Regulators attempt to formulate new laws to prevent the subprime crisis. - 4-Mar-08 - Generational Dynamics

The nominal reasons for implementing new regulations is to prevent anything like the "subprime mortgage crisis" from ever occurring again.

What makes these so laughable is that many of these kinds of regulations were put in place in the 1930s by the survivors of the crash of 1929 and the Great Depression. Those people were determined that credit would never be abused again, the way it had been in the 1920s. So they created new agencies, like the SEC (Securities and Exchange Commission), to prevent anything like the 1920s stock market bubble from occurring again. And they created new laws, like the Glass-Steagall Act of 1933, that mandated two different kinds of banks: Investment banks that could issue securities, and commercial banks that could lend money. (Savings banks that offered homeowner mortgages were another category.)

Well, the stock market bubble of the late 1990s was just as bad as the 1920s bubble, and so the SEC has already completely failed in its primary responsibility. And the Glass-Steagall Act was repealed in 1999, allowing any bank to do any damn thing it pleases, giving rise to the incredible abuses that we've been seeing.

Well, you know how people think. These are "old people's laws." These laws are for people who drive Model T Fords, or who use phrases like "back in ought-five." They aren't for today's ultra-modern world where we know so much more and carry iPods.

The third set of proposed regulations described above are to require banks to make CDOs easy to understand.

On Monday morning, Warren Buffett was interviewed on CNBC. Buffett was born in 1930, and so he remembers the horrors of the Great Depression from his childhood. Several years ago, he referred to credit derivatives as "weapons of mass financial destruction."

He was asked on Monday morning about derivatives. Here's what he said, according to CNBC's transcript:

QUICK: But we're going to start off with a question about derivatives, because Joe, you brought this up earlier. You were talking about those comments that Mr. Buffett's made in the past about these being weapons of financial mass destruction. And Warren, you said you had a couple other thoughts on derivatives.

BUFFETT: Well, you know, the ways you get into trouble in markets is doing things you don't understand, and then doing them with a lot of borrowed money. And derivatives combine those things. And--but the really important illustration that has never gotten picked up on much was that a couple of years ago Freddie and Fannie got into big trouble, billions and billions and billions of dollars of--that they had to restate. Now, Freddie and Fannie had auditors like everybody else, but they also had a government agency called OFHEO that had 200 people in it whose sole job was to oversee Freddie and Fannie. Two hundred people going to work every day, and those people did not pick up at all on all of these problems that Freddie and Fannie had. I mean, they were looking at complex financial instruments, you know, all kinds of swaptions and all that sort of thing. The auditors didn't pick up on it, but more important, 200 full-time--they didn't have to think about General Motors, they didn't have to think about AT&T. They had two companies to think about. And they issued a report later on telling about the failing of all--everybody else.

QUICK: Mm-hmm.

BUFFETT: But it shows you--when things get that complex, you're going to have a lot of problems. And CDO squared--I figured out, on a CDO squared you had to read 750,000 pages to understand the instruments that were underneath it.

QUICK: Oh, my gosh.

BUFFETT: Yeah. Well, you start with the RMB, that's the residential mortgage-backed securities, and that would have [50] tranches. And then you'd take--and that would be a 300-page document--you'd take a tranche from each one of that and create a CDO, 50 of those times three--300, you know, it becomes 15,000. Then you take a CDO squared with 50 more, and now you're up to 750,000 pages.

QUICK: You have to read through it.

BUFFETT: And the mind can't comprehend that. What people did comprehend was that the fees were terrific in selling them to the people.

For those who believe that Buffett is exaggerating, he certainly is not. Take a look at my article, "A primer on financial engineering and structured finance," and go through the math again, and understand that instead of a couple of tranches there can be up to 50 tranches.

Nothing illustrates the power of generational change than this attempt to use regulations to prevent another subprime crisis. These regulations are worthless because when the time comes for such regulations to work, the new generations of people will simply ignore them.

If you go back through history, there are many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash.

These are called "generational crashes" because they occur every 70-80 years, just as the generation of people who lived through the last one have all disappeared, and the younger generations have resumed the same dangerous credit securitization practices that led to the previous generational crash. After each of these generational crashes, the survivors impose new rules or laws to make sure that it never happens again. As soon as those survivors are dead, the new generations ignore the rules, thinking that they're just for "old people," and a new generational crash occurs.

We're now overdue for the next generational crash, and it might occur tomorrow, next week, next month, or next year.

Generational Dynamics Web Log for 4-Mar-08
Regulators attempt to formulate new laws to prevent the subprime crisis.

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Generational Dynamics Web Log for 4-Mar-08 Regulators attempt to formulate new laws to prevent the subprime crisis.

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Generational Dynamics Web Log for 4-Mar-08
Regulators attempt to formulate new laws to prevent the subprime crisis.