s thoughts from his Harvard Law School presentation. A full copy of his remarks can be obtained by clicking this link.

We convene in the eye of a storm that has been described as a tsunami and more recently as “the perfect storm.” In this context, financial reform is akin to rebuilding the levees while the flood is still occurring.

The storm reflects inadequate and sometimes outright avoidance of supervision or regulation, in several areas of financial markets that specifically needed it. These areas include but are not limited to (a) loan origination, particularly residential mortgage; (b) securitization of credit instruments; (c) the credit default market, which has essentially constituted an unregulated $50 trillion shadow market that often dwarfs the regulated credit markets to which it refers; and (d) the safety, soundness and transparency of conventional financial institutions and systemically significant alternative asset managers. We also made mistakes in monetary policy in the years leading up to the crisis and in our more recent emergency bailout policies, some of which reflect gaps in our financial oversight structure.

Our avoidance of adequate oversight reflected until very recently an increasingly deeply held belief in financial de‐regulation, which arose in the context of a generally expanding economy over the past two decades. During this period, our financial system weathered shocks, which occurred roughly every five years – the stock market crash of 1987 following the first wave of leveraged finance and the brewing S&L crisis, the Gulf War recession, the Asia crisis, the Long Term Credit Management collapse, the tech bubble collapse, 9/11, the accounting scandals that precipitated Sarbanes Oxley, and so on.

This resilience to shocks during the long cyclical expansion period encouraged a culture that placed too much faith in the ability of markets to self correct, and permitted a balkanized regulatory structure to remain inadequately mandated for new dynamic global financial markets. This crisis is worse because it reflected not just markets behaving badly, but also our regulatory system behaving inadequately.

Thus did the US become in 2008 a leader in financial destruction, having been for the previous 75 years a global leader in financial market innovation and regulation, the latter reflecting two paramount principles that we, perhaps more than any other nation, represented — transparency to investors and safety and soundness of financial institutions. We applied those principles successfully in the main US securities markets, but we applied them reluctantly and poorly in mortgage origination, credit, securitization and derivative markets. We failed adequately to supervise and in many cases exempted from supervision many systemically significant actors in these markets. We allowed firms that lacked the proper disciplines or incentives to be mortgage originators. We allowed rating agencies effectively to exempt SIVs from the 1940 Act. In the credit default market, we abdicated entirely, creating a shadow $50 trillion credit market to operate often as Off Track Betting, sometimes tenfold the value of the underlying credit instruments to which it refers. In all of these markets, we declined to supervise institutional originators, intermediaries and investors until we were left with no choice but to do that and much more.

The solution to these problems is two-fold.

First, we should apply our time honored principles of transparency and safety and soundness to the areas of financial life where we have fallen short. We should not bow to political slogans that misapprehend the nature of free markets. Financial markets are free when they are organized by rules that are rational, clear and protective of systemic risk; they are not free when they facilitate free-for-all environments in which poorly conceived and highly leveraged bets are placed to the peril of not only the house or investor, but a broad array of market participants whose confidence is sacrificed in the gamble.

Second, the current patchwork of regulatory agencies should be rationalized to accommodate applying our transparency and soundness principles to twenty-first century financial markets.

The CDS market must be regulated to be sound and transparent. Efforts are already well underway to establish a clearing function. That will help, but ultimately the market must have integrity as to safety and soundness of participants and disclosure, even if not real time, as to market activity. We may find some very troubling information once we peer under the hood of this $50 trillion jalopy, so we need to proceed carefully. But if there is a risk greater than knowledge it is ignorance. And if we are unwilling to have a transparent and sound CDS market, then we ought have none at all.

Hedge funds, a special situation, are typically unregulated even though they often use leverage and financial derivatives in ways that their investors, creditors and trading partners may not have contemplated and that may have unanticipated systemic consequences. Funds often invest for pensions, endowments and other publicly or systemically significant investors, and they often operate in secrecy even from their own investors. The phrase caveat emptor may satisfy those craving moral absolutes or Schadenfreude for LP’s in funds gone bad, but caveat emptor misses the point, because it was not merely the GPs and LPs who suffer but a far broader network of constituents whose confidence in markets is fundamental to the functioning of the financial system.

Finally, as we re-engineer financial regulation for the twenty-first century, we should remember that finance is the lifeblood but not the entire anatomy of an economy. We cannot expect finance to prop up companies that would continue to specialize in inadequate risk controls or inadequate automobiles. We cannot bail out companies that would perpetuate poor governance choices, like choosing directors of financial institutions who have little understanding of financial markets or vesting CEOs with de facto control of the Board and the compensation structure throughout the organization. Nor can the Federal Government reasonably be lender of last resort to companies whose compensation structures reward risk choices that are at best misleading indicators of profit or value and at worst ticking time bombs for the institution or the market. We cannot rescue the perpetually challenged. In short, as we obsess about new regulation, we should remember that it is a competitive business economy that finance is supposed to power.

Comments

[Moon Kil Woong:]

I'm 100% on his solution. It mirrors most of the people's calls on Seeking Alpha. The market is half blind and we aren't living in the land of the blind.

We need transparency and sound financial statements. We need banks to not avoid their gearing cap by funneling all investors into non-FDIC insured products and then asking for their unfunded investments to be guaranteed anyway. We need to get rid of Base I off balance sheet accounting. We need to require derivatives position disclosure.

How can you hedge what you can't see. How can you value a stock correctly when a giant financial iceberg remains hidden from view. How can we regulate that which can be written on anything for any reason. Derivatives currently can be written on arcane stuff like banks defaulting, defaults of US on its bonds, a roulette wheel spin, corporate bond defaults, mortgage defaults, meteor strikes, etc. Basically it can be written on anything moral or not. This is often not investing, it's gambling.

The fact that some derivatives are in essence gambling has been brought up before. The solution was not to regulate them because they weren't really financial investments (more like gambling). Since there is no regulation parties can bet against their own positions in the dark (Goldman Sacs), write infinite amounts of contracts with no collateral or risk profile (AIG), hide losses off the balance sheet at will (after all they aren't liquid), bet on the US government going bankrupt, and make gambles with seedy parties that they know don't have the assets or collateral to back up or pay any of their bets on (a problem Goldman has, that's why AIG is given billions to pay contracts to them). Who knows, maybe banks should get into CIA business and start betting on the fall of governments all around the world. Gee maybe they already did. Hell if anyone will know. They are completely unregulated.

So next time an analyst talks about risk. Ask them what the risk of putting you hand in a 6x6 foot black box. As far as I can tell banks put their heads in a lot of these types of boxes. Unfortunately a lot of these boxes made some growling sound before they did.

Jan 14 01:30 PM

[Jason Rines...:]

Thank you for posting this Mr. Sunshine. Great additional comments Constructe. My main debates with other investors of why I was outright avoiding financials when things started looking cheap in financials was the lack of transparency. If I cannot perform adequate due dilligence, I don't invest. Too many investors relied on brokers and middle men. We just finished the age of outsourcing everything from government to our money supply to many other services. America will become a producer again, a painful transition that will indeed take some years.

Jan 14 02:02 PM

[Socialism c...:]

Partly right...mostly wrong. There were certainly areas where regulation and enforcement was entirely lacking...as witnessed by the Madoff scandal. On the other hand, overregulation is a MUCH bigger problem, when defined as a far too large role of government in our lives!!! It is big government that has caused much of this mess -- Community Reinvestment Act for starters. TARP for finishers. And lots in between!

Jan 14 04:51 PM

[donzelion:]

The key problem of modern finance is that in modern times, financial companies sell "financial products," where in the past, they rendered "financial services." The concept of a "financial product" should have been banished from the lexicon.

If someone sells a broken product, it's not too hard to hold them accountable. But what is a "broken service?" The normal way is to make long contracts with dozens of pages of terms, conditions, disclaimers, warranties, and the like. And then, how do you enforce that contract, or negotiate it, or even understand it? And why would you care, since most of the time, it probably won't "break"?

Jan 15 05:24 AM

[monday1929:]

No, Criminal Terroristic Bankers who made trillions caused "this Mess". Keep trying to spin though.


On Jan 14 04:51 PM Socialism cannot compete! wrote:

> Partly right...mostly wrong. There were certainly areas where regulation
> and enforcement was entirely lacking...as witnessed by the Madoff
> scandal. On the other hand, overregulation is a MUCH bigger problem,
> when defined as a far too large role of government in our lives!!!
> It is big government that has caused much of this mess -- Community
> Reinvestment Act for starters. TARP for finishers. And lots in between!

Jan 15 08:42 AM

[John Lounsbury:]

donzelion - - -

You are probing right at the heart of the structural problem. The purpose of finance should be to fund the means of production. We have found ourselves in a system structure which had the purpose of using credit to create more credit and had nothing to do with means of production (except more money).

The author also hits this head on in the last sentence of the article:

"In short, as we obsess about new regulation, we should remember that it is a competitive business economy that finance is supposed to power."

I apologize for being late to the discussion. The comment stream, though short, has a good cross section of thought on this subject.

Jan 15 06:42 PM