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As the G7 (Group of Seven Industrialized Powers) convene upon Washington to discuss and debate a regulatory response to the eight-month old credit crisis, lets see if we can learn some lessons by taking a look back in time to the last time the G7 leaders met in the midst of a financial crisis having its origins in America.

Remember the late summer and early fall of 1998, when the troubles of a single highly leveraged and unregulated market participant, Long Term Capital Management [LTCM], a hedge fund run by the absolute best and brightest that both Wall Street and academia had to offer, supposedly threatened to bring about large scale financial calamity?

As then and now today in the case of not just Bear Stearns (NYSE:BSC) but numerous other market participants, what we are dealing with is trying to avoid potential significant collateral damage to both the financial system and the overall economy as the result of unregulated behavior on the part of over-leveraged entities. Back then, for the most part, it was a mere single player involved. Even so, a single player was still enough, at least in the eyes of the regulators, to create the risk of significant systemic and collateral damage.

As a result of that event, didn't we learn that when it comes to the financial sector, where collateral damage can extend to the entire economy, that combining a lack of regulation with extreme levels of leverage is a reckless and even negligent way to run financial markets? Back in April 1999, didn't the Chairman of the Federal Reserve, the Chairman of the SEC, The Secretary of the Treasury and the Chairperson of the CFTC jointly prepare a 140 page report on the Lessons of LTCM in which they stated that:

The principal policy issue arising out of the events...is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to hedge funds; other financial institutions are often larger and more highly leveraged than most hedge funds...The LTCM episode well illustrates the need for all participants in our financial system, not only hedge funds, to face constraints in the amount of leverage they can assume.

Makes sense to me. So, how to best do it? Some more informative thoughts from the group at the time:

Even if market participants had better information and more fully understood the risks of their investments, their motivation is to protect themselves but not the system as a whole. Every firm has an incentive to restrain its risk taking in order to protect its capital, and firm managers have an incentive to protect their own investments in the firm. No firm, however, has an incentive to limit its risk taking in order to reduce the danger of contagion for other firms.

Again, sounds good. So, what did the group come up with in terms of concrete recommendations? Whatever the reasons, whether blinded by laissez-faire ideology (more on this here) and naive belief in computers by the Fed Chairman, or influenced by too strong industry ties by the Treasury Secretary, or by some combination of the above or something else, they weren't really signficant. Check out the recommendations on pages 31-32 for yourself here.

Effectively, it was a mix of having the participants "provide more frequent and meaningful information" and "enhance their risk practices," while having regulators "encourage," "promote" and "consider stronger incentives" in various ways for market participants. Perhaps the April recommendations shouldn't have been a surprise, as the participants clearly telegraphed their laissez-faire intentions to the G7 in January, 1999 at the World Economic Forum Annual Meeting in Davos, Switzerland. Per the International Herald Tribune:

The United States and its G-7 partners disagreed sharply Friday about overhauling international financial regulations...officials from Japan, Germany, Britain and France appeared eager to press ahead quickly with measures that would toughen regulation, monitoring and oversight of international flows of money through vehicles such as hedge funds. But American officials, while stressing the importance of more openness and surveillance, were wary of creating new regulatory structures.


So, getting back to the present, apparently the markets didn't work it out amongst themselves with "encouragement" and "support" from regulators. In fact, quite the opposite occurred in regards to reducing leverage, defined by the group as "the principle policy issue." Today, rather than a single outlier hedge fund running reckless and creating systemic risk, we have players of all sorts both inside and outside the banking community running their balance sheets at 25-35x leverage.

At the same time, even the less balance-sheet-levered commercial banking industry is making, as a whole, a combined on- and off-balance sheet notional economic bet at arround 150x, yes 150x, their equity capital. I realize that notional amounts are not at all the best indicators of economic risk, but I also realize that using imprecise, illiquid, non-standardized and unregulated securities traded in completely unregulated markets for a great amount of this notional exposure is not exactly a recipe for safe and conservative banking practices. Take a look for yourself:

To save you the difficulty of trying to interpret the chart, the math as of the end of 2007 for the ratio of Total Notional Exposure to Equity Capital is ($164.77 Trillion off-balance sheet derivatives + $11.18 Trillion balance sheet assets) / $1.14 Trillion balance sheet equity = 153.77. That is, on aggregate for the entire U.S. commercial banking sector, $153+ of notional exposure for each dollar of equity capital. The quarterly report discussing this data and more, as of Q3 2007, is available via the U.S. government here.

So here we sit now with a financial crisis that many are calling the worst since the Great Depression. Even the ultimate free and unfettered market radical himself, Alan Greenspan is classifying the current financial crisis as "the most wrenching since the end of the second World War."

In trying to combat this crisis, the Federal Reserve has found it necessary to throw aside basic tenets of sound banking and even of free market capitalism (some of which I previously described here) in various attempts to avoid an even wider crisis. How about forming a Limited Liability Company [LLC] in cooperation with a large commercial bank to manage $30 billion in primarily mortgage securities and related derivatives? Even further, how about having the Fed agree to take losses of up to $29 Billion of taxpayer money in the transaction?

Even more eye opening perhaps were the additional steps taken to open up the Fed's balance sheets for the first time ever, for the use of investment banks. Finally, again for the first time ever, or at least since the Great Depression depending on your interpretation, the Federal Reserve, and ultimately via extension, the U.S. taxpayer has agreed to accept all types of questionable collateral on the loans that it makes to both commercial banks and these highly leveraged, unregulated investment banks.

From a former Fed Chairman (Paul Volcker) who was a bit more willing to perform his regulatory duties:

The Federal Reserve judged it necessary to take actions that extended to the very edge of its lawful and implied power, transcending certain long embedded central banking principles and practices.

Also, in summarizing the current financial system as a whole, Volcker stated:

The bright new financial system, for all its talented participants, for all its rich rewards, has failed the test of the market place.

So, what to do? Beware of the laissez-faire regulators who refuse to do their jobs. Also, beware of false choices being offered by either current or ex-industry insiders. For instance, there are those who attempt to frame the issue as a choice of doing nothing (the "invisible hand" will work it out) and unleashing such ineffectual silliness as "swat teams" of regulators (described previously here).

These "swat teams," as I'm shocked that the bright and highly accomplished author of this idea wouldn't already know, are set up to fail by asking them to investigate and provide "guidance" from afar and even after the fact for unregulated entities continuing to trade according to no set of clearly defined rules and guidelines, using no 3rd party intermediation of any kind.

So what are the answers? We already have them, and they have produced the best and most robust financial markets in the history of the world. They involve a combination of standardized products, exchange-based trading, leverage limitations via margin requirements and / or capital requirements, clear and robust rules of disclosure to assure widely available information and transparency, and finally independent supervision with enforcement authority.

Does that mean that every product and every transaction will fit "perfectly" in this scheme. Of course not, there has always been some degree of OTC as well as unregulated trading of various ilk throughout all of market history. The difference is that we are now at the point where unregulated and non-standardized trading is not an exception from an overall economic standpoint, but is clearly the primary overall driving force for our financial markets.

Source: Back to 1998: Lessons from the G7 Then and Now