Unlike the three little pigs, governments seem incapable of learning from their mistakes. You remember the story. One built his house out of straw, only to find it knocked over in a single puff (or was it a huff?) by the big bad wolf. The second little pig, having learned something from the experiences of his brother, built his abode of sticks. Sadly the structure was no match for the wolf, who quickly knocked it over. The third little pig, having watched the fate of his fraternal house-builders, constructs his house out of bricks, which confounds the wolf and the story ends happily (and least for the pigs).

On many occasions, after a global financial tempest, governments have chosen to allow financial institutions to rebuild on the patterns of the past. Ignoring history, the construction materials of choice continue to be straw and sticks, but never bricks.

Each financial crisis has its unique features, but they also share common causes that could easily be fixed with more robust regulations. Here are just a few examples from the last thirty years, although I could have easily gone back further, as crises have been a regular feature of the financial system.

Going back to the early 1980’s, Citibank almost went belly up after loaning billions of dollars to insolvent Latin American countries. In a moving epitaph to the bank’s folly, its then president claimed, “Countries don’t go out of business.”  Citibank had another near-death experience in 1991 when the junk-bond market collapsed. As one of America’s largest banks, it nearly brought down the whole financial system.

Long-Term Capital Management (LTCM) was a hedge fund management firm run by a couple of math quiz kids, Myron S. Scholes and Robert C. Merton who jointly won the 1997 Nobel Memorial Prize in Economic Sciences. In the late 1990s, their clever computer programs proved to be flawed. In September 1998, LTCM was bailed out to the tune of $3.6 billion.

Only a couple of years later, investors in Enron lost their shirts after it was revealed that the company had manipulated its accounts.   Rather than making a healthy profit, it had chalked up massive losses. This was not the only company caught fiddling with its books. In 2002, WorldCom was caught doing the same.  A year later, Parmalat was also accused of accounting fraud.

Now let us look to more recent events. In 2008, Lehman Bros sank without a trace.  In fact,  most of the other major banks, both in the US and in Europe, were found to have feet of clay. Many had speculated on exotic derivatives, without fully realizing the risks involved. As it turned out, many of those derivatives were highly toxic and the banks lost hundreds of billions of dollars, pushing the world towards a major recession.

In 2012, the situation is no better. JP Morgan suffered a surprise loss of $6 billion, exposing a broken risk management system. Barclays and UBS were caught manipulating the London Interbank Offered Rate (LIBOR), which cost investors untold billions of dollars. Evidence is building up that many of the rating agencies were venal triple-A factories during the first half of the 2000s, as they assessed derivatives, based on sub-prime mortgages, as top-quality investment-grade. And in America, banks were charged with falsifying mortgage records by “robo-signing“ foreclosure documents, robbing mortgagees of their legal rights.

If our fairy-tale wolf was reading this list, he would be growling with pleasure in the knowledge that neither the regulators nor the banks had learned from their past mistakes and that after each disaster continue to rebuild the financial system using similarly flimsy materials.

While each collapse had a different cause, they also had many common features.

The banks are much too large, and when they totter they can bring down the whole financial system. Breaking them up is a simple solution, but one that governments have balked from taking.

With size comes complexity, in which clever lawyers, who are employed by the big banks, are able to create off-balance sheet entities to hide risky investments.  Meanwhile, their no less ingenious accountants have hidden the bank’s true financial position through byzantine annual reports. Paul Singer who runs a $20 billion hedge fund is totally disillusioned. In a message to investors, he warned,

Decades ago, the balance sheets of the Financial Institutions contained most of the information you needed to know to understand their risks. Today the picture is profoundly different, predominantly due to the growth of leverage through derivatives….  As a result, there is no major Financial Institution today whose financial statements provide a meaningful clue about the risks of the firm’s entire panoply of assets and liabilities including derivatives, nor how the firm’s performance, or even survival, will be affected by market movements in the future.

In each of the examples cited above, tepid efforts were made to reform the system, but lobbying by banks invariably ripped the guts out of these reforms. Arthur Levitt, the former chairman of the SEC, claimed that none of the post 2008 reforms have “significantly diminished the likelihood of financial crises.”

All this is undoubtedly encouraging to the wolf.  He will just need to bide his time and look forward to his next effort to blow over the financial house of sticks and straw, which may well exceed his partial successes of the past.

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