Scarlett O'Hara, Doris Day and Financial Market Tumult

Remember the 1939 epic classic "Gone with the Wind" wherein Scarlett O'Hara protests serious conversation? Interrupted by news of an imminent Civil War, this party gal (with the famous 17-inch waist) complains. "Fiddle-dee-dee. War, war, war: this war talk's spoiling all the fun at every party this spring. I get so bored I could scream." 

As I read "Why No Outrage" by James Grant (Wall Street Journal, July 19, 2008), I wonder if this southern belle might now be heard to say "Loss, loss, loss: this loss talk is spoiling all the fun." About structural reforms (a 2007-2008 equivalent of losing Tara, the family homestead), Scarlett might encourage delayed action. "After all... tomorrow is another day." Why fuss now?

Well, as we all know, Main Street and Wall Street are inextricably linked. Unlike Las Vegas, what happens in the financial markets,  does not "stay here." (Read "Slogan's run" by Newt Briggs, Las Vegas Mercury, April 8, 2004.) When huge losses roil capital markets (not just in the U.S. but around the world), real people can get hurt:

• Employees lose jobs
• Shareholders see their portfolios plummet in value
• Pension plans that allocate big money to equities and bonds scramble to improve funding
• Retirees who depend on the financial health of plan sponsors pinch their pennies further
• Vendors who do business with financial institutions tighten their belts and/or layoff staff
• Businesses, seeking to grow, borrow at higher rates, if they can borrow at all...

It is therefore a mystery to the editor of Grant's Interest Rate Observer that relatively few bad players are taken to task "in the wake of the 'greatest failure of ratings and risk management ever,' to quote the considered judgment of the mortgage-research department of UBS." Grant conjectures that high gas prices and an election-focused Congress may be to blame, or that "old populists" have hoisted themselves by their own petard, having pushed for paper money, federal insurance subsidization of higher risks and government intervention with respect to credit decision-making. From the tone of this long, yet fascinating, commentary, Grant rants about big government at the same time that, ironically, big government seeks to become even bigger in the form of new financial market regulations.

For my two cents as an advocate of free markets (not faux capitalism as exists around the world), a return to the gold standard merits serious consideration. Improperly priced federal insurance of bank deposits and pension liabilities (and much more) induces adverse selection and moral hazard. Riskier organizations get subsidized by more prudent market participants and have little incentive (arguably no incentive) to get their risk management house in order. Regarding government intervention as to how credit is allocated, plenty of empirical studies quantify the economic "bad" that results from information asymmetry. When buyers and sellers are not fully informed, supply and demand cannot intersect at the"correct" price of money or the optimal level of borrowing/lending.

Then there is the shame factor. In an era of reality shows, can we expect honor and accountability? Grant has few kind words for market behemoths (current and now extinct) who watch(ed) the Titanic sink "under the studiously averted gaze of the Street's risk managers." Will today's villains of excess rise, Phoenix-like, as have infamous names of yore, now reincarnated as media superstars? (Nick Leeson of Baring's fame has his own website and earns a living as a consultant and speaker. Henry Blodget pens "Internet Outsider" and e-newsletter, Silicon Alley Insider - a fun read for this bloggerette.)

Related to Grant's provocative piece, a recent article about voluntary standards caught my eye with its suggestion that industry attempts may be more show than reality. In its "agenda-setting column on business and financial topics," the Financial Times' Lex states that such guidelines receive little scrutiny and are put in place as a way to attract risk-averse institutional investors and/or to avoid the harsh spotlight of global regulators. (See ""Funds of hedge funds," Financial Times, July 17, 2008.) 

An easy way to check is simply to ask each hedge fund manager about his/her reliance on published guidelines. Inquire how traders are compensated. Are they encouraged to take pure risks or are they instead benchmarked on the basis of risk-adjusted returns (with "risk" referring to the holistic assessment of uncertainties)? Don't stop with hedge funds. Ask any service provider or trader about their controls and how they monitor the quality of their processes.

The creation of an effective reward system and "best practices" are favorite topics of mine. Our team (Pension Governance, LLC) and fiduciary community colleagues decry the status quo that makes it difficult to reward good players, at the same time that questionable practices are frequently left untouched. Poor quality disclosure is just one factor that inhibits the design of a better mousetrap.

Two hours into this post, I'm going to conclude with the notion that "freedom is not free" (anonymous). To enjoy flexibility and regulatory latitude, people of great courage must buck the existing system and both demand and assume accountability. At a minimum, interested parties (retirees, shareholders, taxpayers) want to better understand what went wrong and how internal controls will be strengthened post-haste as a result of introspection. Leaders at troubled institutions do a great service by informing the public about corrective actions underway.

For pension fiduciaries, a critical lesson learned is this: If you are not already doing so, waste no time in getting an operational review. This extends to tough and detailed interviews with your external money managers and service providers about all things risk management. Communicating your process to plan participants (for all types of plans) and shareholders/taxpayers gets you brownie points and helps to raise the "best practices" bar. 

Doris Day's sentiment may be great for meditation class but has no place in a discussion about financial system reform and governance of individual organizations, plan sponsors included. "What will be, will be" is the wrong answer (though "Que Sera, Sera" is a favorite tune).

The power of one keeps us in awe. Who will step up to the podium and say - "The buck stops here?"

Please email us with examples of pension and financial service leaders whom you believe inspire and lead the way in terms of governance. Let us know if we may attribute your comments or should post them anonymously.

Author's Notes:

• To read about the pros and cons of a post 1971 return to the gold standard, check out "What Was the Gold Standard? The Gold Standard vs. Fiat Money" by Mike Moffatt, About.com or "Why Not the Gold Standard?" by Professor Brad DeLong or "The Gold Bug Variations" by Professor Paul Krugman.
• To read about federal insurance problems, click to access the testimony given by Federal Reserve Governor Randall S. Kroszner before the Committee on Financial Services, U.S. House of Representatives, April 9, 2008 or the testimony provided by Sheila C. Bair, Chairman of the Federal Deposit Insurance Corporation before the Committee on Financial Services, U.S. House of Representatives, April 9, 2008 or "On asset-liability matching and federal deposit and pension insurance" by Professor Zvi Bodie, July 2006.
• The Nobel Prize in Economic Science was awarded in 2001 to Professors George A. Akerlof (famous for his "lemons" paper), A. Michael Spence and Joseph E. Stiglitz, respectively, for their research about information asymmetry and related market impact. (This blogger's doctoral dissertation addresses information asymmetry and bid-ask spread decomposition as a function of equity analyst coverage and institutional ownership. While not available in file form, I'm happy to provide hard copies of the published short version to interested parties. Click to email your request.)

Comments

[quetzalcoatl:]

I'm an educated man and don't exactly know where this article went.

2008 Jul 20 07:07 PM

[curious cat:]

sadly, your education was lacking then, wasn't it, my aztec friend?
as it happens, i read greek. please allow me to reiterate:

1) no one wants to hear it but we can't ignore it
2) real damage has been done to real people
3) largely because of a lack of information
4) heads must roll
5) the people should stand up and demand it
6) we should return to the gold standard
7) she has a doctorate and this article is an invitation for anyone who wants to see her resume.

2008 Jul 21 12:16 AM

[Joulie:]

Thanks for the article, I thought it was great.

I haven't read the Grant piece, but the gist seems to be: All the backstops in regulatory, corporate governance and simple individual ethics failed, what happened?

Deconstructing what happened, not surprisingly, the theme running through it all like a red thread is, "Maximize my pay regardless of my performance". Put another way, "Money attracts flies."

So where are we: disorientedly afloat. Asset (stock, commodity) market values are untethered from the price of the financial instruments that created them.

The article points to the gold standard. Is gold the answer? It does tie valuation to something. I think it's too early. We don't know what we don't know, we need more unwinding. I don't even think mark to market by selling 10% and seeing what you get will work -- it's a moving target.

My vote: We need damage control during this "Great Unwinding".

Regulate leverage up the wazoo where ever you find it. Naked shorts, commodity futures, whatever. I'm not sure what needs to be done, but, painful as it may be, we need to have supply and demand relate to the asset, not to the financial instrument alone.

So far, the regulators seem to be saying, to paraphrase Scarlet, "[public] opinion is a matter of supreme indifference to me."

I'd like to see the D&O insurers help as far as governance, maybe they can team up with the regulators and make and actual plan, unlike what we have now, which is chaos.

2008 Jul 21 01:12 AM

[notsosmart:]

conservative socialism is here.it will continue as in this country anything goes without accountability as long as the "tide lifts all boats".can anyone name one person of influence who could have stopped this @ dj14,000(when i bailed).now all the responsible parties are playing musical chairs with the available jobs & the same thing will happen again in about 10 yrs. or so.nothing was learned or done by the s&L fiasco(in fact one of the keating 5 is a presidential candidate.there is just greed& lack of ethics & no leadership for this country.how do you reelect most of congress & then give them a 9% approval?of course its important to know yesterdays sports results while drinking "belgium" beer.

2008 Jul 21 09:45 AM