Was Risk Misperceived, Misrepresented, or Misallocated?

We know that excessive risk taking was a factor in the financial crisis, but why people were willing to take on excessive risk?

There are several explanations for this. In one class of models, misperception of risk generates excessive demand for risky assets, housing and financial assets in particular. There are a variety of stories about why risk is misperceived, ratings agencies failed to do their jobs, risk assessment models turned out to be wrong, people believed that housing prices would continue to go up, and so on. The key is that in this class of models the misperception of risk gives people a false sense of security, and induces them to take on more risk than they can handle.

In another class of models, risk is misrepresented. Here, there is out and out fraud or other practices where, essentially, people know that the house is made of cards, but advertise it as being made of bricks anyway, and assure people that it is perfectly safe. Fraud could cause the victim to misperceive risk, so this is related to the first class of models, but I am trying to separate excessive risk taking brought about by intentional misrepresentation from excessive risk taking brought about by errors in judgment (or, perhaps more accurately in some cases, from negligence).

In a third class of models risk is misallocated, and there are two strands of risk misallocation models. In one, the mechanism that causes people to take excessive risk is knowledge that the government will step in and cover any potential catastrophic losses (risk is reallocated from the private to the public sector). This is the moral hazard problem, and the claim that government intervention led to excessive risk taking has been leveled pretty much wherever government has played a role in housing and financial markets, even when the role has not been very large.

In the second strand of risk misallocation models, the cause of excessive risk taking is market failure due to principal agent problems (e.g. when mortgage brokers are paid according to the number of loans that pass through their hands rather than according to the quality of the loans, and hence have no incentive to monitor risk). Market failures of this type can cause excessive risk taking because the person taking the risks does not face the full consequences of their decisions when the risky decisions turn out to be wrong. Why not take a big risk if you win on the upside, but you don't have to pay the full cost (or any of the costs) on the downside? However, unlike the first strand of risk misallocation models where there is too much government intervention, here the problem can arise when government fails to regulate markets properly, so the problem is often the result of too little government intervention rather than too much.

In a final class of models government is also blamed, but this time government is a bully that forces banks - through regulation or moral suasion - to make loans that are overly risky. The very thoroughly discredited models blaming the Community Reinvestment Act for the financial crisis fit into this class, and the models blaming the CRA are the most prominent member of this category. For that reason, I'll call these models "misguided" and set them aside.

So which was it, misperception, misrepresentation, or misallocation? In the following, Tyler Cowen focuses on the misallocation of risk due to government induced moral hazard. My own view is that misallocation of risk did play a role, but I think risk misallocation due to market failures, i.e. the failure of regulation, was more important in generating the crisis than moral hazard brought about by implicit or explicit government guarantees. I also think the misperception of risk was important, perhaps even more important than the misallocation of risk (though these are sometimes hard to separate):

Here's Tyler Cowen:

Bailout of Long-Term Capital: A Bad Precedent?, by Tyler Cowen, Commentary, NY Times: The financial crisis is a result of many bad decisions, but one of them hasn’t received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad. ...

At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed. ...

The Long-Term Capital episode ... was important precisely because the fund was not a major firm. At the time of its near demise, it was not even a major money center bank, but a hedge fund with about 200 employees. Such funds hadn’t previously been brought under regulatory protection this way. After the episode, financial markets knew that even relatively obscure institutions — through government intervention — might be able to pay back bad loans.

The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.

What would have happened without a Fed-organized bailout of Long-Term Capital? ... Fed inaction might have had grave ... economic consequences,... and the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later.

In 1998, there was no collapsed housing bubble, the government’s budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months.

The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew. ... So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.

While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery. ...

I should add that I agree with Tyler that government action, or in some cases inaction, and in still other cases poorly though out action, particularly by the Treasury, has left far too much uncertainty in markets.

Comments

[chrismealy]

Great post.

I'm sure every big bank, from WaMu to Bear Stearns to Lehman, had a somebody smart at the bottom of the org chart saying, "We're doomed!" (That man or woman was might have been reading Dean Baker, CR, or this blog too!) But that's not how you get to the top. That doesn't get you paid $20 million/year. And that doesn't keep you getting paid $20 million/year.

I remember Brad DeLong celebrating Robert Rubin on the occasion of Rubin's autobiography. Sure he's a Democrat, sure he's no Hank Paulson, but still, he's a rich guy, a rich guy who's more of a lawyer and a schmoozer than an economist. Why does anyone take Rubin seriously at all? Has he even heard of Mandelbrot and Taleb? Does he have any opinions regarding market returns being normally distributed or not? I really, really doubt it. To a guy like Rubin statistics and econometrics are for the nerds in the basement. As long as the money is rolling in, as long as he's flying down to the Caribbean for fishing weekends, he's happy. For these jokers running the system, the system totally works. Like the house, they can never lose. They're never going to admit otherwise.

So ... I guess I fall in the principal agent problem camp.

As for Cowen, he seems like some kind of medieval philosopher trying to maintain his belief in the Earth being the center of the universe. Or the proverbial useful idiot.

[Bruce Wilder]

"why [were] people willing to take on excessive risk?"

Maybe, "people" weren't willing, and maybe their willingness didn't matter.

I think the key phrase is, "other people's money".

You might as well ask why "people" in Tennessee "wanted" to take on the risk of having their land flooded with 6 zillion tons of coal ash.

Why did "people" "want" to take on the risk of being defrauded by Bernie Madoff?

Why did "people" want to take on the risk of a Countrywide ARM? Why did Angelo Mozilo want to take on the risk of the company he built collapsing, and he having to resign in shame, with a measly $142 million in parting gifts to console him?

Why did John A Thain take the wild, crazy risk of riding the Merrill Lynch tobaggon to the bottom of the hill? $82 million? Could that be it?

Why did people want to take on the risk of rating agencies and monolines lying?

Why did "people" "want" to take on the risk of the Federal Reserve owning the world's largest insurance company?

[moola]

"We know that excessive risk taking was a factor in the financial crisis, but why people were willing to take on excessive risk?"

Like 1690s, 1720s, 1850s, 1920s, and all the other speculative orgies, people wanted to make alot of MONEY.

Risk was ignored. As a group, people were not rational. It was about the MONEY. People took excessive risk to make excessive MONEY.

[Bruce Wilder]

You can make a lot of money, moola, by taking the combo of risk and reward, and handing the risk off to someone else, why grabbing the reward and running.

The Washington Monthly: "WaMu's CEO got $88 million in compensation between 2001 and 2007. The most charitable description of what he did for all that money is: he provided a textbook example of the principal/agent problem -- the kind of problem you get when someone (say, a CEO) who is supposed to be working for someone else (say, shareholders) decides to throw their interests overboard and rob them blind, and the structure within which he's working is not set up well enough to prevent him from doing so. The less charitable description is: he looted the company."

[mmckinl]

Was Risk Misperceived, Misrepresented, or Misallocated?

As your post so skillfully explained each of these three types of risk were taken at each step of the mortgage process from initiation to securitization.. As for CRA risk I don't buy it ... Many posts here on the net explain why the CRA program was not at fault including this : http://economistsview.typepad.com/economistsview/2008/04/yet-again-it-wa.html.

BUT: The bigger problem was not the mortgages themselves but the securitization process and the off track betting in the MBS, CDS and derivatives market. For every dollar of mortgage loss we are looking at up to ten dollars of lost bets due to this massive leveraging.

Now: The $50 trillion debt bubble that we have been building for 30 years now is popping. So it is not just a matter of a half a trillion dollars of bad mortgages that began this debacle ... those defaults have triggered bubble after bubble popping ... from libor to commercial paper, to credit card securities, to student loans, to CRE loans ... etc.

It was risk built upon a massive leveraging of every financial market in the economy. Most if not all of the Wall Street Banks are now insolvent. This presents another risk : Total systemic risk due to trillions in unknown and unknowable derivatives losses.

We need to nationalize the banks and rationalize all balance sheets simultaneously under a FDR Bank Holiday or Swedish Plan to get our arms around the whole problem or it could go nuclear destroying what's left of our financial system.

[Bruce Wilder]

Accounting Standards Wilt Under Pressure: "In October, largely hidden from public view, the International Accounting Standards Board changed the rules so European banks could make their balance sheets look better. The action let the banks rewrite history, picking and choosing among their problem investments to essentially claim that some had been on a different set of books before the financial crisis started.

The results were dramatic. Deutsche Bank shifted $32 billion of troubled assets, turning a $970 million quarterly pretax loss into $120 million profit. And the securities markets were fooled, bidding Deutsche Bank's shares up nearly 19 percent on Oct. 30, the day it made the startling announcement that it had turned an unexpected profit."

The "political party" of executive fraudsters is very powerful, and can and will wreck the structures erected to contain them. This includes accounting. And, it includes economics. Just sayin'

[a]

I'm not sure how one can determine which type of risk was "more important" in leading to the crisis. I think Tyler Cowler is correct that the rescue of LTCM was a crucial event. IBs and hedge funds would have had their wings clipped, some would have gone under or been taken over (Goldman Sachs anyone?), and stockholders would have become much more anxious as to how much risk the banks were taking on. That's not saying that "more regulation" *if* properly done (although I think that's a big if) would also have stopped some of the excesses.

[ozajh]

To be fair to the mortgage brokers and other industry insiders, a lot of them seem to have personally invested in exactly the same areas that they were selling to others.

In these cases principal agent misallocation merges into misperception BY THE AGENT (as well as perhaps by the borrower). After all, the agent is going to sell a very persuasive story when (s)he truly believes there is no risk in the product being sold.

[Greg Byshenk]

I'm no economist, so it may be that I am the one who is wrong, but the argument above re LTCM seems mistaken to me. After all, the "bailout" of LTCM was not a government (or Fed) bailout, but a "bailout" by LTCM's own creditors. Yes, the Fed helped organize the bailout, but (at least as I understand it) what the Fed actually did was just to gather LTCM's creditors together and tell them: "if you let LTCM blow up, you are all going to be hurt badly, while if you take it over and dismantle it cleanly you will all be much better off." Which, if I am not mistaken, is not something terribly radical; I believe that creditors recognize that, at least in some cases, forcing immediate liquidation is not the best course of action. What the Fed did in the case of LTCM was help coordinate the creditors.

What the case of LTCM should have been, though, is a stark warning about the dangers of non-transparent networks of risk. Instead, the following decade saw an explosion of ever-more-complex and opaque financial engineering, leading to the situation today in which it is difficult (perhaps impossible) to determine where the risks are hidden.

This should not be seen as a call for "more regulation" per se. It is at least arguable that there should be a "grown-up investors table" of hedge funds and the like for those who are aware of the risks involved and are prepared to take them. But it seems obvious (at least to me) that there must be regulation at least regarding transparency, so that those involved actually can be aware of the risks involved, and suffient (and enforced) regulation to prevent conflicts of interest and/or collusion. I am sufficiently libertarian to believe that, if someone wishes to invest in what is (IMO, at least) an insane venture, then they should not be prohibited from doing so. But there must be sufficient regulation to ensure that the information is available that enables one to make an informed decision, and that the information available is accurate.

[Friedrich von Blowhard]

Mr. Thoma:

I'd be interested in some explanation of why you hold the views that you do on this matter. Apologies in advance if I'm doing your thinking wrong, but your somewhat paradoxical political opinions seem to be in the driver's seat here.

I feel like I'm reading a sort of reversed mirror-image of the Wall Street Journal editorial page. For them, market fundamentalism is always right, and the consequences of failing to regulate market failure are curiously off the radar (to be acknowledged, if at all, only in passing while counting on the inevitable government bailout when things hit the fan.) For you, the Progressive or big government model of finance, with the taxpayer backstopping private financial players in exchange for regulation, is always right, and regulatory capture and moral hazard (really, two sides of the same coin) are oddly off the radar.

Perhaps you might notice that both points of view, while theoretically in opposition, had to work together hand-in-glove to create the current problem. After all, you can't have regulatory capture without a Progressive regulatory state and politically influential private sector interests. There has been an utter failure to address the principal-agent problem realistically at either the governmental level (in the form of suborned politician-agents adopting policies that favor industry interests over those of the taxpayer-principals) or in publicly-owned corporations (in the form of management-agents looting from shareholder-principals). The ordinary citizen-principal's wallet has been, as a consequence, profoundly captured for the benefit of the financial industry agents over the past 25 years, first via financial industry profits and then through public bailouts.

I would think that the very existence of privately-owned, publicly-guaranteed, too-big-to-fail financial institutions seems to scream 'conflicts of interest ahead' and 'we fully intend to privatize the gains and socialize the losses, suckers' to both partisans of the left and the right. At the very least, too-big-to-fail has an obvious solution: break the beasts up until they cease to be 'systemically important.' You seem oddly tolerant of these very odd, grossly oversized public-private hybrids, kept on their shaky feet largely by endlessly helpful public policy bought by massive industry political donations and lobbying budgets.

How could very profitable markets in products like credit derivatives even exist without the current system of public support? They turn out, when you get to the bottom of them, to depend crucially on the belief that the risk of counterparty defaults by major financial broker-dealers is nil because of implied governmental guarantees. And so it is with all forms of 'financial innovation'.

Why your apparently endless tolerance of these peculiar institutions? Do you really think we should all just sacrifice once more in order to nurse these bloated monsters back to financial health and then go back to crossing our fingers and hoping they'll be responsible this time and won't blow up the economy once more? I say if an institution is too-big-to-fail, it should be nationalized; and if we don't like that solution, they can shrink voluntarily or via legislatively.

[yamada]

"...waiting to see what regulators will do next..."

Anyway, the bubble is on the asset side of economic entities' balance sheet and become valueless.
Though the value of the asset significantly disappeared, the value of the debt will not disappear.
Policy makers must do away with these debts, by most efficient and controlled way, as system as below. If policy makers try to relieve the selected economic entities one by one, it means that they need money equal to the disappeared asset value of relieved entities. Policy makers firstly should target the asset that caused bubble which affect the real economy after the bust, but should not target the real economy resulted from the bust.

Bubble is caused by peoples’ expectation that the price of certain asset(real estate) will rise in future, with pouring high-powered money to the asset side of economic entities’ balance-sheet. So, to solve this problem, such asset bubble on economic entities’ balance-sheet must be gotten rid of, by the new system as below.
Though it may be seen contradictory, a kind of high-powered money enables to work this new system.

1. Every economic entities’(including banks) assets that caused the bubble(real estate or CDO et al) on balance sheet should be evaluated on mark to market basis by the authorization of a third party(maybe financial auditor), which brings about some insolvent(i.e. debt section surpasses asset section on balance sheet) economic entities..
2. FRB decide to write off a certain amount of the loans to the banks, which amount distributed to each bank according to the amount of each banks’ insolvency, calculated on 1.
3. Every bank that gets profit from written off should next legally enforced to, by using the profit from written off as original fund, write off its loans to its each debtor, in proportion to the amount of insolvency of each debtor. If the bank is unable to use all the written off profit it earned, the remainder is taxed all and absorbed by tax authority.
4. Other economic entity that gets profit from the written off by the bank should next legally enforced to, by using the profit from the written off as original fund, write off its loan(or trade claim) to its each debtor, in proportion to the amount of insolvency of each debtor. If the economic entity is unable to use all profit it earned, the remainder is taxed all and absorbed by tax authority. These processes are to be repeated operationally(multiplier effect).
5. In consequence, the bubble portion of the targeted asset is extracted from the economy, and is transformed to tax.
6. The tax claims is finally assigned to FRB. It’s up to FRB how they dispose of their above claims, considering the situation of economy, of each bank and of each economic entity. As a option FRB should examine the possibility of the bank’s and the economic entity’s turnaround, together with the other creditors, remaining desirable debt to the bank and the economic entity(empirically it's ten to fifteen times annual earnings before interest, taxes, depreciation and amortization, known as EBITDA), and writing off the rest debt, with taking into account the value of disposable collateral(that do not accrue earnings), of guarantor and of consolidated basis.
7. Every write off must be supervised and traceable by centralized function of the system. So every write off must be executed through this function. Every write off may be done through this function, which exist on internet for access.
8. For cross-border. For each non-residential economic entity, the amount of write off should also be calculated in the same way as 4. , on the only cause from specific asset depreciation in the resident country. Economic entity that will be written off should next write off in the same booked currency. In case profit of the written off exists on the non-residential economic entities, it's taxed and absorbed by the foreign(=non-residential) government and handed over to the sovereign(=residential) government of the currency, based on treaty.
9. FRB should carefully watch the rate of the number of insolvent economic entities to the number of all economic entities in the US, when deciding the amount of the loans(trade claim) written off on 2.
10. To keep FRB’s balance sheet sound, it must be permitted for FRB to generate profit by printing dollars in order to cover write-offs loss. These printed greenbacks is stored to the safe forever(I come to know the journalization if FRB’s profit is generated by their printing dollars is quite irregular). This may be extraordinary bookkeeping nowadays, but it should be permitted, under extraordinary situation.
11. In case price inflation expectation exists(not now), the system enables FRB to on one hand raise benchmark rate to cope with inflation expectation, on the other hand restructuring the balance sheets of economic entities.

For further details, please see the post on the blog as below:

The Post on December 16, 2007, August 14, 2007 on the blog
http://reversewealtheffect.blogspot.com/

[gordon]

Prof. Thoma: “Why not take a big risk if you win on the upside, but you don't have to pay the full cost (or any of the costs) on the downside? However, unlike the first strand of risk misallocation models where there is too much government intervention, here the problem can arise when government fails to regulate markets properly…”.

Regulation doesn't seem to be mentioned in relation to any of the other four types of excessive-risk scenarios that are listed. Does this mean that regulation is only appropriate to this one? Is the second type (fraudulent misrepresentation) the province of ordinary fraud legislation, but not what you would call "market regulation"?
If so, is fraud legislation the whole story? Don't stock markets regulate the information which traded companies must provide? Doesn't the US SEC have a role in disclosure? Aren't these regulations (which must rank as market regulation) aimed at preventing misrepresentation?

And for the first scenario (misperception), aren't regulations imposed by stock markets and the SEC aimed also at ensuring that investors have the means to judge risk? Isn't this also therefore a field where regulation is important?

If these objections are right, regulation becomes important in three of the four scenarios which you take seriously, not just in one. The remaining scenario is the "expected Govt. bailout" one.

[ken melvin]

I assume these risk takers, be they home buyers, or Thains or Mozilos, looked at their options. What was it that they saw?

[bakho]

How much did monetary policy affect risk perception?

When Greenspan took interest rates to near zero early in the Bush years, people were scrambling for "safe" investments that would pay some interest. Even very risky investments were paying much lower returns.

People get used to the level of return for "safe" investments and often misjudged the riskiness by rate of return. Thus they believed that risky investments with low-moderate returns were "safe" when they were not. (How could they be risky if they were only giving low-moderate returns?)

Funds generated subprime mortgages because "mortgages are not risky" and the subprimes could get rates of return up to the level of expectations for relatively safe investments. . They ended up generating risky mortgages in order to get a low to moderate rate of return. They generated these mortgages by changing the rules in ways that made them more risky. The people upstream that were evaluating the risk did not realize that the rules had changed and therefore the risk had changed.

It is easy to model how this happens.

[Tyler Cowen]

I agree, by the way, that bad risk management by the private sector was a more fundamental cause of what has happened. But that's already been discussed plenty, while the LTCM angle has been a bit forgotten.

[Rusty]

Risk was ignored.

"Greed is good." Gordon Gecko

[wjd123]

First Tyler Cowen writes:

What would have happened without a Fed-organized bailout of Long-Term Capital? ... Fed inaction might have had grave ... economic consequences,... and the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later....

Then he ends with this:

While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery....

Since I'm not as willing as Tyler Cowen to have innocent people suffer in a recession because of the actions of LTMC, and putting discretion in regulators hands hasn't worked out to well in the past, while today, cash is sidelined waiting to see what regulators will do, the solution to these problems seems obvious: Regulate now, regulate heavily, and make it be known through government action that regulations will be enforce. Exactly, what the government should have done in 1998 after the collapse of LTMC.

No doubt that had the government done so in 1998 most of those regulations would have been lifted by 2008 because of the incessant complaining of financial institutions about being stifled and not being able to compete in a global economy. It's the same old story, "If we can't do it someone else will and take investors money with them."

Compare that complaint with societies complaint about the trillions financial institutions have lost and the recession we are in now.

I suggest an "ogre in the room" approach to keeping financial institutions form complaining or buying off congress to remove regulations.

The ogre should be one that knows finance and is really pissed off about what financial institutions have done to our society. That's the guy or gal I want sitting in the room when some lobbyist representing a financial institution come up the Capitol Hill to complain about some regulation.

Not only should the ogre be there to question and take notes but it also should be mandatory that he or she, the ogre, testify in front of congress before there is any easing of regulations on the financial industry. No testimony should be allow to be given unless what is said was first said in the "room" with the ogre present.

And in our society where material success is worshiped, sociopaths are easily nurtured. it is unlikely that point, where regulations need to be eased will ever be reached for financial services. Therefore the ogre should be watched by society for signs that he is loosing the quality of ogreism. Nobody wants a soft ogre guarding society against a new lot of sociopaths.

Who to put in the ogre's chair. Tyler Cowen is out, He wants to punish everyone in order to teach financial institutions a lesson. Mark Thoma is out, he thinks restoring trust can wait. He wants understanding before regulating lest we cause more harm than good. I say that regulations now are not only necessary for trust but will bring with them understanding.

[2slugbaits]

Hold on a minute. My history books tell me that LTMC was liquidated 8 years ago, so how was LTMC bailed out? They weren't. What happened was that LTMC's creditors were bailed out. The Fed intervened long enough to allow LTMC to pay off its creditors before closing up shop. The Fed's actions did not create moral hazard on the part of the owners of LTMC because that company went belly up. If there was moral hazard it was due to limited liability provisions of corporate law and not to any govt bailout. Is Tyler Cowen proposing that we eliminate limited liability for corporations?

Okay, what about moral hazard on the part of LTMC's creditors? Did the govt bailout encourage those companies to take excessive risks? That's a tough question. Lehman Bros, Bear Stearns and Merril-Lynch took risks with LTMC long before they had any reason to believe that the govt would bailout LTMC, so it's hard to make the case that govt actions caused moral hazard in that case. In other words, there's a temporal problem....their investments with LTMC were prior to any expectation of a bailout.

The fundamental problem is that limited liability always means risk is asymmetric; it enforces a zero bound on one's losses. I'm not at all convinced that those investment banks would have behaved all that differently even if they had known the govt would not bail them out. Now if shareholders actually exerted some effective control over management, then that might be a different story.

[Bruce Wilder]

2slugbaits: "The fundamental problem is that limited liability always means risk is asymmetric; it enforces a zero bound on one's losses. I'm not at all convinced that those investment banks would have behaved all that differently even if they had known the govt would not bail them out. Now if shareholders actually exerted some effective control over management, then that might be a different story."

Yep. And, some people have noted the conversion of the investment banks from partnerships among the executives to corporations with a marketable stock might have had something to do with their later desire to leverage up.

says...

When dealing with other people's money, the risk can be irrelevant. To a large degree, this was an agency problem, not a risk perception problem. The risk departments would have been given an entirely different set of marching orders had the banks planned to keep the loans on their books. Hedge fund managers would have adopted a different leverage paradigm had they been risking their own money. Home buyers would not have bid so high if they had to actually pay back the loans.

Since banks planned to just foist the loans off onto overseas entities, they told the risk management departments to come up with models that allowed the maximum number of loans to be brokered. Home buyers planned to just mail back the keys if they couldn't flip the property for a hefty gain, so they didn't really care if overseas citizens lost big on the transaction. With few exceptions, hedge fund managers were risking borrowed money by leveraging their clients' money 40 or 50 to one. Many hedge managers didn't really care if the banks lost their loans, or their clients lost their capital. Just take big risks, and get a bonus if it paid off. If it didn't work out, just walk away.

Risk means nothing to many people, if they are only risking other people's money. They just don't care if the other people lose their money, so they choose models that allow them to justify de facto Ponzi schemes.

[roger]

I seem to remember a distant, golden time - call it 2005 - when the increase of risk by the sturdy individual, that little entrepreneur who was the bulwark of the ownership society, was celebrated by all right thinking individuals. Remember? The mantra of its your money? The wonderful world of investments that would be made by freeing Social Security from the stalinistic bonds of government? Surely we remember that the conventional wisdom, from the DLC to the Bush administration, was that we are all amazingly accurate calculators of risk. Along with our skills as carpenters or journalists, it so happened that we possessed an innate ability to read the markets and invest correctly, as utopia appeared on the horizon.

Surely, Mark, you should revisit the models in play at that time. Especially as they dissolved into the rhetoric that celebrated the power of the private sector to efficiently allocate capital. Excellent reading, reminding me, at least, of Swift´s tale of the Island of Laputa.

[Bruce Wilder]

It was nice of Tyler Cowen to acknowledge that he was throwing LTCM into the mix as a red herring. It would be even nicer if he didn't throw.

[Bruce Wilder]

FvB: "both points of view, while theoretically in opposition, had to work together hand-in-glove to create the current problem."

I'm having a little trouble deciding whether you were trying to be facetious. Was your piece too-clever satire?

Two people have an contest over what is to be done. One, on the facts, evidence and morality is wrong. The other is right. The one, who is wrong, wins the contest, and does what he does, with predictably bad consequences. Were they "working together" to create the mess?

[Roger Chittum]

Financial institutions knowingly took on more risk to keep up with their competitors, not because they “misunderestimated” the risk. This Felix Salmon post based on a WSJ interview of Robert Rubin reflects completely ordinary, pervasive, and quite rational business behavior.

Mr. Rubin was deeply involved in a decision in late 2004 and early 2005 to take on more risk to boost flagging profit growth, according to people familiar with the discussions. They say he would comment that Citigroup's competitors were taking more risks, leading to higher profits.

Notice it says they knew the new business was riskier. Not following competitors deeper into the mine field would have meant rather immediate adverse effects such as declining financial metrics vs. competitors, shifting of client loyalties, defections of key personnel, shareholder discontent, and general loss of business and personal reputations. Following the competition at a safe distance risks gradually going out of business. The pressure to match the competition is very, very strong, and we don't compete on price alone.

Economists should add herd behavior to the long list of reasons not to have blind faith that whatever outcome a market yields is always best.

[moola]

Bruce Wilder

"You can make a lot of money, moola, by taking the combo of risk and reward, and handing the risk off to someone else, why grabbing the reward and running."

So you are saying it is about MONEY? And someone else assumed excessive risk and got stuck holding the risk, er, bag?

You say somebody took the MONEY and handed the bag, er, risk to someone else? What does that have to do with anything? Someone else accepted big risk. The question remains, why did people take on excessive risk?

For the MONEY. Somebody made MONEY, someone else tried to make MONEY but unfortunately lost MONEY. Risk was ignored, like 1630s, 1720s, 1920s, 1980s Japan, and all the other spectacular speculative orgies.

[Barkley Rosser]

The answer to the original question is "all of the above."

Regarding the very responsible action by the FRBNY in August 1998 to get the major bankers into a room with the LTCM people and encourage them to work out an arrangement with no Fed or taxpayer money spent, I do not see this as a big deal, even if some have claimed that it made the bankers feel all soft and wild inside. Heck, Lehman was not bailed out this fall.

Probably more significant with respect to 1998 than this well-managed meeting was the lowering of interest rates following it that fall by the Fed. In his 2005 book, Shiller dates the beginning of the housing bubble to 1998, and the old Mill-Minsky-Kindleberger theory of bubbles has most of them being triggered by an initial fundamentals "displacement," which that fairly brief period of very low interest rates certainly was.

BTW, the phrase "too big to fail" had been around long before 1998. Tyler is simply making too much of that LTCM FRBNY meeting.

[Bruce Wilder]

Two things to add to your thoughts, Roger, from Wikipedia:
1.) Hyman Minsky
2.) Robert Rubin "earned" $115 million, while at Citigroup.

[anne]

http://www.nytimes.com/2008/12/28/business/economy/28view.html?ref=business&pagewanted=print

December 28, 2008

Bailout of Long-Term Capital: A Bad Precedent?
By TYLER COWEN

THE financial crisis is a result of many bad decisions, but one of them hasn't received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund's creditors, our current problems might not be quite so bad.

Long-Term Capital was advised by finance quants, or quantitative analysts, who made a number of unsound, esoteric bets, including investments in interest rate derivatives. When Russia's inability to pay its debts roiled global markets, the fund, saddled with high-leverage and off-balance-sheet obligations, was near collapse.

Because Long-Term Capital owed large sums to banks and other financial institutions, the Federal Reserve Bank of New York organized a consortium of companies to buy it out and cover the debts. Alan Greenspan, then the Fed chairman, eased monetary policy to restart capital markets, which were starting to freeze up. Long-Term Capital's shareholders were wiped out, but none of the creditors took losses.

At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed....

[This is simply supposition, not at all reasonable from my perspective, and not the slightest evidence is presented for the argument.]

[anne]

http://www.nytimes.com/2007/10/28/business/28view.html?hp

October 28, 2007

To Know Contractors, Know Government
By TYLER COWEN

ALLEGATIONS of misbehavior by employees of Blackwater USA in the shooting deaths of 17 Iraqis have brought the military's use of private contractors into question. But whatever the possible sins of the Blackwater firm, the overall problem is not private contracting in itself; contractors do not set the tone but rather reflect the sins and virtues of their customers, namely their sponsoring governments....

[Notice the similarity of the arguments.]

[anne]

Why did Bernard Madoff steal what was stolen, for the same reason that Blackwater mercenaries * killed who were killed, government. I am reminded of the still similar argument justifying Somalian piracy during colonial times for being free of government. **

* Contractors is the term preferred by some.

** http://www.cato-unbound.org/issues/who-needs-government/

August 6, 2007

Who Needs Government? Pirates, Collapsed States, and the Possibility of Anarchy

[Bruce Wilder]

moola: "Someone else accepted big risk. The question remains, why did people take on excessive risk?"

Most of the half-million people now losing their jobs each month were probably unaware that they were "taking on" the risks of bad bank lending practice.

As I noted, above, Robert Rubin took home $115 million from his advisor-at-large gig at Citibank. He was in a position to knowledgeably anticipate the consequences of much of what Citibank was doing. He wasn't one of the executives in charge, but he was in a position -- by dint of knowledge and experience as well as position in the corporate hierarchy -- to know what was going on, and understand it fairly well. What risk was he "taking on"? As far as I can tell, he was not bearing appreciable risk.

I think the analogy with pollution and waste is instructive. Pollution and waste are inevitable by-products of production, but unlike the goods produced, they are bads, and must be disposed of, at a cost. One way to handle the cost of pollution is for the producing firm to use a public river or the public air for disposal, at minimal expense to the firm. This is cheap, for the firm. Why did "people" "accept" the "risk" of lung disease from mining coal? The "risk" of polluted streams and groundwater, of fishkills, of smog-enveloped cities?

Of course, there are other ways to handle pollution, ways in which the producing firms pays the cost of secondary processes that reduce or contain the costs of pollution disposal. There are companies, like Waste Management, Inc., that make a business out of waste disposal.

In the financial world, return on investment is the good being sought, and risk -- roughly, the probability of bad consequences in variance from expectation -- is like inevitable waste. The responsible thing is to hire someone with capacity (aka wealth) to bear risk, for a fee. (Sort of like hiring Waste Management Inc and its landfills.)

What has been going on in the higher reaches of American finance is that the responsible bearing of risk has become corrupted. There's a whole narrative about the esoteric nature of derivatives and CDOs, but it is all b.s. thrown up to obscure the simple truth. The simple truth is that executives and managers, bearing no risk themselves, collected fees for bearing risk, using "other people's money" as risk-bearing capacity. This would be OK, if they had passed on enough of those fees, to pay for sufficient risk-bearing capacity. But, they didn't.

It is as if Waste Management Inc collected fees, in advance, for the use of their landfills, but didn't pay to expand their landfills accordingly. One day, the garbage arrives, the landfill is full, and the guy with the fee in his pocket has skipped town.

Say, you are an Investment Banker at Lehman, Bear, Goldman -- one of the old line IBs. In the old days, the executives at those firms were partners. The risk-bearing capacity of the firm was the wealth of the partners. When they charged a fee to bear risk, they bore the risk. But, the IBs became corporations with shareholders and a marketed stock; the SEC regulated how much equity (shareholder wealth) had to be available in proportion to the IB's business. The executives were still collecting fees for the use of the shareholders' wealth as risk-bearing capacity, but they had to pass on a large portion of those fees to the shareholders, since what they were charging for was risk-bearing, and the risk was borne by the shareholder equity. Bummer. So, they went to the SEC to reduce the regulatory requirement. They could do more business, collect more fees. But, because the shareholder equity was so much smaller in proportion to the volume of business, the proportion of fees passed onto shareholders would be much reduced. It's like Waste Management signing more contracts, with fees in advance, while reducing their landfill capacity.

The same thing was going on at the big commercial bank mortgage aggregators, like Golden West (later, Wachovia), Countrywide, WaMu and IndyMac. Again, what's being divvied up are risk and return, with risk-bearing capacity being sold for a fee. The fee is collected, but there's no actual risk-bearing capacity. There's no actual home equity available to back that mortgage, and the home owner's income to make payments? We made that up, too. But, we collected the fees, and we're keeping them.

[Bruce Wilder]

clarification: This would be OK, if they had passed on enough of those fees to the other people (as in, other people's money), to pay for sufficient risk-bearing capacity.

[mrrunangun]

F. von B has this much right-thatthe people running the financial system were able to exploit the inherently corrupt contemporary political system in order to first exploit their shareholders and then to exploit the taxpayers at absolutely positiviely no cost to themselves whatsoever. Republican pols got to bask in the warm glow of free market"prosperity" while they took bankers'money and Democrats got to require loans be made to people who could not reasonably be expected to repay them at economic interest rates while they too took the bankers' money. Neither Democrats nor Republicans in government asked any inconvenient questions. In fact, shareholders have no protection against being exploited by management in the current system. Neither the boards of directors, virtually appointees of management rather than ownership, nor regulators who are suborned politically by management, guard the interest of shareholders. Managements in many states are protected from shareholders by poison pill laws that further disadvantage shareholders.
Back in the sixties the Teamsters' Union got in trouble when the mob took control of the teamsters pension fund and made loans to mob-related businesses knowing the loans would never be repaid. Nowadays the bankers have gotten control of everybody's pension funds and done the same thing on a huge scale. Bankers and politicians benefited. The public gets the bill.

[anne]

Roger Chittum:

Financial institutions knowingly took on more risk to keep up with their competitors, not because they “misunderestimated” the risk. This Felix Salmon post based on a WSJ interview of Robert Rubin reflects completely ordinary, pervasive, and quite rational business behavior.

"Mr. Rubin was deeply involved in a decision in late 2004 and early 2005 to take on more risk to boost flagging profit growth, according to people familiar with the discussions. They say he would comment that Citigroup's competitors were taking more risks, leading to higher profits."

[Here is the working link:

http://www.portfolio.com/views/blogs/market-movers/2008/11/29/rubins-teflon-finally-wears-off?tid=true]

[anne]

Bruce Wilder:

"As I noted, above, Robert Rubin took home $115 million from his advisor-at-large gig at Citibank."

Please set down the reference.

[Organic George]

I remember all the talk about how Japan was eating our economic lunch in the 80's. How we had to deregulate to keep up with the times. When Japan went bust, everyone just said it was a Japanese structural problem and the US should forge ahead with deregulation.

Greed is a common problem of humans in every culture. We must protect society from those who only think of themselves not of the harm they can and will do to the financial system.

I cannot think of one government program that caused the collapse of the world financial system. However when investors are left to their own devices there is a long a tragic legacy to their folly.

[bakho]

I think there is another category where people know that the risk is there but refuse to believe that they will be the one left holding the bag.

[Bruce Wilder]

Captain Renault: What in heaven's name brought you to Casablanca?

Rick: My health. I came to Casablanca for the waters.

Captain Renault: The waters? What waters? We're in the desert.

Rick: I was misinformed.

[Bruce Wilder]

Rubin's take from Citibank, as reported by Wikipedia in its bio of Mr. Rubin, which, in turn, footnotes a WSJ Online article, behind a paywall.

[Stephen Heyer]

Mark Thoma: "So which was it, misperception, misrepresentation, or misallocation?"

All of the above to various degrees and with complex feedback loops linking and complicating them all.

[gordon]

What WJD123 said.

The deus ex machina (the "ogre") that WJD123 is inclined to rely on is, however, a worry. This isn't the first time that I have seen this kind of solution proposed. I used to just think that it's an impossible short-cut out of a situation where you can't find a regulator you can trust. Now, it's beginning to remind me of the Court of Star Chamber, that prerogative court set up by Henry VII to investigate and punish misdeeds committed by people so powerful that the ordinary courts couldn't be trusted to deal with them. The Royal power, with its implication of overwhelming armed force, accusation of treason and maybe an abrupt bisection on Tower Green had to be directly applied.

The Court of Star Chamber got a very bad press in the much later days of Charles I and was one of the grievances much agitated by the Long Parliament. Whig history tends to forget the important role it played in days when the legal system was less well developed and the disorderly days of the Wars of the Roses were still a living memory. However the later history of Star Chamber does remind us that such an institution is itself open to abuse and can be bloody hard to get rid of.

I suppose that if the situation is sufficiently serious a Star Chamber-type institution, a new Court which is closely tied to the Executive and having wide powers of investigation and punishment, may have to be resorted to (though in the US I'm not sure how Constitutional problems could be surmounted). But surely it would be better to try to make existing and more democratic institutions work better before resorting to that dangerous expedient?

[DW]

I think risk was miscalculated. It was seen as the risk of one thing failing once, instead of the risk of everything failing systemically together.

[Phillip Huggan]

Misrepresented 95%. Misallocated 5%. Everyone pushing ABCP as AAA and everyone rating ABCP as AAA was responsible for the USA tightrope between now deflation and soon hyperinflation. You simply cannot get accredited in the financial industry by belieiving real estate prices will rise 20%/yr indefinitely. I'm saying there is a 1/20 chance this would've happened if Investment Bank CFOs ratted out their marketing campaigns and if Moody's gave ABCP an F- rating.
Misperceived would be a class including Greenspan et al's decision to regulate derivatives like cash, but this doesn't seem criminal or wrong to me. Just incompetant. I'm viewing this question through the eyes of criminality, not responsibility.
It is funny, 800000 Americans go to forced labour prisons every year for toking up but false diffusion-of-risk memes are being enacted to prevent prosecution of a few bankers with well-paid lawyers. American judges and police certainly aren't pussies when it comes to beating on the weak/innocent.

[bob mcmanus]

Securitization

I know Bruce linked to the Minsky Wiki page above, but this 1987 memo by Minsky, with a preface and afterword by L Randall Wray dated 2008, seemed prescient, insightful, and relevant.

But you know I can go on about Minsky all day.

[ctindale]

Stabilizing an Unstable Economy. Chapter 12, "Introduction to Policy", Minksy talking to us from 1986.

We need to embark on a program os serious change even as we need to be aware that a once-and-for-all resolution of the flaws in capitalism cannot be achieved. Even if a program of reform is successful, the success will be transitory. Innovations, particularly in finance, assure that problems of instability will continue to crop up; the result will be equivalent but not identical bouts of instability to those that are so eviedent in history.

Political leaders and the economists who advise them are to blame for promising more than they or the economy can deliver. The established advisers have failed to make the political leadership and the public aware of the limitations that economics processes and the the ability to administer impose on what policy can achieve. … [O]ur economic leadership does not seem to be aware that the normal functioning of our economy leads to financial trauma and crises, inflation, currency depreciations, unemployment, and poverty in the midst of what could be virtually universal affluence—in short, that financially complex capitalism is inherently flawed.

Economic advisors, whether liberal or conservative, believe in the fundamental "soundness" of the economy. Finding fault with one thing or another, they may advocate policies such as changing Federal Reserve operating techniques, tax reforms, national health insurance, and wars on poverty, but all in all they are satisfied with the basic institutions of modern capitalism. According to today's gospel [extant faults] are due to secondary, not to fundamental, characteristics.

[T]he economists of the policy-advising establishment differ about details: some propose to fine-tune the economy by fiscal tinkering, others want to achieve a natural rate of employment through steady monetary growth. Neither, however, sees anything basically wrong with capitalism as such. The credit crunch of 1966, the liquidity squeeze of 1970, the banking crises of 1974-75, the inflationary spiral of 1979-80 and the distress, national and international, of 1981-82 are, in their view, aberrations, due to either "shocks" or "errors." Since nothing is basically wrong, they also hold that incisive corrective measures are not needed.

The truth of the matter is that something is fundamentally wrong with our economy. As we have shown, a capitalist economy is inherently flawed because its investment and financing processes introduce endogenous destabilizing forces. The markets of a capitalist economy are not well suited to accommodate specialized, long-lived, expensive capital assets. In fact, the underlying economic theory of the policy establishment does not allow for capital assets and financial relations such as exist. The activities of Wall Street and the inputs of bankers to production and investment are not integrated into, but are added onto, the basic allocation-oriented theory.

Economic policy discussions in recent years have centered on how much more (or less) on the one—fiscal policy—and how much less (or more) of the other—monetary policy—is necessary for economic stability and growth. If we are to do better in the future, we must launch a serious debate that looks beyond the level and the techniques of fiscal and monetary policy. Such a debate will acknowledge the instability of our economy and inquire whether this inherent instability is amplified or attenuated by our system of institutions and policy interventions. ….

Today's economic crisis is as profound … as that of the 1930s. … There is no consensus as to what we should do. Conservatives call for freeing up the markets even as their corporate clients lobby for legislation [to] institutionalize and legitimize their market power…. [C]orporate America pays lip service to Adam Smith, while striving to sustain and legitimize the very thing that Smith abhorred—state-mandated market power.

Liberals, instead of articulating and incisive critique of our capitalism as such and pioneering innovative experimentation and change, are wedded to the past. They support minimum-wage increases without questioning whether these laws have served any real purpose since the Great Depression, when reflation was the policy objective. Liberals are unwilling to face up to the shortcomings of policies inherited from the past and are, fundamentally, timid about setting forth in new directions.

As a consequence, instead of analysis and ideas, we get slogans: free markets, economic growth, national planning, supply-side, industrial policy—imprecise phrases that face up to neither the what nor the how of policy objectives. The various programs for change are based on misconceptions of both the strengths and the weaknesses of market processes. One of the reasons for the intellectual poverty of policy proposals is that they continue to be based on ideas drawn from neoclassical theory. Although economic theory is relevant to policy (without an understanding of how our economy works we cannot find cures), for an economic theory to be relevant what happens in the world must be a possible even in the theory. On that score alone, standard economic theory is a failure; the instability so evident in our system cannot happen if the core of standard theory is to be believed.

Today's economic policy is a patchwork. Every change designed to correct some shortcoming has side effects that adversely affect some other aspect of economic and social life. Every ad hoc intervention breeds further intervention. If we wish to improve upon what we now have, we must embark upon an age of institutional and structural reforms that will check the tendencies toward instability and inflation. Standard theory, however, offers us no guidance on that score; for the problems are outside the domain of relevance of the theory. A new era of reform cannot be simply a series of piecemeal changes. Rather, a thorough, integrated approach to our economics problems must be developed; policy must range over the entire economic landscape and fit the pieces together in a consistent, workable way: Piecemeal approaches and patchwork changes will only make a bad situation worse.

Poverty in the midst of plenty and joyless affluence are but symptoms of a profound disorder [Tibor Scitovsky, The Joyless Economy (New York: Oxford University Press, 1976)]. As we have pointed out, persistent financial and economic instability is normal in our capitalist economy. The commitment to growth through private investment—combined with government transfer payments and exploding defense spending—amplifies financial instability and chronic inflation. Indeed, our problems are in part the result of how we have chosen, inadvertently and in ignorance of the consequences, to run the economy. An alternative policy strategy is needed now. We have to go back to square one — 1933 — and build a structure of policy that is based upon a modem [modern?] understanding of how our type of economy generates financial fragility, unemployment, and inflation. [pp. 319-23]

[wjd123]

gordon,

I don't get the Star Chamber analogy. The ogre isn't there to protect the prerogatives of the government or the interest of the financial community. He or she is there to protect the interests of society.

There is also no seal of secrecy on the "room of the ogre." If anything he or she is there to remind people how government and financial institutions have acted in the past and the misery their folly has caused society.

The ogre as historical reminder when testifying functions as a foil against any return to business as usual. He or she is supposed to be biased toward social interest.

[gordon]

WJD123, since there is no chance of a perfectly honest and perfectly just arbitrator of the social interest (not this side of the Second Coming, anyhow), I came up with a historical instance of an expedient for dealing with very powerful people, too powerful for ordinary institutions of Govt. to manage. There may be other, better instances, but Star Chamber occurred to me. It's a pretty desperate measure and, in the US context, probably unconstitutional (though given what's happened in the "war on terror", I sometimes wonder if anything in the US is unconstitutional any more).

I'm very much in agreement with your comment "Regulate now, regulate heavily, and make it be known through government action that regulations will be enforced". Are you really sure that some kind of superman is needed for this to work?

[ken melvin]

Accepting that capitalism is no more than the name given a necessarily constantly changing model, might be a good time to acknowledge that any economic model is but a proposed way for dealing with what is, and that the sooner we start focusing on the what is and what should be the better.

[Phillip Huggan]

so much for inspiring a bloodthirsty mob...

[doug carmichael]

It was not a risk and not a failure: the purpose was for strong players to get richer,and they did. And many still are.

[Roger Chittum]

What Minsky said. Especially this:

[F]or an economic theory to be relevant what happens in the world must be a possible even in the theory. On that score alone, standard economic theory is a failure; the instability so evident in our system cannot happen if the core of standard theory is to be believed.Thank you, ctindale.

[egc]

Nassim Taleb has been yelling that risk was misunderstood: reliance upon historical loss leads to incomplete assessments of risk that, no matter how faithfully represented by sellers or perceived by buyers, always fail to account for inundation by Black Swans.

He would argue that at the root of the current crisis is a misunderstanding of risk that affected everything that followed: from fatally constructed portfolios using measures of VAR, through the emphasis on sales volume incentives by "principal agents" on the belief that "risk had been solved", to the apparent initial assumption behind TARP that a 3rd party could "correctly price" toxic securities, to our situation now where "too big to fail" institutions sit on piles of taxpayer cash they aren't using because they've finally realized they've misunderstood risk all along.

[Eric Dewey, Portland, Oregon]

Mark, because of a lack of time I'm going to weigh in without having first studied the other commenters - apologies in advance if I missed something already stated or debunked.

This is a great post, and a great set of questions. From inside the industry, I think it's clear that all three type of "mis"-stakes were made, but for purposes of economic theory a focus on misperception and misallocation is appropriate (recognizing of course that the breadth and depth of regulatory failure will significantly impact the extent and volume of misrepresentations that occurred).

You mentioned that misperception was impacted by misrepresentation, but did not make a link between misperception and misallocation that I consider quite obvious - you seem to be making a distinction based on assumptions that have not been fully fleshed out, and I would encourage you to do so. A "misperception" that one can avoid, or redirect, the consequences of one's foolish decisions, or that someone else will come to one's rescue is what leads to what you're calling "misallocation".

Two thoughts on your distinction between "models" of misallocation:

1. while economists like to use "moral hazard" as a technical term, most people would see both of these models as representing moral hazard, because in both models, one manages to avoid accountability for one's foolish actions. Principal-agent problems are thus simply a special subset of broader moral hazard issues.

2. In the principal-agent model, what the agent is really betting on is that the consquences of their "wrong" decision cannot be traced back to them, either because of the volume of decisions being made or because the principal lacks the resources and/or will to make the connection (i.e. the principal may actually like the "wrong" decision because it appears profitable).

But your focus appears to be on the principal-agent problem (which makes sense to me), and bears a resemblance to game theory involving simple one-on-one interaction (which makes my head hurt even though I acknowledge it's power as a explanatory thesis).

This may have some explanatory power, but may not be sufficiently developed to handle the extremely complex set of multiple principal, multiple agent issues that were in play as the mortgage/housing bubble expanded - particularly where there is a lack of clarity as to who are the "principals" and who are the "agents" (see recent articles on judges declining to allow foreclosures to occur because of lender difficulties in proving legal ownership of the debt). Rendered still worse if it is possible for the principal and the agent to be the same corporate entity.

However, if sufficient investment is made in clarifying the trail of legal and financial accountability that was missing in the buildup of complex securitized lending relationships, then it may be possible to reduce the effect of the principal-agent problem.

Given that there are so many highly trained financial engineers that are currently at risk of losing employment (if they still have a job), it should be possible to build the infrastructure needed to creat more clarity around how the complex securitization model of modern finance could actually work.

[Beezer]

The priorities should be:
1) Take care of labor first. Pay, working conditions, health care for all. Labor shall NOT be the lowest common denominator in a business plan. If you can't do this, you can't be in business. Nor can you sell your products in our country if you're a foreign corporation that pays poverty wages to labor, or a domestic corporation who owns facilities overseas where labor is abused.
2) Restore Depression regulations separating banks with depositor money versus investment banks, and restore market restrictions regarding leverage and transparency. Leverage should, in all efforts, be limited by law and such laws shall be ruthlessly enforced. Whether you're General Electric, a totally private company, or someone looking to buy a home, leverage limits will apply.
3) Capitalism is great. It's Capitalists who bear watching. Tax rates on income shall be steeply progressive. If you're a smart con and you spot a moronic group of directors who will pay you $115 million over 5 years, most of that pay will be be confiscated by taxation. Eliminate stock options as a form of pay. You want some stock, buy it.
4) Short term capital gains shall be taxed at a minimum of 50%. All mortgages shall contain a 3 year prepayment penalty.
5) Utilize basic, broad based taxes, including value added taxes. Tax internet commerce. If you sell you get taxed. No free rides, no tilted playing fields when it comes to taxation. If the guy on Main Street has to pay a tax, so should the digital guy.
6) Make it a law that the federal government design and publish long term goals in areas that the free market won't address--such as infrastructure programs.

All the above will limit risk taking as well as much of the "churn" capitalism creates under the guise of "creative destruction."

[kharris]

What Barkley said. Which problem was operative depends on where you were in the chain. Misallocation is the underlying problem, but risk could not have been concentrated where reward was not if there had not been misperception and misrepresentation of risk.

[rufus]

"anne says...
http://www.nytimes.com/2008/12/28/business/economy/28view.html?ref=business&pagewanted=print

December 28, 2008

Bailout of Long-Term Capital: A Bad Precedent?
By TYLER COWEN
...
[This is simply supposition, not at all reasonable from my perspective, and not the slightest evidence is presented for the argument.]"

The key phrase is highlighted. I believe a drip of TC's economic sweat would fill the thimble full of knowledge that you hold in regards to finance and economics.

TC's article that you cited, contains little if any supposition according to the accepted analysis to date, and if it lacks sufficient evidence as presented to the court of 'anne' to affect persuasion, I'm sure TC, like myself, is oh so woe begotten.

As my late father would respond when asked for the spelling of a word or the meaning behind it, 'look it up'. I doubt TC or anyone else here has the time or the inclination to educate you in this matter.

[anne]

Notice how a comment holding that as usual there is no substance to the argument is met with a comment of no substance. Being kind, I argued there was no substance "from my perspective." I am still waiting all tingly to learn of any, which I am entirely sure I will not. Down with government, up with mercenaries and pirates, is the underlying argument.

Imagine me not being in awe of TC, whoever TC may be.

Tra la.

[anne]

While I was trying to be polite (who knows why), I have no respect for a writer who can as easily argue that monumental financial crimes, monumental mercenary crimes against a people, are of no consequence because there were the existence of government actually fostered the crimes. That the methodical undermining of responsible government or government regulation fostered the crimes is of no concern to the writer.

Imagine this passing for conservatism.

[Barkley Rosser]

rufus,

As kharris said, like I said.

More specifically, allow me to step up to defend anne. Tyler really did not present much evidence in his piece. In the comments section over on marginal revolution about his own posting on this column, one Curt Fischer did cite some evidence, a report by the GAO in 2000 that made a similar argument. However, it was pointed out by others that in effect the real problem was not the original meeting arranged in 1998 by the FRBNY, but the lack of increased regulation after that meeting that led to increased moral hazard problems.

So, I would say that your supposition about anne's supposition about Tyler's supposition is rather full of it. All your ranting about Tyler's "economic sweat" and thimbles is foolish rhetoric. For one thing, I know Tyler, and I have not seen him sweat very much, economically or otherwise.

[wjd123]

gordon,

The ogre is necessary if regulations are going to stick. She or he is not a superman but more of an irritant to those who would salve our wounds and cloud our collective memory. The ogre can't stop regulations from being eased but she or he can pick over the scabs of old wounds given to us by the financial community.

The problem is how does a democracy clean out the Augean stables of the mess left by the financial community. The Republicans aren't up to the task their philosophy about government and the economy allowed the horse droppings to get out of hand in the first place. Now it's the Democrats turn to clean up.

I worry about their connections to the financial community. Barack Obama isn't Hercules, thank god, he is, judging by his cabinet, a consensus builder. I want an "ogre in the room" to remind society how out of hand the financial communities mess can get if not kept in check with regulations that are enforced.

The first push by the financial community against regulations will be blather about the government cutting off their dynamism. That's more horse droppings in the stable.

[rufus]

B. Rosser:

Sir, I have read your comments for many months, and have been quite amused in a most condescending manner. Citing kharris in citing yourself tickles me to no end in the same fashion. To be deemed foolish by a fool is what it is. However weighty you might view your chivalric post the one incontrovertible fact you cite is that my post was nothing more than rhetoric, as nothing more was intended when nothing more was offered. Requesting or requiring substantive proof when all one can offer in rebuttal is tautological critique is far more foolish still.

‘Better to keep your mouth shut and be thought a fool than to open it and remove all doubt.’ M. Twain

[LDIR]

Several posters have noted that for the Wall Street insiders (thousands of them) who profited mightly from the buuble, reckless risk taking was both rational and highly profitable. Indeed. After all, no one is asking Fuld (CEO of Lehman) to disgorge his ill gotten gains to compensate the losers from the fall of Lehman.

The other point is that Wall Street believed that at the end of the day, the taxpayers would make them whole for any losses resulting from excessive risk. The phrase "too big to fail" isn't exactly new.

Of course, Wall Street was almost entirely right. When the impending fall of AIG threatened to bring down Goldman and Morgan Stanley, the Treasury Secratary from Goldman did the honorable thing, he bailed out AIG to save his former employer.

Given the actual course of events since 2000 (or 1992 for that matter), it is hard to argue that Wall Street did anything "wrong". A much stronger case can be made that Wall Street correctly interpreted the political economy of the U.S. (which Wall Street strongly influences) and pocketed the proceeds (perhaps $200 billion in bonuses alone since 2000).