A Solution to the Financial Crisis

Let me preface this post by saying that I have no idea what I am talking about. That said, I think I understand the root cause of our current financial crisis and I would like to propose a solution, or a class of solutions, to the problem.

First, let me explain my view of the problem: gambling masquerading as investment. The financial universe has become two separate worlds, one that is used to finance economic activity and the other used to gamble large amounts of money on a global scale. The second world has become much larger than the first and has leaked into the first. When you have a huge pot of crap that drips onto a much smaller cup of soup, everyone ends up eating shit. That is what we have now. The ultimate solution to this problem requires separating the gambling from the investment and putting different lending standards on these two activities. For example, a bank should be able to loan money for investment purposes but not for gambling purposes.

Even separating what is investment from what is gambling can be difficult for some. For example, is a mortgage on a house to someone who will never be able to pay it back an investment or a gamble? I would call this mainly a really bad investment. Why? because you always have the underlying house which is a real property with real value. Now, if I insure a mortgage on a house to someone who will never be able to pay it back, that is a gamble because either I get my money back or I get nothing depending on what someone else does. Sounds like gambling to me. Does that make the entire insurance industry gambling? Maybe, but perhaps one could say that something like life insurance or car insurance or fire insurance isn’t a gamble because of the history of probabilities involved. Still, covering one gamble with another gamble is really just gambling. How about options trading? I would call that 100% gambling. I am not against gambling, but I wouldn’t loan money to someone to do it. Gamblers all have the same underlying drive, when things are hot they can’t quit. Eventually they get cold and lose it all and then some.

One general rule for differentiating between an investment and a gamble is that an investment will have an influence on the outcome of that investment, while a gamble will not. For example, if I were to invest $1B in Cisco, the odds that I will get a good return (because they can use the money to grow the company) are much better than if were to invest $1. On the other hand if I were to gamble a $1B on a coin toss the odds of winning are no better than 50/50, same as if I were to gamble $1. This is not the sole distinction between gambling and investment, but I think it is a start.

So here is my solution: all public companies should be reviewed by an accounting firm that assigns a new class of shares for that company. We can call that class the “I” class for investment. Everyone owning shares in a company would be able to trade so many regular shares for so many “I” shares depending on the “gambling index” for the company. A company that has no gambling assets would have 100% “I” shares. An investment house or other company that has 50% regular assets and 50% gambling assets would split its shares 50 I and 50 regular. The “I” shares would then trade on a separate basis. The margin requirements for the “I” shares would be higher than for the regular shares just to make sure that banks don’t get too much into gambling.

I don’t think that evaluating the risk of an investment is anything new to the financial world. That is what rating agencies like Moody’s do for a living. In fact much of the current mortgage problems have been caused by rating agencies assigning AAA ratings to complete crap. Before my scheme could work these companies would have to abandon their current rating schemes and adopt a new one based on the gambling index.

I realize that any real solution is probably 1000 times more complex than what I have proposed, but the principle is there. Let people gamble if they like, but let’s not let gambling leak into our economic system.

One Response to “A Solution to the Financial Crisis”

  1. Dr Richard Lawson Says:

    Seems like sound thinking to me. The Green Party in England and Wales is drafting policy along these lines:
    4. We will ensure there is stricter regulation of the banks, limiting them. principally to the on-lending of customer deposits.
    5. We will split retail banking from merchant banking and securities trading.

    Also I rate Willem Buiter’s Toxic Asset Dump solution to the derivatives.
    though I am sickened by the thought that we the people should pay real money to buy these financial phantasmogoria.

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