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In a previous post, I wrote about what I see as the cowardice and small-mindedness of the U.S. government and in particular the regulators for not demanding daily portfolios of all large investors.  Of course this goes for the governments in Europe as well, and especially right now.  The Economist had a good article this past Friday which attempted to quantify the results of a Greek default, but there were major holes, especially in the realm of “who owns the CDS contracts on Greek bonds, and how many are there?”.  This fear of the unknown is a root cause of the current political wrangling which will probably end in a postponement of resolving the Greek situation; the question is whether the borrowed time will be used properly or squandered.

It’s ridiculous that nobody knows where the risk lies, but as a friend of mine pointed out to me last week at lunch, it probably won’t be enough to demand the portfolios daily, even if you had the perfect quantitative risk model available to you to plug them into.  Why?  Because if “transparency” is what the regulators demand, then “transparency” is what they would get – in the form of obfuscated lawyered-up holding lists.

In other words, let’s say a bank has a huge pile of mortgage-backed securities of dubious value on their books, but doesn’t want to accept losses on them.  If they knew they’d have to start giving their portfolio to the SEC daily instead of quarterly, it would change the rules of the game.  They’d have to hide these holdings by pure obfuscation rather than short-term month- or quarter-end legal finagling.  So for example, they could invest in company A, which invests in company B, which happens to have a bunch of mortgage-backed securities of dubious value, but which is too small to fall under the “daily reporting” rules.  This is just an example but is probably an accurate portrayal of the kind of thing that would happen with enough lead time and enough lawyers.

What we actually want is to set up a system whereby banks and hedge funds are motivated to be transparent.  Read this as: will lose money if they aren’t transparent, because that’s the only motivation that they respond to.

In some sense, as my friend reminded me, we don’t need to worry about hedge funds as much as about banks.  This is because hedge funds do their trades through brokerages, which force margin calls on trades that they deem risky.  In other words, they pay for their risk through margins on a trade-by-trade, daily basis.  If you are thinking, “wait, what about LCTM?  Isn’t that a hedge fund that got away with murder and almost blew up the system and didn’t seem to have large margins in place?” then the answer is, “yeah but brokers don’t get fooled (as much) by hedge funds anymore”.  In other words, brokers, who are major players in the financial game, are the policemen of hedge funds.

There are two major limits to the above argument.  Firstly, hedge funds purposefully use multiple brokers simultaneously so that nobody knows their entire book, so to the extent that risk of portfolio isn’t additive (it isn’t), this policing method isn’t complete.  Secondly, it is only a local kind of risk issue- it doesn’t clarify risk given a catastrophic event (like a Greek default), but rather a more work-a-day “normal circumstances” market risk.

Even so, what about the banks?  Are there any brokers measuring the risk of their activities and investments?  Since the banks are the brokers, we have to look elsewhere… I guess that would have to be at the government, and the regulators themselves, maybe the FDIC… in any case, people decidedly not players in the financial game, not motivated by pay-off, and therefore not prone to delving into the asperger-inspiring details of complicated structured products to search out lies or liberal estimates.

The goal then is to create a new kind of market which allows insiders to bet on the validity of banks’ portfolios.  You may be saying, “hey isn’t that just the stock price of the bank itself?”, and to answer that I’d refer you to this article which does a good job explaining how little information and power is actually being exercised by stockholders.

I will follow up this post with another more technical one where I will attempt to describe the new market and how it could (possibly, hopefully) function to motivate transparency of banks.  But in the meantime, feel free to make suggestions!