Posted by The Real Don Johnson on Sunday, December 20, 2009 8:43:12 AM
This post is a follow up of my previous post on the subject, with some additional thoughts and information.
· On December 14,2009, the Wall Street Journal published a report titled “Fixing Global Finance“. The report is the result of a gathering of 80 top financiers. This report seems to me another attempt to study the problem, find the root causes, and recommend fixes as appropriate. I highly recommend this report.
· The President, as usual, blamed the “greedy bankers” for the problems in the financial system. You may be in agreement with him, and to some extent you may be partially correct. However, let me direct you to some findings that I just briefly pointed out in my last post; I will include the appropriate text here for your connivance from the journal Critical Review.
Was It the Bankers’ Greed, Then, After All?
It might seem that we have now laid the financial crisis at the feet of government, not “capitalism”: Without the Basel rules, commercial banks would not have loaded up on subprime securities. And had they not done so, the dawning realization that these securities might be “toxic,” despite their ratings, would not have caused lending among the banks to freeze. No Basel rules, no overinvestment in toxic securities by the banks; no overinvestment in toxic securities by the banks, no financial crisis.
But if we look at the same process from a different angle, the bankers concentrated risk in their own portfolios so that they could make more money. So it might seem that, after all, the most popular explanation of the crisis is true, although for a reason most people have never heard of:
“Greedy bankers” were indeed at fault, because they took advantage of the Basel rules to “leverage up.” They bought (risky) subprime securities to reduce the amount of capital they were required to hold against the risk (ironically) of lending—so that they could make more (risky) loans, hence more profits. Nobody forced them to do that. It was the bankers’ avarice, then, that caused the crisis. And is not avarice, a k a “self-interest,” the engine that is supposed to make capitalism produce wonders?
The short answer is no. Avarice did not cause the crisis. And avarice is not what makes capitalism work. The latter point, and thus a resolution of the relationship between “capitalism” and the crisis, requires its own exposition (Part III). For now, let us consider whether the story of the Basel rules is a tale of “greed.”
The Basel rules were indeed designed to be buffers against excessive risk-taking by commercial banks. The 8-percent Basel capital minimum, multiplied by the 50-percent risk weight assigned to mortgage loans, amounts to a leverage ceiling of 96 percent on those loans. By exchanging mortgages for mortgage-backed securities, a bank could increase its leverage even higher. This may seem like excessive risk-taking. But truly “excessive” risk-taking causes a bank to lose money. A greedy banker may want to make more money, but he also doesn’t want to lose it. The miser who hoards his pennies is as greedy as someone who borrows as much as possible in order to gamble with it: With leverage comes not only the promise of large gains, but the risk of great losses. Avarice, therefore, can lead to leveraging down as much as it leads to leveraging up: If greed is a banker’s motive, raising his capital ratio (to reduce his leverage) makes as much sense as lowering it.
Thus, when we see bankers leveraging up, avarice is not the issue.
Confidence is.
A bank that leverages up is relatively confident in the accuracy of its judgments about how to make money—and relatively confident in its judgments about how to avoid losing it. If its judgments are right, its confidence will be rewarded with profits. If they are wrong, then—in hindsight—its confidence will have been imprudent. So the question, in hindsight, is not why so many banks acted so greedily, but why they acted so imprudently.
Still, even if the problem with financial capitalism is better described as imprudence than greed, it would be quite a problem. So the question is whether taking advantage of the Basel rules by leveraging up indicates that bankers were imprudent. That, in turn, depends on how one defines imprudence.
If imprudence merely means miscalculating risk—i.e., making a mistake—then the answer is yes, almost by tautology. With the clarity of hindsight (and assuming, as we have been doing, that the ratings of the double- and triple-A tranches were inaccurate), then the bankers’ actions were manifestly imprudent.
On the other hand, if imprudence means a reckless disregard for risk, the bankers’ actions indicate quite the opposite. If the only thing bankers had cared about was making money, heedless of the risks involved, then they could have exclusively bought double-A subprime securities, which conferred exactly the same capital advantage as triple-A securities—but which produced a higher yield. But Acharya and Richardson’s Table 1 shows that in fact, only 19 percent of the rated securities held by banks were rated AA or lower. Eighty-one percent of the time, bankers chose lower-yielding triple-A securities. The bankers’ preference for AAA over AA securities demonstrates that they were not blind to risk.12 It also demonstrates that they, like everybody else, believed in the accuracy of the triple-A ratings, since they were trading the greater returns on double-A tranches for the supposed safety of triple-As. As Mark Zandi (2009, 116) writes of subprime securities, Banks themselves were the first in line, picking up most of the senior-rated segments. Returns on these were low, but greater than the banks were paying to their own depositors.
This behavior is nothing if not prudent.
Moreover, most banks went the extra mile and bought additional insurance on these securities, both from “monoline” insurers, which provided 100-percent loss protection (Gorton 2008, 38n42) on some portion (generally 20 percent) of the securities; and in the form of credit default swaps—as Wallison explains in “Credit-Default Swaps Are Not to Blame.” 13 The evidence, then, suggests that bankers were not imprudent in the sense of ignoring risks that they knew about. Rather, they were ignorant of the fact that triple-A rated securities might be much riskier than advertised.
Take the head of the two Bear Stearns subprime hedge funds, Ralph Cioffi. It was his pitch to investors that consisted of endlessly repeating the fact that the funds’ assets had triple- or double-A ratings.
Not only did his clients believe that these assets were safe; so did he. Thus, he was willing to risk a jail term by lying to his clients from December 2006 to February 2007, when news of subprime defaults was spreading and the credit-default swap insurance price of subprime CDOs was rising (Cohan 2009a, 311-12). To reassure his clients, Cioffi reported that he was selling subprime CDOs during this period when he was actually buying them. He must have been sure that there would be no investigation, hence no jail sentence, if doubling down on subprimes turned out well for his investors—so clearly he must have believed that in buying them, he was not courting disaster.
Cioffi’s partner, Matthew Tannin, seems to have held the same set of beliefs. Tannin followed Alan Greenspan (Zandi 2009, 72-73) and Ben Bernanke (Posner 2009, 90) in thinking that there was no nationwide housing bubble, as opposed to local bubbles in a few cities (Cohan 2009a, 305). E-mails to Cioffi unearthed by the F.B.I. show that Tannin thought buying subprimes was a good idea as late as February 28, 2007 (ibid., 322).
Both Tannin and Cioffi had millions of dollars invested in the subprime hedge funds they ran, and Cioffi moved $2 million of his $6 million investment out of these funds only on March 23, 2007 (Cohan 2009a, 325). As of March 28, however, Tannin was still in: “‘I simply do not believe anyone who shits all over the ratings agencies,’ he wrote. ‘I’ve seen it all before. Smart people being too smug’” (ibid., 326). It was not until April 22, 2007—two months before the funds collapsed—that Tannin began to have doubts. A new internal analysis of subprime CDOs suggested to him that “the subprime market looks pretty damn ugly. If we believe the [new CDO report] is ANYWHERE CLOSE to accurate, I think we should close the funds now” (quoted, Cohan 2009a, 328). This was toward the end of a tortured letter that Tannin routed to Cioffi through their wives’ personal e-mail accounts (ibid., 327). The message began by reflecting on how much Tannin loved his work with Cioffi, and how “he had no doubt ‘I’ve done the best possible job that I could have done. Mistakes, yep, I’ve made them,’” he admitted, but “‘all one can do is their best—and I have done this.’”
These are not the words, nor were Tannin and Cioffi’s actions the behavior, of people who had deliberately taken what they knew to be excessive risks. If Tannin and Cioffi were guilty of anything, it was the mistake of believing the triple-A ratings.
The Executive-Compensation Theory
Eminent economists have been joined by the president of the United States, however, in claiming that the problem was precisely that bankers knowingly took excessive risks. The reason they have offered is that the compensation structure of the banks gave bankers an incentive to disregard risk. Executives and, in many cases, lower-level employees were rewarded with bonuses for profits; but if profits turned to losses and the executives were fired, they often had “golden parachutes” to protect them from financial damage. Meanwhile, lower-level employees suffered no diminution in base pay even if they failed to get a bonus because of losses (Posner 2009, 93–100).
This theory has the advantage of relying on the basic tool of contemporary economics: incentives. But it has the drawback of economists’ insensitivity to other factors—such as ignorance—which is so trenchantly pointed out in Colander et al.’s critique of contemporary economics.
There is no question that incentives have real effects—when economic agents are knowledgeable about how to make more money, for example, or how to avoid losing it. But while compensation may skew economic actors’ incentives, the question is whether particular economic actors—real bankers at actual banks—were knowledgeable about the risk
of losing money on triple-A rated securities, and thus were imprudent in
buying them. That is an empirical question that can be answered only
with evidence; it cannot be decided a priori. And thus far, it seems that
the theory has no evidence behind it, and a great deal against it.
We do not have any reason to think, for example, that banks whose
employees got bigger bonuses for taking more risks actually invested
more in subprime securities—or more in double-A than in triple-A
subprime securities. Nor has anyone named an actual executive (apart
from Countrywide’s Angelo Mozillo) who is supposed to have known
that his bank was taking on undue risk. On the other hand, we do know
that the bankers in question often took tremendous amounts of compensation
in the form of their banks’ stock, which became virtually worthless
as a result of their subprime investments. This was true of Bear Stearns,
whose executives collectively lost billions of dollars; of Lehman Brothers,
where the CEO, Richard Fuld, single-handedly lost $1 billion; and of
Citigroup, where Sanford Weill lost half that amount (Cohen 2009).
The available evidence, then, suggests that the alleged miscreants were
not setting aside knowledge of risk in pursuit of higher paychecks. “We
were just told by our risk people that these instruments are triple-A, like
Treasury bonds,” said Peter Kurer, the former chairman of the huge
Swiss bank UBS (quoted, Tett 2009a, 139). The UBS report to its shareholders
and the Swiss government on its performance in the crisis bears
Kurer out.14 The risk-management process may (in retrospect) have been
flawed, but the results it produced were reassuring, and there is no reason
to think that Kurer was less than reassured. Nor is there evidence that the
risk managers who generated these reports deliberately underplayed the
risks.
Even more telling is what we know about Cioffi and Tannin of Bear
Stearns, who were just about the two best-placed bank executives in the
world to know that there was excessive risk in triple-A tranches of
subprime securities—if any bank executives knew that. Bear Stearns led
all the investment banks in securitizing subprime loans, and Tannin had
spent seven years intimately involved in the securitization process itself
before he joined Cioffi in buying mortgage-backed securities for the Bear
Stearns hedge funds (Cohan 2009a, 283). By contrast, the commercial-bank
employees who bought these securities typically would not have been in
a position to know anything about them except that they were rated
AAA. If Cioffi and Tannin were ignorant of the “true” risks, as the
evidence suggests, then we have every reason to think that commercial
bankers were just as ignorant of them.
This applies doubly to the executives at the top of the corporate hierarchies.
When the market for the securities that Cioffi and Tannin were
selling (and buying) dried up and Bear Stearns had to close the two hedge
funds, Paul Friedman, the CEO of the firm’s fixed-income division,
reports how bewildered everyone was: “At that point we still believed that
an AAA rating meant an AAA rating, and we all believed that these things
were reasonably well structured” (quoted, Cohan 2009a, 365)15—just as
did the infuriated executives at BlackRock, Fortis, Vanguard, and Pimco.
The papers by Bhidé and Colander et al. suggest that economists are
poorly equipped to recognize ignorance when it is staring them in the
face—because most economic models assume that economic actors
(“rational representative agents”) are, in effect, omniscient.16 Notably,
this is the default theory in popular politics and in much of political
science, too: In the populist theory, major problems aren’t caused by
human error; instead, some evil person or cabal must be at fault—“special
interests,” lobbyists, or, indeed, greedy bankers. Mistakes simply don’t fit
into standard economic and political models, because standard economic
and political models take ignorance out of the human equation.
Instead of mistakes—caused by ignorance—the standard models focus
on motives, i.e., “incentives.” The effect is to model economic and political
agents as if they automatically get what they want (unless they are
blocked by agents with contrary desires, as in game theory), which sidesteps
the question that actual human beings constantly confront: How do
I get what I want? Desires are not self-actualizing, and to assume that they
are might be called magical thinking to emphasize how unscientific it is.
But let us instead call the assumption that an agent accomplishes whatever
he or she intends (unless blocked by another agent) “the intentions
heuristic.” This nomenclature should remind us of how fundamentally
destructive of good social science the heuristic can be, since good social
science should, above all, identify unintended consequences.
If, as I have been assuming (along with all of our authors), Cioffi and
Tannin were taking bigger risks than they thought—a question that will
be settled only if triple-A tranches end up paying out significantly less
than promised to their investors (which may not be the case)17—then,
ex post facto, we can pass the judgment that their confidence in the value
of mortgage-backed securities was “overconfidence.” However, this is
not evidence that they were imprudent in a meaningful (non-tautological)
sense. They were not being particularly greedy or hubristic. They,
like the other investors, and the rating agencies, were simply
mistaken—or so it seems, with the luxury of hindsight. And the reason,
apparently, is that they were ignorant of the true risk of the securities
they bought.
· Has the congress or administration taken into account the issues and problems raised by either of these studies? I would hope so, but have serious doubts because of all of the scapegoating and finger pointing. I have e-mailed Senator Joe Lieberman on two occasions, and he has responded both times to my specific concerns. I will e-mail him again concerning these two studies, and will let you know how he responds. By the way, I have also sent the same e-mails to Senators Dodd, Feinstein and Boxer, with no responses.
My conclusion is that we have a multifaceted problem that can’t be solved in a political manner, but will take the honest efforts of bankers, financiers, politicos, news media and others. Our job as voting citizens is to press for the honesty we all deserve.
Regards,
don
A Yearning for Publius 