Just as an fyi, this is not something Greenspan has just recently decided to pin the problem on.

Infact, as early as 2002 (http://www.federalreserve.gov/boarddocs/speeches/2002/20020830/), the fed has been referring to this, as well as myriad other inadequacies in the financial market.

E.g. Risk management within financial bubbles.

With all due respect (and I know you are sincere in your distaste for regulation), you can’t have “compliance” without regulation.

You would get no, or very unreliable financial statements if there were no regulation. Brokers could tell you anything, not be held to fiduciary standards, misexecute your trades, and you’d have no recourse if there were no regulation (I’ll be the first to admit the arbitration process ain’t great, but it’s better than nothing). You wouldn’t have standardized settlement if there were no regulation. Brokers are now required to execute market orders within a very tight time frame (I think 3 seconds of electronic receipt of the order) AND they have to be able to prove they executed it within that time. No more playing with the order book to benefit the house to the disadvantage of the customer.

I worked in the securities industry when it was more heavily regulated as a whole than today. Aside from the fact that the SEC now requires disclosure documents to be written in a more user friendly fashion, the industry then delivered much better results for the economy as a whole than it does now. And despite your concerns, there was far less off balance sheet and whatnot creativity than we see today.

Yes, fees and spreads are lower than they were then. But does the world benefit from the hair trigger trading that lower costs facilitate? The average time that an NYSE stock is held is now 7 months. No wonder no one manages for the long term. They pretty much don’t have long term shareholders. And that trend has been hugely destructive to the real economy. (One of my buddies nearly 15 years ago proposed a transaction tax because he recognized that near-fricitionless trading would foster speculation).

Similarly, as I’ve noted before, the Fed sat by while derivatives markets exploded, Now I have worked for derivatives firms; derivatives can be highly useful tools. But you can blow yourself up very quickly with them.

And the biggest derivative market, credit default swaps, isn’t a classic derivative but more like a massive unregulated insurance market. There have been so many firms whose balance sheets are not subject to outside inspection (hedge funds) writing CDS that it is scary. Oh, they will assure you they are hedged. Right. Dynamically hedged using correlation models with maybe 5 years of data, never tested in a bad market, and oh BTW many of those models are blowing up right now. I assure you we will have a CDS train wreck; the only question is whether it can be contained or whether it spirals into something worse.

Regulation does not stop bad behavior, but when designed properly, it makes it sufficiently difficult and costly so as to limit its scope and therefore hopefully its impact. The S&L crisis was the direct result of poorly thought out deregulation. When you have a financial system that is effectively underwritten by the public at large, it is imperative to have some controls.

Richard Bookstaber has compared the modern financial system to a nuclear reactor. You wouldn’t dream of letting a private unregulated operator set up a nuclear reactor within 20 miles of your home. This is fundamentally no different.

I believe the problem with regulation is a) the difficulty of tweaking rules when they are discovered to work badly and b) the fact that regulators are subject to “regulatory capture” meaning being co-opted by their charges. The SEC and the FDA are prime exhibits of the latter. But that is also due to the cultural drift over the last 25 years successfully fomented by the Chicago School against regulation. As this credit debacle rolls on, regulation will come to look very attractive because we will get repeated illustrations of the costs of insufficient regulation.

Frankly, regulation scares me, blame it on some long delayed bout of adolescent instinct to rebel. Regulation keeps most people oin line but tends to encourage the channelling of creativity towards finding loopholes and exploiting them, think for instance SIVs. Give guidelines, encourage compliance, let investors, lawyers and the market in general “punish” those who don’t want to play nice, so to speak, moral hazard really is about how people won’t learn not to stick their hand into the fire until they feel the scorch. That’s not not dismissing the fact that some people like pain, hey, it takes all kinds to make the world.

As for models and regulation, sure the Chinese have more incidents of irregularities and opacity, but no model can ever include fraud as a variable or even opacity, some things cannot be quantified, that is a major failing of a system that is so reliant on stats and quantification. As said in a previous post on my own site (no, this is not pr or advertising; just stating that this is not a new thought), the wider the number of variables, the less accurate the resultant model. Aggregation of models might produce conflicts in terms of predictions as well as reasonableness (did that make sense?).

What is sad in the present crisis is not the widespread failure (amongst some of the best minds in the business) to see crisis looming but that reaction and the race for solution has been pushed aside by a desire to pass the buck. The best model cannot rival reality and foreseeing disaster is useless if you don’t have a solution.

If I ever get around to writing a book, I am sorely tempted to have a go at this incoherent, internally inconsistent, yet somehow-part-of the-orthodoxy concept of “free markets.” Free markets is interpreted as meaning “unregulated” but if anyone understood what that meant, no one would want to operate in a system like that (well maybe Harry Lyme types, acting as profiteers in an lawless regime).

The problem is that others have written books in this general subject area and the orthodoxy remains intact (and I’m not sure the books did all that well either).

Stocks are an inappropriate instrument to exchange on an anonymous basis; unlike bonds, which make very specific promises regarding their payments and the owners’ right if there is a default, equities are extraordinarily ambiguous” “gee we’ll pay a dividend if we make enough money and we feel like it. Oh, and you can vote, but hey, don’t be surprised if you are diluted.” Historically, equity owners were more like venture capitalists: they knew the company and the management and were often actively involved in promoting the enterprise.

Lots of regulation made it possible to trade stocks on a mass basis. Yet most people thinks of the stock exchange as an idealized example of a market. Bizarre.

Greenspan’s comments are entirely reasonable if you believe that markets are some sort of natural phenomena that we must do our best to predict and model rather than try to change. The weather can’t be changed by people (in the short term, at least, global warming aside…), so the best we can do is predict it as accurately as possible, continuing to tinker with our models as our knowledge increases.

But the markets are our own creation. Rather than accept negative feedback loops and other phenomena that lead to instability, why not regulate the markets better and force a more linear (or at least more predictable) behavior?

For example, after the 1987 crash, the feedback loop nature of program trading was recognized. What did we do? We didn’t just exhort traders to update their models. We changed the rules and instituted circuit breakers to suspend trading when there are extreme swings in a stock.

Again, I think Greenspan’s fundamental mistake isn’t his analysis of models. It’s his inability to entertain any alterations to his beloved “free” markets as part of the solution.

That says a lot about where we are at today.

The aging tuning parameter is designed to speed up or slow down the aging effect in the model. The aging effect controls when the model forecasts loan/pools to reach their full amount of turnover and refi SMM’s. Increasing the aging parameter will make the model reach the full amount of turnover and refi SMM sooner, and decreasing it towards 0 will push the aging peak out further. Values for aging can be any number greater than 0, and the default value is 1.0.

The lag weighting on the mortgage coupon used when determining refinance incentive. The model uses a blended mortgage interest rate from the previous 3 months to determine the relative refinance rate for a given loan/pool. Adjusting the lag parameter above 1.0 puts more weight on the interest rate from 3 months ago, and decreasing towards 0 places more weight on the rate from last month. Values for lag can be any number greater than 0, and the default value is 1.0.

Burnout tuning allows the user to adjust the rate at which the model’s burnout occurs. There are two types of burnout tuning, “model” and “sensitivity.” Choosing “model” will change the historical burnout rate (if you are running an analysis where the loan/pool has already aged) from pool/loan origination, and going forward into forecast. Choosing “sensitivity” will only change the burnout rate going forward from today, i.e. in the forecast only. This tuning parameter is useful for situations where the user feels that the model does not slow down enough when the loan/pool becomes seasoned, or where too much prepayment occurs too soon and the speeds being forecast for the older ages are too low. Increasing this parameter above 1.0 will make more prepayments occur sooner, and decreasing towards 0 will make seasoned collateral prepay at a higher rate. Values for burnout can be any number greater than 0, and the default value is 1.1.