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Thursday, June 03, 2010

"Bankers Have Been Sold Short"

Raghuram Rajan:

Bankers have been sold short by market distortions, by Raghuram Rajan, Commentary, Financial Times: ...Inquiries under way are bound to unearth more instances of ethically, and even legally, challenged bankers. ... How do we instill more social values in the industry? Or is banker greed mostly good? ...
Take for instance a trader who sells short the stock of a company he feels is being mismanaged. He does not see the workers who lose their jobs or the hardship that unemployment causes their families. But short sellers perform a valuable social function by depriving poorly managed companies of resources they will waste. A company whose stock price tanks will not be able to raise financing easily and could be forced to close down.
The trader does not cause the company to go out of business. ... Mismanagement is the source of the company’s troubles; the trader merely holds up a mirror to reflect it. The best measure of the trader’s value to society is whether he made money from the trade... This is why free-market capitalism works and why bankers usually do good even as they do very well for themselves.
However, when the discipline of markets breaks down, as it sometimes does, the finely incentivized financial system can derail quickly and cause immense damage. The very anonymity of money then makes it a poor mechanism for guiding financiers’ activities toward socially desirable ends. Did the mortgage broker make his fees by offering a variety of sensible options to the professional couple who were looking to upgrade their house, or did he do so by urging an elderly couple to refinance into a mortgage they could not afford? When the broker’s loans are scrutinized by sensible banks that refuse to refinance shaky mortgages, there is a market check on his behavior that forces him to focus on persuading the professional couple instead of deluding the elderly one. When the market is willing to buy any loan he makes, however, he leans towards easy pickings.
The key then to understanding the recent crisis is to see why markets offered inordinate rewards for poor and risky decisions. Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets. The tsunami of money directed by a US Congress ... towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans. And the willingness of the Fed to stay on hold until jobs came back, and indeed to infuse plentiful liquidity if ever the system got into trouble, eliminated any perceived cost to having an illiquid balance sheet. Chastise the banker who hankers after his bonus, but also pity him for he is looking for his primary measure of self-worth to be restored. Rather than attempting to instill social purpose in him, however, it is probably more useful for society to target the forces that distorted the market.

I agree that it we should correct bad incentives when we are aware they exist, but as I've argued before, we are never going to be able to ensure that financial markets are perfectly safe. Another meltdown is always possible. So we should also put measures such as strict leverage ratios in place that limit the damage when the next crisis occurs.

Also, in addition to the causes of the crisis that he mentions, I'd add poor risk assessment due to the use of mathematical models that did not properly account for systemic risks, and the reliance on ratings agencies that used the same bad models and had incentives to rubber stamp approvals indicating assets of high quality. I'd also mention deregulation of the financial sector, and an ideology that promoted the idea that greed (maximizing self-interest) is good independent of the conditions that exist in a particular market, i.e. independent of whether the market discipline mentioned above is present.

A change in thinking that recognizes that markets do not necessarily self-correct or lead to optimal societal outcomes on their own, that oversight and regulation is needed to ensure that markets function properly (and safely when a meltdown could threaten the larger economy), is an important part of the solution to the problem. If regulators had taken seriously the possibility that financial markets could meltdown the way that they did and insisted upon the proper safeguards, we might not even be talking about a crisis or what new regulations are needed, the crisis might have been prevented. I think new regulation is needed, as well as a new attitude from those who are charges with enforcing the regulations on the books. But the attitude of regulators can change with the administration in power, and regulators make mistakes in any case, so some part of the new regulation must make discretionary errors by regulators less costly (hence the call for measures such as strict leverage ratios in the previous post).

Let me also add this from Paul Krugman (as noted below, this point has been made repeatedly -- for quite a bit more on the role, or lack thereof, of the CRA, Fannie, and Freddie in the crisis, see here and here.):

Things Everyone In Chicago Knows, by Paul Krugman: Which happen not to be true.

It was deeply depressing to see Raguram Rajan write this:

The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans.

That’s a claim that has been refuted over and over again. But what happens, I believe, is that in Chicago they don’t listen at all to what the unbelievers say and write; and so the fact that those libruls in Congress caused the bubble is just part of what everyone knows, even though it’s not true.

Just to repeat the basic facts here:

1. The Community Reinvestment Act of 1977 was irrelevant to the subprime boom, which was overwhelmingly driven by loan originators not subject to the Act.

2. The housing bubble reached its point of maximum inflation in the middle years of the naughties:

Robert Shiller

3. During those same years, Fannie and Freddie were sidelined by Congressional pressure, and saw a sharp drop in their share of securitization:


while securitization by private players surged:


Of course, I imagine that this post, like everything else, will fail to penetrate the cone of silence. It’s convenient to believe that somehow, this is all Barney Frank’s fault; and so that belief will continue.

    Posted by on Thursday, June 3, 2010 at 02:43 AM in Economics, Financial System, Market Failure, Regulation | Permalink  Comments (58)


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