No one to blame

It seems that when things go bad, people want to find somebody to blame for all the misery.  But is this really so? 

What if you could travel back in time 8, 10 or 15 years and axe all those company executives whose decisions led to current crisis, would that be enugh to solve our financial problems now? No! This all  has happened before and happens again (remember junk bonds, LBO, ...) Changing people changes nothing. 

The problem is systematic

Financial risk management is the practice of creating economic value in a firm by using financial instruments to manage exposure to risk. That's what those investors and bankers do. There is nothing sinister  in that. 

Suppose that financial sector hires 1000 financial professionals who can value financial risks exactly right on average. 500 of them are little too pessimistic and 500 are too optimistic. It seems logical that those who are too pessimistic get lower returns because they leverage too little, and those who are optimistic get less returns because they take too much risk and suffer losses. Mr. Average would be winner. 

Unfortunately above is only true only in long term (we are all dead in long term).  To get from risk management to tragedy,  you need  different game. Reward people, not from managment of risks, but from outperforming other risk managers in short and medium term. Have customers who look at the short and medium term profits, but can't understand or care about the total risk. 

Martingale strategy

Suddenly the game is totally different. To win, or even stay in the game, you have to play using some kind of variation of martingale strategy. Increase short term wins by exposing customers to increasing long term losses.  When capital markets are highly competitive and reward wrong things, those who don't play martingale, will eventually not play at all.

There is exellent article explaining all this: The real cause of the financial crisis - An MIT Blackjack Team perspective by Semyon Dukach:  

In the world of investments, there are many ways more subtle than the Martingale to guarantee a better return over a period of months, years, and even decades, at the cost of certain ruin way down the road. Let's say for instance that you're managing a hedge fund which invests in stocks. Your strategy of sound fundamental analysis is fairly well understood. You have found that you can generate an average return of 6% per year, and so can most of your equally qualified competitors who have access to the same talent pool and knowledge base as you do. But then one of your competitors realizes that he can automatically increase his return to 9% by selling something called "out of the money puts" on the market. This means that the competitor's fund essentially sells insurance against the market crashing dramatically. In normal times his fund will gain the premium from selling this insurance which boosts his returns. However, in the rare event of an extreme market crash his investors will lose everything. This form of Martingale can be easily tuned to work for various time periods with various chances of collapse.

When investors see a fund manager generate a higher return that his competitors, they will move their money into that fund and out of the other ones. And money managers are rewarded based on the size of their fund, or the level of returns. The managers do not risk their own money. If they can provide a bigger gain for a few years, they win everything. They might even be lucky enough to be retired by the time their investors are paying the piper. The managers who have the discipline to understand and avoid the Martingale tricks will not be able to compete on the basis of their returns over a few years, and will eventually lose their funds and their jobs.

Can it be avoided?

Dukach gives his solution: "forbid money management as we know it. We could certainly have people like Warren Buffet manage investors' money." It rings true to me, but I don't think that even  that could prevent this all happening again. Very few people are like Warren Buffet. I suspect that most people managing their own money get carried away eventually, just by peer pressure.

My answers:

• No  wide spread trading in over counter financial instruments shoud be allowed. Trading allowed only in the regulated market places.
• Better accounting. If instrument is so complex that company, regulator, and tax officials can't understand how it should be valued, taxed,  and how much there is risk, it should not exist.
• Notional value of derivatives should be more limited.
• Owning derivatives without any stake in underlying should not be possible. 
• Global limits for leverages. (As far as I know this is my original idea). If derivatives can be bought and sold only in regulated marketplaces, government could put strict limits on how much leverage debt could have in the economy as whole. I could see markets for rights to create new derivatives :)

I don't believe that you can prevent these things completely. Humans are not very rational people. We  rationalize, but that is not the same thing. We like to play games and we like to win. Everything else is boring. 

ps. It seems that Kent Pitman calls this "Hollow Support".