Have you ever noticed that when you are sitting in around a table in a meeting, when the “alpha” laughs everyone else typically follows suit?

Often this is the boss, and I remember reading somewhere this is explained by some social-psychological theory about pecking order or something like that.

I think of it as another example of the fact that most people in the world are followers. It is really hard to be a leader, because leadership implies taking chances and putting yourself out there, which is scary.

But this phenomenon also explains why leadership is so important.

On the global stage it is hard to argue with the fact that America is the alpha. Foreigners follow our media, our companies and our politics.

That’s why it is not surprising to see that foreign governments are now following suit in applying the “too big to fail” moniker.

Hypo Real Gets EU50 Billion Government-Led Bailout

The German government and the country’s banks and insurers agreed on a 50 billion euro ($68 billion) rescue package for commercial property lender Hypo Real Estate Holding AG after an earlier bailout faltered.

…

The government and the Bundesbank have said that Hypo Real Estate, Germany’s second-biggest property lender, is too big to fail.

In these challenging times it is important for leaders to be principled in their decision making and in their actions.

This need for leadership is all the more reason why the “pork” included in last week’s bailout bill is all the more troubling.

The government had the chance to take a decisive step in the direction of bringing the country together to help stave off a deeper economic crisis. But in this moment, when the spotlight was shining and the microphone was in our hands, we faltered. Rather than booming with laughter, we mumbled, and stuttered. And although we did take a step in the right direction, because of the body-language, the message was not nearly as powerful as it could have been.

This need for clarity and precision is somehow related to the appeal of clean design in user interfaces, but I’m not sure that I understand Aristotelian ethics enough to make the connection intelligible. I think it has something to do with simplicity and directness.

In any event, as we head into the final months of this election season and beyond, it is important that we demand this kind of leadership from our government. The world is watching.

What caused the credit crisis?

People have been speculating about this for months, and until recently most of the conversation on the topic was relegated to our corner of the blogosphere and academia.

During the lead up to the current headline events, this debate has been enriching, and although people disagree about the fundamental causes, it is clear that a full accounting of the problems includes a variety of the following:

1. Everyone was overconfident in their understanding of the world and risk
2. Mortgages were issued to people who could not afford it with terms that some people didn’t understand
3. Sophisticated institutional investors invested in products with risks they misunderstood
4. Credit Rating Agencies rated securities much more highly than they should have
5. “Wall Street” created complex securities (including CDOs and CLOs) which increased leverage throughout the system, making the repercussions of failure greater, and they were highly incentivized to do so
6. Insurance companies and bond insurers guaranteed far more risk than they realized or should have
7. Mortgage brokers and originators were incentivized to issue as many mortgages as possible
8. Banks were allowed to create off balance sheet entities, which did not affect their regulatory capital requirements
9. No one (with any clout) was standing outside the system thinking about and measuring what would happen if things went wrong
10. Etc.

However, now that the credit crisis has entered the mainstream dialogue, rather than recognizing that this issue is complicated and that many factors are to blame, people are trying to wrap a bow around things and blame it on the “left” or the “right”.

Case in point, one of many similar blog posts from this morning:Who is to Blame for the Economic Crisis? The Republican Argument

The post references a video suggesting that somehow the push to issue people affordable mortgages is to blame for the credit crisis.

This blatantly political maneuver would be more infuriating if it was not so obviously overly simplistic and false. One simple counterargument to this is that if institutional investors bothered to do their homework on the securities they were purchasing rather than relying on credit ratings and the assurances of “derivatives” salesmen, they would have charged more, pricing in the reality of people’s inabilty to pay. But they didn’t…for lots of reasons.

Overly simplistic binary thinking is widespread in politics.

Unfortunately, this idiotic binary debate is symptomatic of a broader phenomena in our society: politicians are too intellectually condescending to describe things in the honest and nuanced way that they are in the world.

I refuse to believe that the American people are too stupid to understand. In fact, perhaps the reason people are fed up with politics is because the smokescreen is so obviously false.

Throughout my life I have found the “us against them” mentality of the two-party political system to be stomach-churningly simplistic. There are far more people and ideas than can be represented by “red and blue.”

It is no coincidence that the two presidential candidates both espouse politics beyond “party”. In times like today, it is clear that people “hope” that things will “change” and that someday it will be true that politicians put “America first.”

In the mean time, why don’t we seek to engage in a more nuanced debate. I for one reject this antiquated binary thinking. Computers can’t replicate human ingenuity, and I think we can avoid using their language.

Congress has released a draft of the proposed bailout Bill, the full text of which is embedded below (information on download is here: Bailout Bill)

In summary, it seems like 3 major positives have emerged from the negotiations. On the whole, I think people are making reasonable compromises and that as a result something will get passed shortly.

1) Mortgage Modifications. Beginning on page 27, the bill discusses the requirement that the fund work with homeowners to modify their mortgages to the extent doing so would save money for all involved (i.e. foreclosures can destroy value for all involved if home values in the area are already severely depressed). This is an excellent idea, and for those of you who are familiar with my work on this topic, it is one that strikes close to home. Basically, it looks like Congress is trying to take some of the stumbling blocks out of the way for rational the renegotiation of home mortgages.

2) Equity Participation. Beginning on page 45, the bill introduces a requirement that the fund take warrants in any company that is registered, or has approval to be registered (Read: Goldman Sachs or Morgan Stanley), and is aided by the bill. The purpose of which is to:

provide for reasonable participation by the Secretary, for the benefit of taxpayers, in equity appreciation [created by the bailout]

This is great news, and this addresses my primary concern with the initial draft. Although it does not eliminate moral hazard, at least we (taxpayers) get to benefit with those who are bailed out.

3) Judicial Review. As expected, on page 65, the Bill introduces the concept of judicial oversight which was lacking in Mr. Paulson’s initial proposal.

These are phenomenal developments, and it shows that the regulatory process is working. I would love it if a bailout was unnecessary and preventable. However, given that it is inevitable at this point, I am very glad to see that our government and our leaders are coming to reasonable and rational conclusions on these matters.

It gives me faith in our government and our country. Let’s hope they keep moving in this direction.

Another interesting structuring detail: On page 50-51, the bill discusses a gradual provisioning of authority. Basically, the fund will start with $250B, then with Presidential authority and Congressional notice, the limit is raised to $350B, and finally it can be raised to $700B (it looks like Congress has veto power over any amounts over $350B, although it must exercise disapproval before the limitation kicks in).

One final somewhat “negative” develoment. Suspension of Mark-to-Market Accounting. A sign of the likely trade-offs made to get the bill closer to the finish line is buried near the back of the Bill, starting on page 95. It appears that the Bill gives the SEC authority to ban mark-to-market accounting as well as requiring a report on the accounting standard. This seems like an example of the regulators getting the cart before the horse. One would imagine that a study should precede any rule change, but it seems like Banking lobbyists have a lot of pull.

Here is the bill:

Bailout Plan – Get more Legal Forms

Following President Bush’s excellent speech last night, I thought it might be worthwhile to review the various issues contributing to this crisis with a focus on the institutional side of the problem and why these companies need to be bailed out. Having spent the last year and half focused on this problem, I thought my perspective might be worthwhile.

To be clear, I think intervention may very well be necessary and preferred at this point. My biggest concern with the proposals to date is that they: 1) do not allow taxpayers to particpate in the upside of saved financial institutions and 2) have not made it clear that taxpayers may suffer losses on these investments.

The video is a bit long, because I tried to walk through the history as simply as possible. Hope it is helpful.

As I have discussed the bail-out with friends and professors over the last few days, one question keeps emerging:

If we are at the point where we need to infuse this capital into the system to break-up the logjam, Why not participate in the upside?

This is a question that I can’t seem to answer in the negative besides pointing to the pragmatic challenges of having our government run the bailed out institutions. However, at least one nation apparently faced a similar crisis with just this approach. From the NY Times, Stopping A Financial Crisis, The Swedish Way:

Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.

That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.

“If I go into a bank,” said Bo Lundgren, who was Sweden’s finance minister at the time, “I’d rather get equity so that there is some upside for the taxpayer.”

This seems relatively straightforward, although dealing with the reality of running a number of large financial institutions including Freddie, Fannie, and AIG may not be something we want to leave to our Federal Government. One way around this is to become minority shareholders much in the same way Warren Buffett is now a minority shareholder of Goldman Sachs after his investment in the firm overnight. That way we can participate in the upside without having to take complete control.

In the let’s get angry and irrationally make bad decisions camp: there has been a lot of talk in the last couple of days about capping salaries on Wall Street. From In Bailout Furor, Wall Street Pay Becomes a Target:

The stratospheric pay packages of Wall Street executives have become a lightning rod issue as Congress shapes a $700 billion bailout for financial firms. Proposals circulating on Capitol Hill vary, but they all would impose some limits or approval authority on salaries of executives whose firms seek help.

This is simply ludicrous in my opinion. If we want to run these institutions, then let’s do it as owners not by creating some massive regulatory overhang that will have deterrent effects for decades to come.

We cannot forget the fact that even after this recession America will still have been the greatest economy in the history of the world, and part of that success is driven by the entrepreneurial drive to succeed. Limiting incentives can only have negative effects here and does not do anything except appease embittered politicians and impassioned constituents.

The political process is grinding through these various considerations, and as of yet nothing crazy has emerged. I am still optimistic that our system will come up with the best possible solution for a very bad situation.

Searching for clarity in a world as cluttered as the one we live in today could possibly be the hardest task we face in the twenty-first century.

In trading parlance, it is known as deciphering the “signal” from the “noise.”

In everyday language it is called making good decisions.

The government is currently facing a massively complex decision with conflicting data points, and principles pointing in every direction.

If you believe in free markets, you should not support government intervention. But, all economists know the markets need a little nudge now and again, so some intervention is ok…but not too much.

We also don’t want the financial system to collapse because credit and financing is one of the central driving forces behind our economy. Should we stand behind our principles and spite our face?

What about Moral Hazard? Everyone hates that. No one wants to create bad “incentives” for future decisions by management.

But what does this mean really? Do we think that companies will intentionally drive themselves into the ground so that they can receive $10 / share rather than $0 (as was the case in Bear Stearns)?

People should face the consequences of their own actions…but what if said consequences were unpredictable by anyone? If I step outside my door and a satellite falls from the sky, am I responsible? If I am a Nasa satellite expert might I be?

We should ensure that the American economy remains the strongest in the world…but if we couldn’t predict the repercussions of securitization and its spawn, how can we predict what the impact on the USD will be from these bailouts? Is Ron Paul right to worry about a collapse of the system entirely? But isn’t he being pessimistic? What about my argument below about taking our chances with ourselves in the drivers seat rather than foreign owners?

In times like these, it seems best to sleep on it and see what tomorrow brings. Unfortunately, the decision-makers and market participants are in a frantic race with night-filled negotiations to try to predict the best possible outcome.

I genuinely appreciate that effort and their attempt at crafting the best possible solution.

It is also in such trying times that the foresight of the founders of our nation are put to the test. They created a constitutional arrangement that has heretofore allowed us to be the greatest nation in the history of the planet.

And so, I reluctantly admit I don’t know what the best outcome is. I don’t know what the government should do. I won’t give up trying to figure it out, but the best I can hope for today is to trust that somehow, through some collective wrangling and wrestling some kind of clarity will come out of this mess.

And, thankfully, tomorrow is another day.