Because we wanted to have the cake and eat it, too

<< We just wanted it all.
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Monday morning was subdued because North America was still on the beaches for Labour Day. That didn't keep media coverage off the meeting of G20 finance ministers and central bankers held in London over the weekend, ahead of the G20 meeting in Pittsburgh later this month.

The FT outlined the agreements attained at the meeting:

The G20 meeting agreed [on] three main points: banks must raise much more capital once the financial crisis has passed; complex financial institutions should develop “living wills” to plan for their unwinding; and banks should be required to retain some portion of loans they repackage and sell as asset-backed securities.

Allow me to quickly rephrase that in simple English.

The second point mentioned is simple enough: in case a financial institution goes bust, they should outline the ways in which various instruments and deals should be cleaned up, or in financial jargon, "unwound."

The third point, while it may sound the most complicated, is also quite simple: banks should have the actual stuff they sell, deal, and work with (in this case, loans).

The most complicated of the three is actually the first point regarding raising more capital, which deals with the amount of debt (capital structure) financial institutions have. Of a given bank's debt, about 92% of it is made of bonds and other debt instruments. About 4% is made of stocks (shareholders' equity), and is there as a 'cushion' as deemed by regulation. The remaining 4% is what is called bank regulatory capital in Europe (in the US, it's called trust-preferred securities, or trups). This stuff has both debt- and equity-like characteristics.

Without going into too much more detail, the basic point of note here is that bank regulatory capital was categorically created and adopted in order to at once appease regulators' concerns about how well-capitalised banks are, and appeal to investors. In other words, everyone wanted the cake and eat it, too.

To be grossly simplistic, one could quite easily argue that most causal elements of the current financial crisis came down to this one, cliche statement about having the cake and eating it. To be more specific, it was about having the cake - not paying for it - and then eating it - and then getting away with it.

Take mortgage borrowers, for instance. A telling article in the Valentine issue of the New Yorker this year illustrated the literal foreclosure of the state of Florida. A university professor aptly described the situation as a "Ponzi scheme" where the US' hottest real estate market spiraled into a disaster. People bought homes with easy money from the banks, but when property prices fell off the cliff and people lost their jobs, no one was able to repay the mortgages. Apparently, convincted criminals were running around the market scene as well. Hence,

Fort Myers real-estate agent named Marc Joseph tells the writer, “Greed and easy money. That was the germ.”

Of course, the mortgage lenders are to blame as well. Loose credit history checks - or even none at all - and financial unplanning from irresponsible financial advisory allowed borrowers to get away with terms that defy what I would think of as common sense. You don't spend beyond what you don't have or earn - having been on a $1 per month allowance up until the age of 15, financial prudence was something my mother was very strict about. But, given high incidences of credit card spending - combined with the so-called American Dream of home ownership with white picket fences, lush-green front yards and a golden retriever puppy - perhaps the average American consumer is far from prudent.

Here, the role of the mortgage borrower and lender - what I think of as the key trigger to the subsequent fall of already-wobbly dominos - is a microcosm of the greater picture: people had the cake, didn't or couldn't pay for it, but ate it anyway, and for the longest time, didn't own up to it. And this kind of irresponsible behaviour was widespread, from the individual consumer all the way up to the private equity firms and the bulge-bracket banks. So no, the Goldman Sachs and the Morgan Stanleys of the world did not single-handedly bring down the entire global financial system - such are incredulously outlandish statements made in the blaming game, and completely ignores the fundamental cause of the financial turmoil (irresponsible borrowing, spending, and lending) and more broadly, the essence of how our economy functions. That is, capitalism.

Capitalism, which is essentially what the majority of the financial world operates in, is based on the one basic rule of supply and demand. Unfettered, efficient capitalism has at its core this simple rule that if supply goes up, demand comes down, and vice versa. And for this reason, like it or not, much of how the economy moves is based not just on tangible changes in supply or demand, but also the perception of these changes by the broader market, as well as by individual consumers.

The crux of capitalism is the freedom to supply and demand; that is, no one can tell me whether or not I can buy a pair of shoes, or produce a pair of shoes, over a pair of glasses. An efficient capitalist economy relies heavily on this liberty. But, as much as we'd like to rely upon the individual and collective conscience in maintaining an orderly and civil society, there is something to be said about the fragility of that conscience - whether it be moral, ethical, whatever. Laws and regulations govern human behaviour by permitting and prohibiting certain actions within society. Whether we had hoped too far or unrealistically expected market participants to exercise self-restraint is a mull point; the fact of the matter is, without rules or boundaries - and more importantly, a widespread perception of them - people will always look to have their cake and eat it, too. If laws have been around for most of human history to tell us what we can do and what we cannot do in a social context, it should be obvious by now that something fairly similar should exist in an economic context.

This isn't to say that burdening the financial system with piles of regulation is the solution. Going forward, rules and regulations for this particular industry will have to tread a fine line of optimum efficiency. Not an easy task, at all. But in a system where most of its participants have developed habits of having the cake and eating it without owning up to the costs, some re-training will have to occur.