Two significant market problems that contributed to the crisis.
By Daniel at 15 April, 2009, 11:06 pm
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First, securitization, as it was done, was a regressive step for the market, as it decreased transparency. This can be compensated for by creating better standards for CDOs and the like, and, more importantly, tying the initial issuer to the security in some way by having them own some part of the security for the life of the loan. That helps ensure that some information about the origins and quality of security are kept alive for the life of it. As an aside, this is important for compensation structures too; until a position is closed, bonus compensation should be tied to the performance of a position. This would help eliminate paying out bonuses for short-term performance upswings that don’t account for long-term risk.
The second major market failure was the mispricing of insurance/naket puts. The sellers of naked puts or insurance are leveraging themselves, and when the size of these types of assets grow, they become, as Buffett put it, financial WMDs. It’s important that the amount of leveraging that was allowed (30x) both be not be allowed to exist. We need to encourage less consolidated or homogenic economic risk by discouraging larger entities from being able to take the same risk as smaller entities. As companies get larger, their leveraging capabilities should decrease.
The general principle here is that as an entity gets more powerful, it needs to purchase more insurance so that it has less ability to affect the system as a whole. That is how we deal with public citizens when they gain control powerful objects, such as automobiles (auto insurance) or dangerous chemicals (licensing or registration).
— Frank Tobin
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