Lessons of Financial Crisis?

Today's Wall Street Journal's Money & Investing carried an article by Joellen Perry entitled, "Lessons of Financial Crisis."

Ms. Perry opens her piece with this passage,

"Some of the world's brightest economic minds agree the current financial crisis exposed major flaws in the system, but disagree about the role regulators should play in preventing a repeat.

At an annual gathering Thursday of economic Nobel laureates on a tiny, medieval island in southern Germany, three winners of the Nobel Price in economics and one Peace Prize winner lamented the excessive risk-taking, lax management and impenetrable complexity at the heart of the financial system's current turmoil."

So far, so good. But as Ms. Perry reports on the laureates' angst over bankers tossing their clients over the side in pursuit of profits, it becomes clear that this gang of ivory tower geniuses just doesn't understand the real world of finance.

The fact that Myron Scholes, co-architect and gargantuan money-loser, with John Meriwether and another Nobel prize winner, Robert Merton, of Long Term Capital Management, is one of the whiners should tell you something. These guys are not all rooted in the real world of modern day finance.

For example, Daniel McFadden, the 2000 Nobel Economic laureate, suggested,

"We may need a financial-instrument administration that tests the robustness of financial instruments and approves only the uses where they can do no harm."

Have you stopped laughing yet? I haven't.

At least Scholes noted,

"Sometimes, the cost of regulation might be far greater than its benefits."

Let's get a few things straight.

First, financial services is unique among sectors in that leverage allows a few individuals to profit, now, from transactions which might, in the future, prove to be money-losing. So the incentive of really smart people to quickly fleece less-smart people on a large scale is immense.

Second, regulators aren't paid very much. And operate in specific countries. Thus, the smart individuals who design and produce new, complex and 'innovative' financial instruments will always be a few steps ahead of the regulators.

McFadden's idea is so stupid you almost can't believe anyone would actually voice it. All someone has to do to evade his proposed regulatory scheme is locate their financial services business or exchange in Lower Slobbovia, after having contributed generously to that country's government, or promising to pay attractive tax rates for the privilege of nonexistent regulatory oversight.

There's always a domicile for the financial service concept seeking less regulation.

Third, how can anyone affect, in process, the harmful use of financial products? Sometimes the damage comes from a fallacy of composition, wherein what a few may profitably do becomes disastrous on a large scale.

Isn't this what occurred with CDOs? A few badly-designed instruments wouldn't have really affected but a few unwise investors. A huge volume of them has undermined valuations on a global scale.

Which brings me to my own salient point about this topic, and Ms. Perry's very good article.

The real lesson of financial crises, in my opinion, is that buyers always need to beware. Period.

As noted investor Wilbur Ross has stated,

" 'When someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.' "

Why would you buy something so complex that you can't understand it? Why would a 'sophisticated' investor, including a Wall Street Journal investments columnist, buy something because,

"Like other victims I've heard from, I got a call urging me to take advantage of an offer that was being extended to valuable clients."

Financial services isn't like medicine, where the doctor treats a largely-unaffectable supply of diseased bodies.

In financial services, everyone with money is a target whom to separate from said money. The implied fiduciary principles and behaviors of financial services purveyors, consultants, et. al., are highly suspect when paired with the motive for these vendors of products and advice to make a profit from their clients.

Simply put, responsible adults do not:

-take out mortgages at rates and in amounts they feel they cannot actually pay.
-invest in financial instruments they can't understand simply because someone paid to get them to do so says it's 'a good idea,' or 'an offer to valuable clients.'
-hand over their financial assets and futures to people who will be paid in the event of non-performance.

Most of the so-called financial services 'crises' came about because investors- either in financial institutions or financial products- exercised too little, or no, due diligence and caution when investing in the aforesaid 'assets.'

It's not the suppliers of financial services we need to regulate. They will always exist, smarter and faster-moving than any regulator.

We need to make sure that investors realize they are on their own to analyze their asset and liability options and must live with the financial consequences of their choices.

That's how risk is best managed. When the investors and borrowers feel they must take responsibility for their financial actions.

That's the real lesson of financial crises. They are preventable if people don't expect something for nothing, or extra financial gain for no added risk.