Unrestrained capitalism leads to reckless behavior for the benefit of the few at the expense of the many. That is what we are witnessing now. Capital standards only go so far. What is needed is more daylight in the system. Skyrocketing oil prices can be traced to exemptions in the CFTC rules for oil trading, for example. Hidden manipulation of markets is threatening world stability. We need to move quickly to circumscribe these excesses
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High Finance Laid Low
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And though now overused, "securitization"—the packaging of mortgages into bonds—has tended to lower rates by tapping a larger market for funds.
The story is similar for other innovations. Personal investment choices have mushroomed. In 1980, households had half their financial assets in bank deposits and savings accounts; only 34 percent were in stocks and a meager 2 percent in mutual funds. Since then, Americans have diversified: in 2006, 25 percent of household assets were in mutual funds, 28 percent in stocks and 28 percent in bank deposits and savings accounts (the rest were scattered across bonds and money-market funds).
Or take a more sophisticated innovation: the rise in the 1980s of "leveraged buyouts" (LBOs), now known as "private equity." In an LBO, a group of investors buys all the stock of a publicly traded company mostly with borrowed money (the "leverage"). On balance, the threat or reality of a takeover has improved corporate performance, says finance professor Steven Kaplan of the University of Chicago. But there's also the dark side. LBOs follow boom-bust cycles, he says. In the speculative climaxes, the bet is that companies can be bought with cheap money and later sold profitably in a rising stock market. If the bet fails, defaults will ensue.
It is often wrongly said that the present problems originated in the mindless financial deregulation begun in the 1980s, as if everything would be fine if the old financial system remained. Actually, the old system—dominated by banks and savings and loan associations—essentially collapsed. Many S&Ls failed when high inflation raised interest rates on their short-term deposits above the levels on their long-term mortgages. Banks suffered huge losses on energy, commercial real estate and developing-country loans. Securitization and other new forms of financing filled the void left by weak banks and S&Ls.
So modern finance has a split personality. Greed, shortsightedness and herd behavior compromise its fundamental usefulness. But we cannot regulate our way out of this dilemma, because regulators can't anticipate all the problems and hazards either. The best protection against human fallibility and the financial system's self-inflicted wounds is to insist that major financial institutions have ample capital to absorb unexpected losses. The Paulson report did not focus much on that—Congress should.
© 2008
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