We Learned the Wrong Lesson

David Einhorn at Greenlight Capital said, "We learned the wrong lesson."

We should have learned that existing capital requirements were insufficient and that regulators needed legal authority to safely wind down non bank financial companies. Instead, we learned that some institutions are too big to fail.

We learned that we live in a world where reckless misallocation of capital is not punished and bondholders do not take losses. We learned that rules of capitalism are arbitrary and unstable.

Depositors and consumers responded by fiercely reigning in credit to any and every institution (except the US Government!). Confidence collapsed. The negative feedback loop created the Great Recession.

Somehow, the sanctity of the creditor preempted the rules. Markets hate that. On the other hand, markets are perfectly capable of taking (assigning) losses. The bond market gains and looses trillions of dollars every single day. Creditors lend at a spread which compensates them for the risk they take. If things go wrong, they know they don't get their money back.

Receivership that cuts away and transfers operating assets of a financial institution in a clean and efficient manner bolsters solvency of they system and preserves its operations. Losses taken by bondholders can be recouped, in aggregate, by repricing the assets to generate sufficient returns. There is a whole industry of distressed specialists.

"What the global economy is not capable of taking is the uncertainty that results when policy makers apply arbitrary rules, leaving all other decision makers in the economy frozen at the edge of their seats to discover what the results of those arbitrary decisions will be." - John Hussman

Appendix 1:
http://www.cnbc.com/id/15840232?video=3000012150&play=1
On CNBC, the former auto task force chief Steven Rattner argued (convincingly it seemed at the time to a truly stunned and undermanned Ken Falcone, founder of Home Depot) that the reason it was necessary for the U.S. government to step in and finance General Motors was because there was no private capital available at that time (at 4:30 mark). The crisis was so bad, the government had to act.

What makes this argument so apparently strong is the simple truth of it. This is also the argument's weakness: its too simple.

There was no private capital available because the policy makers were applying arbitrary rules, leaving decision makers, the risk takers, frozen.