(The following is an excerpt from the most recent letter to the partners of Braewick Holdings LP. I’ll be posting a presentation that goes along with this commentary shortly.)

There have been many explanations thrown around of how we got ourselves into this mess. However, I have a slightly different take on what really caused the problem—and what hasn’t been fixed yet.

The public always enjoys finding someone to burn at the stake. Who is to blame for the current mess? Many culprits have been named: greedy executives, The Fed, short sellers, Democrats, Republicans, CDO’s, CDS’s, real estate speculators, and so on. However, the real issues are more systemic. Derivatives and bad mortgages may be where the problem started, but in and of themselves, did not cause this mess.

In my view, there were three problems that led to the collapse of financial markets: misaligned incentives, poor risk management, and needless complexity. All three problems are not specific to the current crisis, but are widespread and must be addressed to avoid future dilemmas.

If You Give A Mouse a Cookie…

He’s going to want some milk. And if you give a Wall Street executive a $30 million bonus, he’s going to want a bigger one (and he’ll use the same methods to get it—after all, it worked the first time, didn’t it?).

Misaligned incentives were pervasive. And because incentives drive behavior, things are eventually not going to turn out as desired.

This occurred on almost every level. Executives were being rewarded for taking risks with only short-term payoffs. Mortgage originators made money based on the volume of mortgages given, not on their quality. Rating agencies getting paid by the companies they have to subjectively rate (causing a huge conflict of interest). Home buyers were incentivized to buy a house they couldn’t afford with low down payments, teaser rates, no-documentation Adjustable Rate Mortgages, and 0% interest.

Many of the asset managers (including banks, hedge funds, and insurance companies) were given incentives to take huge risks with the firm’s capital only because they produced outsized short-term gains. They were given very large bonuses or a cut of the profits with no downside risk (other than a pink slip and severance payment). There was no link between immediate actions and their future consequences.

Business managers and decision makers need to constantly look at how their incentives are structured. People will naturally do things in their own self-interest, and managers need to react accordingly. Some incentives aren’t so obvious—giving a trader a cut of the profits may not sound bad at all. But even if it’s not their intent, people usually end up gaming the incentive in their favor. If traders aren’t punished for taking long-term risks in pursuit of profit, then guess what—that’s what they’ll do.

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The New York Times, 11/4/1907

In October of 1907, financial markets in the United States came to a complete halt. Credit markets froze, major banks collapsed, and the stock market plunged. Heads of industry, like J. P. Morgan, were forced to inject massive amounts of capital to prevent a complete collapse.

The circumstances of the Panic of 1907 are very similar to our current crisis. In both, the economy had experienced huge growth over the preceding decade. Banks lowered lending standards, which led people to take on more and more debt. When bank assets began to decline, depositors panicked, and there was a run on the financial system.

But for the rest of this post, I’d like to focus on the period that follows a financial crisis—not on the crisis itself. (Keep in mind that although I speak in terms of American progress, my point applies to any country around the world.)

* * *

The period following 1907 was monumental in American history.

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Before I finish up with a longer post I’ll get to tomorrow, I thought I’d relay a few good articles on the financial crises:

$700 Billion Bailout Celebrated With Lavish $800 Billion Executive Party

How Did The Economy Go Bad?

The Onion’s 2008 In Review: The Economy

And this: (not too far from the truth)

In The Know: Should The Government Stop Dumping Money Into A Giant Hole?

Chart: 10-year trailing Graham (“Real”) P/E Ratio. Price of the S&P 500 divided by the 10-year average of earnings, inflation adjusted.
Current value (10/31/08): 15.9x

Chart: Profit Margin of U.S. Economy. Annualized corporate profits as a percentage of GDP. (A good reason why the Graham P/E Ratio is a better valuation measure than the TTM version.)
Current value (6/30/08): 9.40%

Chart: Bond Yield over Equity Yield. 10-year treasury yield minus inverse of Graham P/E Ratio (10-year average equity earnings yield).
Current value (10/31/08): -2.4% (equities yield 2.4% more than bonds)

Keep calm & carry on. Sound advice during the current bear market.

Forget about Mr. Market’s terrible mood swing. He is there to serve you, not to guide you. Why would he be offering such low prices for the businesses he owns? Who knows. Take advantage of his irrationality. If hearing it from me isn’t enough, listen to John Bogle. (Image credit: The Principles of Uncertainty)

The first version of the bailout bill (3 pages). The third version of the bailout bill (110 pages). And finally, the current version of the bailout bill (451 pages). It seems it is in the nature of politicians to needlessly increase complexity.

Warren Buffett’s interview with Charlie Rose. As usual, Buffett gives a great explanation of the current crisis. On the bailout bill: “It’s better to be approximately right than precisely wrong.”

The best “story” of the events in the past few weeks is this article from the New York Times. My guess is that the full story won’t be revealed for at least another few years.

A great letter by Howard Marks on the bailout plan, the circumstances surrounding it, and what got us to this point in the first place.

I agree with Roger Ehrenberg in his post “Investment Banking 2.0“: the best thing for the financial industry is smaller, more nimble banks that aren’t part of large conglomerates. This forces more redundancy into the system and mutes the domino effect that a single bank’s collapse can have on the industry.