In the 1930’s, Louis Brandeis’ image of a sturdy policeman standing by a bright streetlight guided the federalization of financial market regulation.  What should the new image be to best guide the necessary regulations to deal with the current financial crisis?

My recommendation is that we supplement Brandeis’ streetlight (disclosure rules) and policeman (fraud prevention) with a more interventionist approach when faced with one especially destabilizing investment strategy: the strategy of combining the purchase of a risky asset with a put on that same asset.  This investment strategy has played a central role in the stock market crashes of October 1929 and October 1987, and in the recent downturn in residential housing and the near-collapse of the credit default swaps market.  Investing in both a risky asset and a put on that asset can lead to an increase in demand for that asset as prices rise and decrease in demand for that asset as prices fall.  As well as being destabilizing, there are two additional reasons this investment strategy should be regulated.  First, investors often find this particular investment strategy attractive, even though it is a strategy which rarely makes sense for a long-term investor.  Second, the people writing the puts (selling the “insurance” component of this investment strategy) have historically failed, in the absence of regulatory intervention, to hold adequate reserves or correctly price their product.  “Break it up,” Brandeis’ policeman should say when growing numbers of investors start to purchase both a given class of risky assets and a put option on those same assets.

The problematic investment strategy of combining the purchase of a risky asset with a put on that same asset can be packaged in a number of different ways.  This investment strategy became widespread prior to the October 1929 market crash when increasing numbers of stock market investors purchased shares using borrowed funds.  The 1934 Act margin requirements provided a sound means by which to prevent a reoccurrence of the widespread use of margin debt as a way to combine an investment in a risky asset with a put on that asset.  This investment strategy reemerged in 1987 in the form of portfolio insurance.

More recently, this investment strategy became popular among holders of corporate debt, who combined their debt holdings with the purchase of a credit default swap.  This combination allowed an investor in a company’s debt to insulate themselves from a decline in the creditworthiness of the issuer of the debt.  AIG and other companies selling credit default swaps were selling a product, which is in many ways fundamentally the same as selling an insurance policy.  In the absence of regulation, firms sold this put protection too cheaply and without maintaining adequate reserves.  The result was, as we’ve seen before, a situation where the demand for a risky asset, corporate debt, in this case, declined sharply as the price of the asset declined.  It is likely that the sales of credit default swaps will become regulated in a manner similar to the sales of other insurance products. The trick will be to guard against allowing history to repeat itself by ensuring that the destabilizing investment strategy of combining the purchase of a risky asset with a put on that same asset is properly regulated as it reemerges in new forms in the future.

The idea of a more interventionist component of financial market regulation is certainly more palatable than it was just a few years ago.  The more difficult question is when and how to intervene.  Developing a sound answer to this question has been the central purpose of this series of posts.  In these posts, I have attempted to uncover the dynamic that lies at the heart of the historic market crashes of 1929 and 1987.  Doing so has generated a simple principle to suggest when regulatory measures that go beyond disclosure and enforcement are warranted.  Disclosure requirements and the enforcement of anti-fraud provisions provide many benefits.  However, the investment strategy that I identify as playing a pivotal role in these historic market crashes is not the product of too little disclosure, the result of fraudulent practices, or the lack of investor sophistication, and so the regulation of this type of investment requires more than disclosure and fraud prevention measures.  What is needed is a return to regulatory interventions that have proven helpful in addressing these kinds of failures in the past, such as requiring that insurers maintain adequate reserves, and limiting the amount of leverage allowed in certain transactions. Translating these regulatory principles into workable rules that apply to complex transactions in a global market will be a difficult task.

The first step in creating regulation to prevent future crashes as we have experienced in 1929, 1987 and 2008 is to understand the root cause of these crashes.   In my post on October 10 I promised to explain why markets crash and to set out the relatively short and simple list of appropriate regulatory responses.  I hope I have delivered on that promise.

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