Sunday, September 28, 2008

II. Why did it happen?

The blame is being spread around for the current crisis:  securitization, lax regulation and the housing bubble have all been fingered as culprits, but I think that these were contributing factors. I would attribute what has happened on financial markets to two phenomena, one of which is age-old and cannot be easily cured by regulation or laws and the other of which can be remedied.
1. Over optimism and hubris: Through history, we (as human beings) have always exhibited these traits. In good times, we become complacent and under estimate the likelihood of their ending, and we also tend, when successful, to attribute that success to our skills (rather than to luck or good fortune). It does not surprise me that there was a housing bubble and I do not believe for a moment that this is the last bubble that we will see in our lifetimes. There will be other bubbles in other markets, just as there always have been through history.
2. Risk taking and risk bearing: I know that risk is viewed as a bad word now. Rather than viewing excessive risk taking as the problem, we need to examine why it occurred in the first place. I believe that the separation between risk taking and risk bearing is at the heart of this crisis. Our risk takers (traders, bankers, mortgage brokers) sought out risks because they shared in the lucrative upside (with compensation tied to profits from activity), but the downside of risk was borne by others (the deposit insurers, taxpayers, other banks and investors). To fix this asymmetry we need to do two things: 
(a) Reform compensation systems to make them less tied to outcomes in short periods. A trader who receives a large bonus in the year in which he makes a large profit on his trading position is receiving encouragement to take the wrong types of risk. Compensation should not only be tied to more long term results but should also be linked to process (as opposed to outcome). In other words, a trader who makes money by taking the wrong types of risk should be punished and not rewarded. 
(b) Price risk correctly: A system that systematically subsidizes excessive risk taking by charging the same price for insuring all risk takers, no matter how much risk they take, is a system designed to fail in the long term. Charging all banks the same price for federal deposit   insurance, while allowing them to have very different loan/asset risks, will result in some banks gaming the system for profit. Prudent banks and taxpayers should not be providing subsidies for imprudent risk taking.
I am not suggesting that either of these actions will be easy to implement, but the task is laid out for us. It is time to get to work!

1 comment:

evileconboy said...

You are dead on about compensation. There is too little downside risk for executives over long periods of time. Let them bear the risk over the period that their decisions have effect (i.e. decades)

Perhaps we could have avoided much of this if we forced banks to retain the equity tranche of securitizations. If they do, they have a vested interest in assuring that underwriting actually happened correctly.

Mortgage fraud is still going on. My landlord, for example, pretends this is his primary residence and is no doubt getting a few basis points lower rate. Underwriting fraud needs to be cracked down on big time.