FRB Minneapolis: Interview with Eugene Fama

Eugene Fama on ratings agencies and problems in mortgage markets:

Interview with Eugene Fama, by Douglas Clement, The Region. FRB Minneapolis: ... Region: Some observers have suggested that regulators and others have put too much reliance on ratings agencies to determine the risk of mortgage-backed securities and that even financially sophisticated parties “didn’t really know what they were buying.” Is this evidence that credit markets are inefficient?

Fama: That story just doesn’t appeal to me. First of all, it’s well known that rating agencies tend to lag actual changes in credit worthiness. For example, stock prices predict changes in ratings better. The best models of credit quality are basically options pricing models that work off the stock price. So I’m very skeptical of these stories.

The bond market is a simpler market than the stock market. Bonds are simpler to evaluate than stocks, because there’s downside risk, but you don’t have to worry much about the upside: They’re not going to pay you more than they promised. So bonds are much simpler to deal with. Now bond products have become more complicated because of the securitization of that market, but still not that big a deal. [entire interview]

Update: Richard Green comments on this passage.

Comments

[Bruce Wilder]

Fama: ". . . still not that big a deal . . ."

One thing you can always, always count on Fama for is to never take the magnitude of anything seriously as evidence.

Whether it is CEO compensation or the Crash of 1929 or a speculative bubble, magnitudes never ruffle his feathers. He's a classic modeler -- how good is the model for your purpose -- his interest in trying to figure out how the world works ends when he has figured out how well his model works.

The man is analytically brilliant. But, his judgment is terrible.

[david]

"If the [compensation] process gets captured by the CEO, then it can get corrupted. But if what you’re seeing is a market wage, then I don’t know why you would say it’s too high. If it’s a market wage, it’s a market wage. I don’t know of any solid evidence that the process was corrupted. So my premise would be that you’re just looking at market wages. They may be big numbers; that’s not saying they’re too high. It’s easy to say that people are paid too much, but when you’re on the other side of the fence trying to hire high-level corporate managers, it turns out not to be so easy."

Yuck.

[Meh]

Hard to disagree with Bruce Wilder's assessment of the man.

However, I think the question excerpted "are credit markets inefficient?" isn't really the issue.

The real issue is how do we regulate the markets?

As a quick aside, we regulate the banking markets because we've found that the schumpterian waves of creative destruction seem to be a bad thing to apply to the banking market, as somehow it seems to promote very damaging economic instability.

i.e. the market may or may not be efficient, but reality requires us to be concerned not just with efficiency of the credit market, but also it's robustness.

Anyway, given that we're going to regulate the banks and the borrowing and lending in the credit markets, what do we do?

In the past we've couched part of the solidity of banks in the reserve requirement, but another part in terms of demanding "safe investments" and the definition of "safe" has been left to the credit rating agencies.

And there are serious issues about the effectiveness of this approach. IF we want continued robustness in the credit market, we're probably going to have to invent some new (or resurrect some old) regulatory approaches.

[calmo]

David and Bruce have divergent opinions about Fama, it appears...the evidence:
....from Bruce: "The man is analytically brilliant." And Fama is no stranger to his brightness, yes?
(you have to clip it somewhere, people, if you want to make yer point --don't let it make you.)

and from David (possibly a graduate of the melvin haiku foyu school):

"Yuck." And David wishes he were a stranger to Fama's brilliance. Me too. Can we overcome Fama's remark:Well, economists are arrogant people. And because they can’t explain something, it becomes irrational. What I mean is: does that photo look like a picture of a man who keeps mice...not only in his kitchen, but in his pockets...one or 2 cradled in his hands even as the photo is taken? Or is he always that pleased with his ex-mice keeping accomplishments? Mid seventies...in a few years he'll look different and his work, too...standing too close to the mirror does this to you, no?

[Bruce Wilder]

calmo: "David and Bruce have divergent opinions about Fama"

Not at all. I read the passage David quoted, and had exactly the same reaction.

I would say, that "if what you’re seeing is a market wage, then I don’t know why you would say it’s too high" reflects abysmally bad economic judgment, but "yuck" works for me, too.

[calmo]

Darn, I knew, Bruce'd object to my "clipped" quote...Ok, here itiz in toto:The man is analytically brilliant. But, his judgment is terrible.I'm so sorry...I'll never do it again...not without italics, bolds, CAPS...something more evident.
Bring out the whips.
Tie me to the stake.
Let the dogs loose.
Actually, I need to see this "wage" line coming from Fama in a Liberace-like costume in a suitably luxuriant setting repleat with servants and another photo of market wages at work in developing countries.