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Sunday, April 11, 2010

Moral hazard and the financial crisis

You may have noticed that I've written little about the financial crisis recently, despite having written a great deal about it before and during the events (see here for slides from my talk on the crisis). I suppose it's because I'm 1. tired of thinking about it, and 2. pessimistic about what will be learned (by regulators, economists, the general public) from the experience. The subject is just too complex and requires a combination of detailed knowledge of financial markets together with an appreciation of theoretical issues such as market efficiency, agency problems and regulatory capture. On a positive note, some economists who were, at the time of the crisis, familiar with the latter, but (shockingly) had little knowledge of the former (what is a CDS? is that like a CDO?), are finally getting up to speed.

See here for a link to what I consider one of the best papers characterizing systemic risks in the "New Financial Architecture". It seems that ideology still rules in certain places.

A number of talented people have written books on the crisis -- from economists like Simon Johnson to financial journalists like Gillian Tett and Michael Lewis. Note the absence of books by actual practitioners -- to my knowledge no CDO modeler or CDS trader has written a book [see comments for a correction to this statement]. I suppose Paulson's book or Congressional testimony by people like Rubin might give the CEO's perspective, but those people were plausibly, and by their own admission, clueless about what was being done in their own firms leading up to the crisis.

Yesterday I listened to this bloggingheads discussion: The Past, the Crash, and the Future, between two Brown economists. Ross Levine is a finance expert and Glenn Loury is an interlocutor with a gift for clarity. I think they got almost everything right except that Levine continues to blame moral hazard. At the naive level, moral hazard is a big issue because many of the bad actors (banks) were indeed bailed out by taxpayers like you and me. However, the story only works at the institutional level -- yes, Citi and JP Morgan Chase and Goldman all continue to exist as institutions. But the principals -- the actual people -- involved could never have been sure, at the time, or leading up to the crisis, about their own fates or those of their companies. I suspect most Goldman partners were scared out of their minds at the height of the crisis. And, certainly, people involved in the actual mortgage finance business within those companies have mostly lost their jobs. One friend of mine (a prop trader) noted, referring to the mortgage business, that an entire industry had disappeared, and that none of those jobs were coming back.

Compare this to the outcome if the traders and modelers and salesmen in the mortgage industry had produced real alpha, as opposed to fake alpha -- they'd still be gainfully employed. The guys collecting huge bonuses in 2010 are, by and large, not the same people who nearly destroyed the entire financial system leading up to 2008. (The public is upset because they belong to the same firms, share the same backgrounds, and do similar things. But a guy who trades FX isn't really responsible for the mortgage meltdown, except through guilt by association.) So where is the moral hazard story? It falls apart when you look at the incentives and outcomes for actual individuals.

To repeat, the real story behind the crisis (among many other factors, but not including moral hazard) was fake alpha, which isn't that different from a plain old-fashioned swindle:

How then can untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return. [The guys who bundled and sold CDOs in, say, 2005, got paid by their firms, and "sophisticated" counterparties at other banks, or at pension funds, bought the securities ... Mr. Market failed to detect the fake alpha. The idea with fake alpha is to be rich and retired, or in another job, when the sh*t hits the fan. It's not that someone is going to come and bail you out. There is no moral hazard.]

But many economists don't like the idea of fake alpha because it exposes a fundamental and scary kind of market inefficiency -- if markets were really good at pricing long term risks and complex uncertainties, then compensation committees and CEOs and shareholders would be able to detect the timebombs in fake alpha. The record shows they cannot.

Ideological capture (efficient markets!) of academic economists and political theorists, combined with political-economic capture of government, in the form of campaign finance, allowed lax regulation. And lax regulation allowed fake alpha schemes to create systemic risk. I should also mention, as always, bounded cognition: not even the CEOs really understood what was going on in their own firms, let alone directors and shareholders. (People are stupid -- look around!)

To be fair to Levine, moral hazard will be a huge problem going forward -- the remaining banks NOW know with some certainty that they are too big to fail. However, I'm unconvinced that moral hazard was one of the leading factors in the last crisis.

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