Beware the Consensus Stampede

As the financial sector reform bill takes final shape, the S&P and credit spreads are gyrating. This suggests a mixed effect on the confidence of market participants. Meanwhile, the bill’s proponents’ confidence appears to be boundless.

As a market practitioner, I’m confident of one thing: The reformers’ confidence is misplaced. No matter how sensible Congress’ provisions may be, crises will happen again. Regulatory changes can affect the frequency, severity and nature of financial panics, but they mostly trade off growth against stability. Crises are to financial systems as fires are to forests.

A system that turns things that aren’t money (HELOCs, asset-backed commercial paper) into instruments people treat as ready money (bank deposits, balances in money-market funds) relies on the power of illusion. From time to time, people see through the illusion and realize that what’s behind their “money” is really baloney-namely, assets that have lost value. Suddenly, there is no substitute for real money, and the exchange rate between it and baloney moves violently. That’s what’s called a crisis.

In the wake of the Great Depression, economist Henry Simons advocated that financial claims exclusively take the form of equity. No illusions there, but good luck getting a mortgage or even a good night’s sleep. You can know exactly what you’ve got and worry constantly about fluctuation in value, or you can rely on the illusionists to turn volatile assets into nominally fixed claims-but at the cost of periodic, violent crises. Financial reform will surely move our system toward safety, but for any system of baffles, there is an investment calculus stupid enough to crash right through them.

As a hedge funder, I’d love to see banks’ proprietary trading limited (I hate competition), and it is certainly conceivable that a bank could blow itself up through unwise prop activity. Yet the vast majority of failed and nearly failed banks didn’t have meaningful prop books. They made foolish decisions in ordinary lending activity.

What underlie crises are bad investment decisions, and they are difficult to regulate away. Sharp and empowered regulators can do a lot to prevent intentionally bad decisions (e.g., fraud). But most investment errors are sincere. Humans are irrational, prone to bouts of foolish optimism. Regulators are humans, too. Worse, when regulators have wide discretion, market participants focus less on fundamentals than on trying to predict the regulators’ actions.

As an emerging-markets investor in the ’90s, I watched very talented economists put aside their models and spend their days tracking the travel of I.M.F. senior management in order to predict which country would get a bailout. Making people bear the consequences of their investment decisions will produce better decisions than otherwise, but it is hard to see how the new rules do much on this score.

If there’s one thing that I wish the regulators understood, it’s that the worst blowups are ignited by bad trades that become a consensus stampede. In emerging markets, the crashes always traced back to something everybody considered “the trade of the year.” This time, it was the strong and wrong consensus around housing values. The next one may arise from the assumption that developed-markets sovereigns don’t default.

Stability depends on disagreement. A constructive regulatory regime would institutionalize disagreement-by, for example, increased risk-weighting for assets that are heavily owned-and, in automatic fashion, lean against monolithic consensus. Alas, politicians so unanimous in their views about the power of regulation to prevent crisis appear to be caught in a consensus stampede of their own.


HFM’s Diary of a Very Bad Year: Confessions of an Anonymous Hedge Fund Manager is out this month.



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