Six Ways to Save the World

Look at a long-term chart of just about anything related to the economy. Stock prices. Commodity prices. Housing prices. Interest rates. Money supply. Almost all show a similar trend -- relative stability for most of the post-World War II period and then … snap! … synchronized bedlam for the past decade. Former Federal Reserve chairman Alan Greenspan titled his memoir The Age of Turbulence. That's being gracious. The past decade has been the age of shock and awe.

Why? There are many reasons and even more people to blame. But an overarching flaw is a system that's not only conducive to piling on risk, but concealing and ignoring those risks while they brew. We're a cauldron for cooking up black swans -- hard-to-predict (or easy to ignore) risks that wreak havoc when they strike.

I've been talking to Ken Posner, a former Morgan Stanley veteran analyst covering the financial sector and author of the book Stalking The Black Swan, a wonderful read on how to think about, analyze, and react to extreme events. He recently put together a list of six things we can do to lessen the risk of black swans. Here are his six, along with a few of my comments.

1. Cut government debt, a potential cause of extreme outcomes. Politicians should focus on this rather than blaming markets, which reflect volatility but do not cause it.

Ask yourself what changed in the past few months that catapulted Greece from trudging along one day to fears of bankruptcy the next. War? Natural disaster? Nope. More than anything, it was simply the market suddenly deciding that it had enough of the country's profligacy. Before Greece could blink, bond yields surged and credit shut off to a point where heavy austerity and bailout packages may not be enough. They call these Minsky moments.

The lesson: If you wait until the problem is in your face, it's too late. You have to be proactive about these things. I can't imagine there's a single member of Congress who truthfully thinks our long-term fiscal situation is sustainable, but the consensus attitude is to hold off on doing anything about it until there's a Category 5 hurricane in the Treasury market, at which time it'll likely be far too late.

2. Place Fannie Mae, Freddie Mac, and the Federal Home Loan Banks into run-off and reduce U.S. government liabilities by some $7 trillion.

A runoff means halting new business while letting liabilities slowly run down as people repay their mortgages.

What would a world without Fannie Mae (NYSE: FNM  ) and Freddie Mac (NYSE: FRE  ) look like? These guys control substantially all of the residential mortgage market, but it's not accurate to assume that there would be no functioning mortgage market without them (I once fell into this flawed thinking). Large commercial banks like Citigroup (NYSE: C  ) and Bank of America (NYSE: BAC  ) pale in market share only because it's not worth trying to compete against Fannie and Freddie -- the two essentially have a mandate to underprice and lose money. More private mortgage lending would pop up in their absence. Mortgages would still be readily available sans Fannie and Freddie, but only in the form of those that properly price the risk-reward tradeoff between borrower and lender. Imagine such sanity.

3. Build "shock absorbers" into the system like mandatory "contingent capital" for systemically important financial firms, rather than proscribing activities for banks and hedge funds.

Contingent capital is a phenomenal idea. It's debt that automatically converts into equity upon a predefined stress trigger. So when a bank loses its shirt and needs to raise equity, but can't because the market won't give them the time of day, the contingent capital automatically converts. Boom. There's your equity. Stand down, bankruptcy.

Ken and I seem to disagree on forbidding some activities at banks and hedge funds. I'm a firm believer that certain financial transactions are like crystal meth labs -- they only produce momentary bouts of pleasure (or profits) before blowing up and ruining the life of not only the owner and his clients, but everyone who happens to innocently live in the owner's neighborhood.  

4. Impose shorter term limits on the Federal Reserve Chairman's service because too much trust in the persona can contribute to excessive volatility (the "Greenspan put").

The Greenspan put is the idea that stocks could remain at premium valuations because investors knew Greenspan would slash interest rates when anything started giving off the aroma of imperfection. This kind of thinking, while rational, is the epitome of moral hazard. And the longer it persists, the more dangerous it grows.

As for term limits, Senator Tom Coburn once said of politicians: "It is easy to see how after receiving … adoration for a term or two most members become convinced they are indispensable." That pretty well sums it up. Greenspan was Fed chairman for almost 20 years, and near the end, he was held in such high regard that few dared to question whether his policies were flawed (they were).

5. Improve corporate governance to mitigate the problem of "cognitive dissonance," when successful executives dismiss new data that contradicts deeply-held beliefs, evidenced by Goldman Sachs’ missteps in reacting to the SEC lawsuit and managing the firm's political vulnerability.

The Motley Fool is a big fan of overhauling corporate governance. By and large, the C Suite has turned into a club of personal entitlements, thin responsibilities, and a drain on free thinking and problem solving. Back in April, Fool co-founder and CEO Tom Gardner gave written testimony to Congress on how corporate governance can be effectively revamped. We've also pushed for a Shareholder Bill of Rights in an effort to give you, the investor, more say in corporate governance.

6. Return to fundamental research, a practice that executives, risk managers, and individual investors should follow to better understand the macro and micro causative factors likely to affect a company's performance.

There's a great commercial on CNBC where reporter David Faber says (and I'm paraphrasing), "Ten years ago, I would talk to hedge fund managers who were having a bad year. A few years ago, they would be having a bad six months. Today, they're having a bad five minutes."

More and more of the market couldn't care less about what they're investing in; how quickly they can trade it is all that's important. The primary goal is to skim a tiny bit off the top rather than increase the size of the pie.

Fellow Fool Ilan Moscovitz wrote a great article showing that the average holding period of stocks fell from 100 months in 1960 to eight months in 2009. In 2007, the average holding period on Lehman Brothers' stock was just 2.5 months. As long as that's the case, management's duty to shareholders is to focus on the current quarter and nothing else, which goes a long way in destroying the relevancy of fundamental research.  

Any ideas of your own? Have at it in the comment section below.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.


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