In 1988, a large fire tore through Yellowstone National Park, profoundly transforming one-third of the park in an ecological blink of the eye. Old pine and spruce made way for prairie grasses and wild flowers. For many years, charred hillsides reminded visitors of the devastation. Some lamented the destruction, while others saw in the conflagration nature’s indomitable sense of balance, of the cyclical nature of nature.
One of the most intense aspects of the fire and its aftermath were the intense arguments about the role of government policy on creating conditions prime for just such a fire. Many claimed that the decades-old policy of preventing even the smallest fires had led to an unsustainable build-up of underbrush highly susceptible to lightening or man-made sparks. In a well-intentioned effort to correct this policy mistake, forest managers had instituted new guidelines allowing for controlled burns to reduce the tinder. Ironically, in August 1988, several of these controlled burns were propelled by wind and dry conditions into the massive fires that consumed tens of millions of trees and plants. Thus, it would be fair to say that government policies helped create the conditions for fire, then provided the actual catalyst that caused the fire (with nature’s assistance, of course).
It would be almost too easy to draw parallels between the Yellowstone blazes and the implosion of the residential real estate market. One could blame well-intentioned government policies for creating the real estate mess in the first place and similarly well-intentioned policies for catalyzing the crisis and intensifying its impact. However, we would go further. For while it is convenient and fashionable to fix blame for the current economic crisis on congressional policy, Fannie and Freddie, regulatory failure, the Federal Reserve, and other government agents, the current crisis was fed—and continues to be fed—at least as much by consumers and business.
Consumers sought access to an impossible product: equity-free (and hence risk-free) access to real estate ownership and speculation. But many others benefitted as well from a poorly managed real estate market: Lenders, home builders, insurers, building material suppliers, real estate agents, furniture makers, contractors, utility providers, appliance makers, and countless others sought to sell to consumers a product too good to be true at an unsustainable growth rate to a highly leveraged consumer base. Investment banks, money managers and private investors provided the liquidity that kept the impossible possible for as long as it lasted.
The broad base of complicity (government, consumer, business) belies the challenge of using regulation as the primary lever for preventing similar bubbles from forming and popping. Regulation and policy strive to prevent a past crisis from happening again rather than preventing a new crisis from occurring in the first place.
Wearing our loosely labeled “libertarian” hat, we would like to think that the problems inherent in our financial system can be solved by improving the general character of humanity, creating a culture of accountability and personal responsibility in which people would choose NOT to develop, participate in, or otherwise benefit from unsustainable consumer and business practices. Wearing our similarly loose “progressive” hat, we would expect increased regulation of compensation, risk management, credit practices, consumer lending, the sale of securities, and the provision of investment advice to stabilize the financial markets and re-earn consumer confidence.
Rather than dismissing both of the above approaches (personal responsibility v. government intervention) due to their obvious limitations, we advocate—and strive to practice—a two-pronged approach. Given the influence of behavioral finance, we must make it culturally undesirable to get wealthy unethically. As a society we must ask, “Who do we admire? From whom do we accept charitable dollars? Whom do we elect? Where do we hold our deposits? From whom do we accept political donations?” We remain—and always have been—much tougher on the petty criminals amongst us that we are on those who destroy tremendous wealth through negligence and malfeasance, but do so with a suit and tie.
Sitting as we do at one of the nexus points in the continuum of the investment industry, we would advocate one simple theme to drive new regulation: transparency. Describe in plain language what an investment consists of, it’s true cost, the total compensation for assembling and/or selling the product, and specific risk factors to consider. All of the bundling, packaging and marketing of securities (e.g. MBS, ABS, CDO, HFOF, MF, ETF, PE and even money market) confuses even sophisticated investors who in other parts of their lives rely on common sense to make informed decisions. Remember, McDonalds started selling salads only when consumers started to take their business elsewhere. So long as investors and consumers want the impossible, the business community will create and sell it and elected officials will permit them to do so. Food for thought as we make our wish lists for 2010.