Roots and Remedies

Last night I participated in a TV roundtable on the current financial crisis. My rationale regarding the roots and remedies of this crisis is based on the following:

Roots:

1) The end of the Bretton Woods agreement in the early 1970's issued by then US President Richard Nixon;

2) Decades of artificial monetary creation, in particular two periods since the beginning of this new millenium:

- the rate reduction cycle initiated in 2001 by Alan Greenspan which took interest rates down to 1% and, in effect, negative real interest rates;

- the huge spike in M3 growth initiated by Greenspan after the Iraqi invasion, and relentlessly continued by Ben S. Bernanke, which culminated in double digit growth rates by mid 2007.

3) As a direct result of low interest rates and high monetary growth, commercial and investment banks unleashed the credit beast to households and non financial institutions. And also elevated the OTC credit derivatives market to a whole new level.

4) The SEC failed to secure the beast and allowed a $60 trillion OTC market to put the whole financial system in jeopardy. And, as usual, rating companies, corrupted by their eternal conflicts of interest, were again useless.

Remedies:

1) The "Paulson Plan". Reality has shown that, under the kind of corporate incentives and monetary growth we have had over the past 20 years, a self regulated market is mere fiction. In fact, the Federal Reserve and Wall Street are victims of their own creation. Therefore, it is their responsability to clean up the mess. Wall Street has done its share. Over the past year, worldwide major banks have written off almost $600 billion in bad assets, they have raised in excess of $400 billion in additional capital and have laid off more than 120.000 employees. But now it appears they have reached a breaking point. That is why the world needs the "Paulson Plan" in its current or in a slightly different version. The world needs confidence that ultimately only the deep pockets of governmental authorities can provide.

2) Regulation in Over the Counter (OTC) markets, where credit derivatives (CDS, CBO, CLO, CCO, CFO and many more) ignited this whole crisis. There's an argument that defends OTC markets as the natural habitat for financial innovation. I agree. In that sense, it is perfectly adequate to allow private counterparties to directly trade and market among themselves certain illiquid instruments in a non regulated environment. However, that is not the case when a) these particular OTC markets are originated in a regulatory loophole within banking and insurance laws and; b) this innovation becomes a mainstream $60 trillion market which is equivalent to five times the US GDP! So, the regulatory oversight needed in this instance is quite simple and straightforward: all innovation markets must be brought into clearing houses and listed exchanges once they have achieved a certain size.

3) Higher capital requirements at commercial (and investment) banks. Given their size and systemic role, banks cannot be allowed to leverage their capital base by 20, 30 or 40 times. For example, as a trader try doing that with a simple futures account and tell me what happens if the market moves a whisper against you. You blow up! That's what banks are facing now - blowing up. Hence, the Federal Reserve has to issue an administrative rule requiring mandatory increases in banks' minimum capital levels. This will allow for the gradual disappearance, through acquisition or bankruptcy, of unsustainable banks. Of course, this third remedy can only be implemented after a government backed bailout plan has been given some time to work.

4) Last but not least, a return to some degree of tangibility, or currency-hard asset convertibility, of the global financial system. Because it was the breakdown of the Bretton Woods agreement that laid the groundwork for the current crisis in the first place.