Margin Calling

 A common feature of both the 1929 Crash and the unnameable financial crisis of 2008 is a high volume of margin calls on highly  leveraged securities portfolios.  This time it's hedge funds that have done the excessively leveraged buying.  As the prices of the securities the hedge funds bought at a high margin plummet, the hedge funds need put up more cash collateral to their lenders to replace the lost collateral represented by the plunge in value of the security bought on margin.  This forces the excessively leveraged hedge fund to sell shares, driving prices down.  Forced sales to meet ever increasing margin calls creates a vicious cycle that leads to a market plunge.  This is what has been repeatedly happening in the markets  lately and was a key factor in the 1929 collapse.   An important provision of the Securities and Exchange Act of 1934 allows the Federal Reserve to set margin limits on the amount of leverage used to purchase securities.   The Federal Reserve does this through Regulation T.  But Hedge Funds exploit an exception in the Investor's Company Act of 1940 that allow investment entities comprised of sophisticated investors (investors holding more assets than most people have, no Mom & Pop investors need apply) to avoid margin regulations.  The exception was not meant to apply on the scale it is being exploited by Hedge Funds today.  No one foresaw the hedge fund explosion and how it would introduce the same systematic risk caused by over leveraged equity purchasing that proved so fatal in the fall of 1929.  Yet here we are again.  Despite the earnest arguments that hedge funds should be unfettered in order to take risks that are net beneficial for the economy, it makes no sense to allow them to engage in the same unregulated margin purchasing that destabilized the financial system in 1929 and now again in 2008.  The systematic risk from over leveraged security purchasing has nothing to do with the sophistication of the investor, rather it arises from the aggregate actions of a number of risk taking investors.  It is naive a la Greenspan to think that because someone is a  sophisticated investor they won't take on risk that when aggregated with that taken on by other sophisticated investors  proves disastrous.  This notion has been proven false now twice.  The loophole that hedge funds exploit to escape margin requirements needs to be closed.  This would be one small step to restoring sanity to our markets.       

God is Dead!

Isn't Alan Greenspan admitting that free markets need regulation to avoid collapse a little like the Pope admitting God is dead? I believe in free markets, but as I've said before equating freedom with anarchy is a mistake. And this is precisely the mistake that Milton Friedman and Alan Greenspan made. No rational person wants to live in a lawless society precisely because their freedoms become subject to the whims of the more powerful. It is the rule of law that is the basis of our freedom, not the lack of law. Some laws may be misguided, vindictive, or even irrational, but that is an argument for changing those laws and not for throwing out the entire legal system. Likewise, what has just happened in the markets is an argument for reforming the regulation of capitalism, not for abandoning capitalism for its empirically proven worse alternatives.

Milton Friedman We Hardly Knew You

Alan Greenspan just admitted that his central assumption regarding financial institutions, that they could take care of themselves without government regulation, was wrong. Pretty big mistake Alan. More on this later, I'm at work, but reading this admission from such a devout Friedman disciple made my jaw drop. Most economists strike me as naive in the sense that they generally don't have much real world experience that can temper their abstractions, and in this case we're paying a monumental price for the free market naivete of the Ayn Rand school.

Risk Management Failure

The New York Times has a good article outlining the opposition to derivative regulation during the last couple of decades.  It's particularly damning to Alan Greenspan, and Robert Rubin, two avid proponents of not regulating derivatives.  For them and other free marketeers  derivatives had  dispersed risk among investors to a level that made the risk negligible.  Greenspan believed that derivatives were the ultimate hedge and used his stature to prevent derivative regulation on the grounds that doing so would damage the markets.  On the Oracle Greenspan's bidding, the Republican Congress legislatively blocked derivative regulation, and a lame duck President Clinton signed derivative deregulation into law.  High finance had solved the vexing problem of capitalism's cyclical credit crises.  

Events have revealed the extent of this hubris.  Irony has turned into tragedy.  The ultimate hedge spawned into viral risk spreading swiftly as the plague through the entwined parties and counterparties.  Now the best we can do is try to stanch the mortality rate while madly searching for a cure.  Take up the bodies.