Taleb: How to Prevent Other Financial Crises

Nassim Taleb presents a very simple principle for avoiding financial crises.

But sometimes the simplest principles are the most difficult to implement.  For example:

Thou shalt love the Lord thy God, with your whole heart, and your whole mind, and your whole strength, and love your neighbor as yourself.  This is the whole of the law.

But even as we fail to achieve its simple perfection, the principle remains, and one can judge how well they are doing by how close, or far away, they are to it.

Obviously the failure to aggressively prosecute fraud, and even the rewarding of participants as agents, when they both succeed and fail, has created a system that is completely, utterly broken.  The regulations proposed as remedy are complex, and that is no accident, because fraud revels in complexity and loopholes.

And the watershed event in all this was the decision, and I would say the glaring policy error, to bailout the banks and cover up their crimes.  That cover up continues and grows like a cancer, distorting policy and public discussion with its corruption, even to the highest reaches of the system. 

There are no heroes here, just craven, compromised, and even badly used men who promote the interests of the powerful monied interests, and their own illusions and delusions, on the broken backs of their fellows and their oaths to uphold the law. 

They will either change and reform the system, or they will eventually be thrown down and cast out in disgrace and dishonor.   It is hard to imagine it while they are riding high, but that is the simple lesson of history.

SAIS Review Volume XXXII No. 1
How to Prevent Other Financial Crises
Nassim Nicholas Taleb and George A. Martin

This article argues that the crisis of 2007–2008 happened because of an explosive combination of agency problems, moral hazard, and “scientism”—the illusion that ostensibly scientific techniques would manage risks and predict rare events in spite of the stark empirical and theoretical realities that suggested otherwise. The authors analyze the varied behaviors, ideas and effects that in combination created a financial meltdown, and discuss the players responsible for the consequences. In formulating a set of expectations for future financial management, they suggest that financial agents need more “skin in the game” to prevent irresponsible risk-taking from continuing.

Introduction

Let us start with our conclusion, which is also a simple policy recommendation, and one that is not just easy to implement but has been part of history until recent days. We believe that “less is more” in complex systems— that simple heuristics and protocols are necessary for complex problems as elaborate rules often lead to “multiplicative branching” of side effects that cumulatively may have first order effects.

So instead of relying on thousands of meandering pages of regulation, we should enforce a basic principle of “skin in the game” when it comes to financial oversight: “The captain goes down with the ship; every captain and every ship.”

In other words, nobody should be in a position to have the upside without sharing the downside, particularly when others may be harmed. While this principle seems simple, we have moved away from it in the finance world, particularly when it comes to financial organizations that have been deemed “too big to fail.”

The best risk-management rule was formulated nearly 4,000 years ago.  Hammurabi’s code specifies:

“If a builder builds a house for a man and does not make its construction
firm, and the house which he has built collapses and causes the death of the
owner of the house, that builder shall be put to death.”

Clearly, the Babylonians understood that the builder will always know more about the risks than the client, and can hide fragilities and improve his profitability by cutting corners—in, say, the foundation. The builder can also fool the inspector (or the regulator). The person hiding risk has a large informational advantage over the one looking for it...


Read the rest here.

All those who are in favor of reform, and justice,
and equal protection under the law for all, including
the weakest and the least among us, please raise your hand.

Clear and Present Danger: Why We Must Break Up the Too Big To Fail Banks Now - Dallas Fed

What makes the attached essay on the US banking system so striking is not so much what is being said,  since others have said it before, but rather, who is saying unequivocally that the status quo in the US banking system presents 'a clear and present danger' to the national economy.

"More than three years after a crippling financial crisis, the American economy still struggles. Growth sputters. Job creation lags. Unemployment remains high. Housing prices languish. Stock markets gyrate. Headlines bring reports of a shrinking middle class and news about governments stumbling toward bankruptcy, at home and abroad.

Ordinary Americans have every right to feel anxious, uncertain and angry. They have every right to wonder what happened to an economy that once delivered steady progress.

They have every right to question whether policymakers know the way back to normalcy. American workers and taxpayers want a broad-based recovery that restores confidence. Equally important, they seek assurance that the causes of the financial crisis have been dealt with, so a similar breakdown won’t impede the flow of economic activity.

The road back to prosperity will require reform of the financial sector. In particular, a new roadmap must find ways around the potential hazards posed by the financial institutions that the government not all that long ago deemed “too big to fail”—or TBTF, for short.

In 2010, Congress enacted a sweeping, new regulatory framework that attempts
to address TBTF. While commendable in some ways, the new law may not prevent the biggest financial institutions from taking excessive risk or growing ever bigger.

TBTF institutions were at the center of the financial crisis and the sluggish recovery that followed. If allowed to remain unchecked, these entities will continue posing a clear and present danger to the U.S. economy.

As a nation, we face a distinct choice. We can perpetuate TBTF, with its inequities and dangers, or we can end it. Eliminating TBTF won’t be easy, but the vitality of our capitalist system and the long-term prosperity it produces hang in the balance.

Harvey Rosenblum, Choosing the Road to Prosperity: Why We Must End Too Big To Fail - Now, Dallas Federal Reserve Bank

Harvey Rosenblum is the Dallas Fed’s executive vice president and director of research.

Read the rest here.

The perpetuation of the status quo is favored by the monied interests on Wall Street and the very powerful New York Fed which has always been their house bank.

It is also supported by the politicians and advisors of both parties who have become addicted to taking Wall Street money, both as campaign contributions, as well as highly paid sinecures and consulting fees when they leave office.

The Banks must be restrained, and the financial system reformed, with balance between individuals and the corporations restored to the economy, before there can be any sustained recovery.

Gold Daily and Silver Weekly Charts - Silver Refused to be Used

Tomorrow is the end of quarter for the funds and prop desks.

Here is where we are on the options calendar.

I think it can help one to understand the relative weakness of gold as compared to silver.

March 27 Comex April gold options expiry
March 27 Comex April copper options expiry
March 28 Comex April miNY gold futures last trading
March 28 Comex March silver futures last trading day
March 28 Comex March copper futures last trading day
March 28 Comex April E-mini copper futures last trading day
March 28 Nymex March palladium futures last trading day
March 29 Comex April E-mini gold futures last trading day
March 30 Comex April gold futures first notice day
March 30 Comex April copper futures first notice day

SP 500 and NDX Futures Daily Charts - Another Light Volume Wash and Rinse - Quarter's End

Durable Goods, Stock Market, Fed in the Driver's Seat & Why
by Ilene

After reading Lee's article, I asked him, "Why is it the Fed's job to be propping up the stock market? Doesn't it make the whole market a Fed-controlled game, rather than what it started as - a mechanism for companies to raise money and people to invest in public companies?"

Lee answered: "Bernanke has made no bones about it. He sees the stock market as a legitimate instrument of policy manipulation. It's his biggest tool, much bigger than the ones between his ears and his legs. The Fed works for the banks, and the capital markets exist as a means for 'capitalists' to extract wealth from the public. Stock markets weren't started for the purpose of enriching the public, that's for sure... The Fed has two clients, the US Treasury, and the banking system. It operates to make sure that they stay in business."

Lee also noted that the history of the Fed is replete with a variety of programs where it tried to manipulate something. "The stock market manipulation is relatively new as an overt policy tool, but the Fed can't manipulate indefinitely. Eventually the unintended consequences will rise up and bite it in the ass."

Worth moving up, "the grateful unemployed" asked an excellent question in the comment section of Zero hedge: "So why did the Fed precipitate the 2008 crash? Any thoughts?"

Lee: "It was just another one of their serial blunders. It's just that some of their mistakes look good on the surface for a while until the unintended consequences overwhelm the intended ones. That one went bad immediately. I was shocked at the time that they would sterilize the alphabet soup programs that started with the TAF in 2007, by pulling the funds from the SOMA, thus crippling the Primary Dealers. I warned repeatedly that it would precipitate a crash, especially as the Treasury began selling over $100 billion a week in new debt to fund the TARP in Q3 2008. Bernanke fucked up, plain and simple. They started to realize the mistake in November by starting direct purchases of limited amounts of GSE paper, but didn't go full bore until they started massive Treasury purchases in March 2009. That turned the market."

Read the rest here.

Tomorrow is the end of the first quarter. hi ho