The Problem No One's (Seriously) Addressing

Of all the financial reform proposals out there right now, not one seriously addresses the overriding problem with the current financial model. This problem is, of course, the famous Musical Chairs Problem described by then-Citigroup CEO Chuck Prince:

"[A]s long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he said in an interview with the FT in Japan.

Financial houses, even at the highest levels, knew that subprime mortgage bonds were bad investments. They're not (that) stupid. In fact, they knew that subprime would cost them -- and not just naive investors they peddled subprime to -- substantial sums of money. Financial houses were forced to hold the worst tranches of subprime mortgage bonds, because even they couldn't unload that crap onto unwitting investors. As Jon Danielsson noted in an article on VoxEU today:

Unfortunately, the quality of SIV ratings differs from the quality of ratings of regular corporations. A AAA for a SIV is not the same as a AAA for Microsoft.

And the market was not fooled. After all, why would a AAA-rated SIV earn 200 basis points above a AAA-rated corporate bond? One cannot escape the feeling that many players understood what was going on but happily went along.

So why did they keep going? Because the music was still playing, and "as long as the music is playing, you’ve got to get up and dance." When you see other firms generating huge fees by originating more and more crappy mortgage bonds, you have to keep pace, lest you be seen as less successful, and lose valuable market share. The same thing happened in the tech bubble: remember the beating Warren Buffett took for not investing in internet stocks when the bubble was inflating?

Essentially, the problem boils down to this: The payoffs from maintaining short-term competitiveness are greater than the payoffs from sound, long-term investing. Until we break the link between the short-term competitiveness of a financial firm (which, as we've seen, is often illusory) and the overall success of the firm, we have not learned our lesson from the subprime crisis. It's a big task that requires fundamental changes, but it's a task well worth undertaking. Unfortunately, no financial reform proposal I've seen seriously addresses this issue. (Alan Blinder proposed forcing firms to keep a slice of a mortgage bond, but Yves Smith quickly tore down that simplistic solution.)