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Maybe I'm Old Fashioned

I've spent some time trying to learn some of the reasons behind the recent Wall Street meltdown.  Here are some good things to check out:

Fresh Air interview with Prof. Michael Greenburger 9/17/08

The Giant Pool of Money from This American Life 5/9/08

Definition of Credit Default Swap

My conclusion is that the fundamental problem is that financial institutions were not required to truly represent or report the value of their holdings, the level of risk represented in their holdings, or to ensure that they had sufficient capital behind the leverage they were utilizing.  This isn't new news.  Excessive leverage and speculation was on of the major reasons for the Wall Street Crash of 1929.  In fact, as I was reminded last night when I watched Enron: The Smartest Guys In the Room that complicated financial structures that defy transparancy have led to problems just in the last few years.  Enron and their auditors continued to obscure the fact that the company was losing huge amounts of money, right until it collapsed.  In many ways, many of the investment banks have done the same thing with credit default swaps.

I think that deregulation has gone too far, but I am not at all in favor of having the government restrict the type business transactions.  I think people should be able to do whatever kind of crazy financial structures they like.  But, where the government and the SEC can be very helpful is in ensuring that these transactions are accurately reflected on various firms balance sheets in terms of true underlying value, level of risk, concentration of risk, liquidity, and capital reserves.  This will make over-leveraged companies stand out and be more fairly valued in the market.  As it was, companies were rewarded for taking big risks because they could report higher profits, which led to big bonuses and higher stock prices.  And, as in the mortgage crisis, you can't count on independent rating agencies to figure it out.  Such a house of cards was erected that we are still seeing it topple long after the subprime mortgage mess first became visible.

An interesting contrast I see -- after Enron, Worldcom, etc., Sarbanes Oxley was passed with the intent of making companies have more accurate and transparent financials.  And FASB and the IRS (see 409A) have gotten stricter and stricter with the recommended accounting practices you have to follow to get a clean audit.  Where were these guys when the financial institutions were making credit default swap deals to inflate their profits and hide their risks?

I guess I am just an old fashioned guy.  As an entrepreneur and VC, many people may have thought that I was a risk taker.  But, those risks are nothing compared to these complicated financial transactions.  At least I understood the risks I have taken.  And, I prefer a transaction where people's interests are aligned -- I buy stock, company grows and performance improves, stock goes up, I sell my stock.  It's not as simple as it sounds.  But, it's easy to understand and straight-forward to value!


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