The meltdown last year

This is a followup to my post One Year Ago. Seems to me that mortage lenders offering no down payment loans to those without good credit and the bundling of these securities into bonds by Wall Streeters which they sold based on phoney ratings by the rating companies is still be best causal explanation. Still, we need to remember that events are often over-determined; there are many causes. The story about Fannie and Freddie is the favorite of the right who don't like these agencies and were trying to blame the problems on democrats even though they were in control of both houses of Congress and the presidency when the bad stuff took place. A bubble bursting is correct, but the question is why the bubble was so big and the burst so challenging to the financial system. The story about the history of deregulation has some truth, too, but it usually comes from the left blaming everything on Reagan. And we must ask whether all deregulation is bad? Deregulating the airlines wasn't so bad (oh, but Carter did that...but then all deregulation did not start with Reagan. On incentives, Steve Pearlstein had some nice commentary on these recommendations of a high-profile panel at the Aspen gathering this summer:
-- An excise tax on all security trades and a higher tax rate on short-term trading profits.
-- A revised definition of the fiduciary duty that pension and mutual fund managers owe to their investors, along with compensation schemes that better align their incentives with long-term objectives.
-- A requirement that only long-term shareholders be allowed to elect directors or vote on corporate governance issues.
-- Fuller disclosure by private investment funds of their holdings and their compensation.
"The roots of this short-termism go back to the 1980s, with the advent of hostile takeovers mounted by activist investors. This newly competitive "market for corporate control" promised to reinvigorate corporate America by replacing entrenched, mediocre managers with those who could boost profits and share prices. In theory, the focus was on increasing shareholder value; in practice, it turned out to mean delivering quarterly results that predictably rose by double digits to satisfy increasingly demanding institutional investors. Executives who delivered on those expectations were rewarded with increasingly generous pay-for-performance schemes.
As fund managers grew more demanding of the short-term performance of corporate executives, investors became more demanding of the short-term performance of fund managers. To deliver better returns, managers responded by moving money from bonds and blue-chip stocks to alternative investments -- real estate, commodities, hedge funds and private equity funds -- where there was more risk, higher leverage and bigger fees. In time, the managers of these alternative investment vehicles began looking for new strategies to improve their results, and Wall Street was only too willing to accommodate with a dizzying new array of products.
At times, it seemed to work spectacularly. During the late '80s, the late '90s, and again during the recent boom, investors earned record returns and corporate executives and money managers earned record pay packages. But after the bubble burst in each cycle, the gains to investors turned out largely to have been a mirage, while the gains of the executives and the money managers remained largely intact.
It is all well and good to vow that compensation schemes will be changed so that executives and money managers sink or swim with their investors, but there is a limit to how far those incentives can be aligned. While these new and improved financial markets promise greater efficiency and liquidity -- except, of course, when they don't -- it's now clear that the benefits of all that efficiency and liquidity are captured largely by the Wall Street middlemen rather than their customers, or the economy as a whole.
The more fundamental problem, as the Aspen panel reminds us, is that the components of modern finance -- the securities, the trading and investment strategies, the financing techniques, the technology, the fee structures and the culture in which they operate -- are all designed to work together to maximize short-term results. And, in such a self-reinforcing system, it is very difficult to change any one feature without changing all the rest."