naked capitalism

Lune says:

The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up “super-senior AAA” tranches of CDOs were looking for safe assets, not risky assets.

I’m not so sure it was an unwillingness to take risks so much as chasing promises of high returns while not analyzing the risk involved.

The problem is that everyone wants more yield, and when some snake oil salesman comes around and tells you that you can have risk-free yields of 10% or even 5%, you take it since it’s better than treasuries. No one did their due diligence and wondered exactly how they were getting that extra few points of return, and what risks they were taking on as a result.

Did people want AAA debt? If someone convinced you that you could get AAA debt at a 10% yield, why not choose it over risky investment in things like alternative energy small-cap stocks? If all they wanted was safety, they’d just by treasuries. But they wanted the fantasy of safety and high returns.

There’s an old saying in the investment world that amateurs chase returns while professionals manage risk. Unfortunately, the professionals seemed to be missing this last decade.

Oh, and as for choosing housing vs Pez dispenser, we already had the Pez dispenser bubble. It was called dot-com mania. Billion dollar IPOs for companies with no product, no prospects for profit, and a burn rate of millions per month? They made Pez dispensers look like AAA bonds! :-)

Ingolf says:

Spot on, Steve, and a core point that it’s all too easy to forget.

Much of the blame can be sheeted home to a dysfunctional financial system which over time has largely severed the linkage that ought to exist between savings and credit. The latter has become a free floating abstraction, albeit one with real world consequences that are all too concrete.

JKH says:

You might be assuming too much in one area and too little in another, with respect to the “job description” of the financial system. Most economic investment results from asset allocation strategies of business (including new housing investment, which starts off as a business enterprise, which is then sold as an asset to households). Such strategies are financed either from internally generated funds or externally. But the financing is not the same thing as the investment strategy. The investment strategy is the job of the business manager; financing is the job of the CFO. (Downstream, mortgage financing funds a new house that resulted from some builder’s investment strategy). That’s simplistic perhaps, but it reflects at the micro level a corresponding physical and intellectual separation of the real economic system from the financial system, and a separation of real economic investment from financial asset investment.

So I would separate the idea of risk taking as between these two planes of the integrated system. Your view that there was not enough risk taking translates, I think, to the idea that there was not enough visionary thinking in the real investment side of the economy. This could include both private and public enterprise. I wouldn’t debate that part of it except to say the counterfactual would seem to involve at lot more central planning in the economy. Otherwise, how can we say that business was responding to anything other than the invisible hand that was dealt to it?

The financial system in such a world view is quite a separate issue for debate. One of the things that the financial system does is link savings with investment at the macroeconomic level. But this is not the only aspect of its activity. It may not even be the largest aspect. It is involved in several other macro categories of financial activity.

First is that the financial system connects many economic units with positive saving with those that have negative saving, neither of which has a direct connection to macroeconomic investment. For example, banks offering home equity loans, which borrowers use for consumption purposes, fund them with household unit savings in the form of bank deposits. But neither side of this linkage is necessarily connected to the level of macroeconomic investment. The two sides are brought together as a clearinghouse for the expenditure of current income on consumption of goods and services – not for its net saving and investment. Similarly for the famous mortgage equity withdrawal tsunami, much of which was used for personal consumption expenditures. One might push this analysis to the limit by suggesting that all finance is “inside money”, without any direct real economic effect, and that the true economic transaction is the linking of real investment with ultimate household equity (true saving), regardless of the nature of financial intermediation, but that’s going a bit far with the idea. Nevertheless, the complexity and circuitousness of the financial system reinforces the idea of its separateness from the nature of the real investment it finances. For example, the new house builder and buyer together drive supply and demand for real economic preferences. Finance is the enabler of such a transaction but not the real asset allocator. Teaser rates enabled by Fed policy, and CDOs that manipulated paltry mortgage cash flows are quite distinct from the motivation behind and the result of the granite countertops they financed. Who would question these real preferences other than central planners?

Second is that the financial system has a great involvement in the trading of financial assets, which has nothing to do with the level of macroeconomic investment. For example, the super-senior CDOs that you refer to I believe are mostly synthetic. As such, they are a bet on the cash flow behaviour of a similar mortgage based financing cash instrument. But like all derivatives, they are a bet involving asset and liability counterparties at the level of the financial system, and again have nothing directly to do with underlying macroeconomic investment. Of course, there are a zillion examples of such derivative bets that are disconnected from real economic investment flows.

There was a great deal of risk taking in the financial system defined in this way. Most of the ensuing risk malfunction can be attributed prosaically to a failure of imagination in the sense of an overreliance on statistically based risk management systems (i.e. “value at risk” systems), and a corresponding underestimate of capital adequacy. But this failure followed from risk taking that is in a separate category from the heroic visionary risk taking that one might hope for in the real economy.

A couple of other points:

I do think one can go a bit far with this idea that leverage is inherently evil. If you really believe that too big to fail institutions should not be leveraged, then you also believe that commercial banks should not be allowed to take deposits. Deposits are liabilities, and constitute leverage to the position of bank equity holders just as much as other forms of debt. Deposits are the dominant source of commercial bank leverage. And of course there’s almost nothing in the way of money supply remaining if banks can’t take deposits. (Is this what Austrians want?)

Finally, the global savings glut is a croc. This is the “inside” financial system working overtime and globally. China has tons of US assets because it has pegged its currency for trade reasons, and US consumers have responded to such a manipulated pricing basis with a rampage of buying. Apart from those dollars it sells for other currencies, China has no choice but to cycle its surplus back into dollar financial assets. To the degree that China has bought treasuries, its connection with underlying real US investment is very tenuous. And to the degree that it bought agencies, its connection might be just as much with those US consumers who extracted MEW funds through mortgages for the purpose of buying Chinese products, as it is with the amount of US GDP that was actually attributable to excess new housing investment. To the degree that China has done other “riskier” stuff with its money (e.g. Blackstone et al), the relative amount is trivial, and even then is somewhat disconnected from real underlying US investment.

Thus, the scope of the financial system is in fact larger than the constituent issue of directing saving into investments in the macroeconomic sense of these terms. As such, and with all its failures, the financial system has taken all sorts of risk that doesn’t directly connect with underlying economic investment, and which may have a quite different risk taking problem of its own, quite separate from the heroic failure of real investment risk taking that you have described.

Crosscommented from Interfluidity

David Merkel says:

Steve, I think we had two, maybe three things go on here. First, the “originate to sell” model failed because basic underwriting was not done well. The incentives against failure were not left with the originator, i.e., having to hold onto a large equity piece.

If the underwriting had been done well, the next problem would be weak financing structures on the part of the certificate buyers. Many were leveraged higher than prudent, even on “super seniors.”

Finally, the servicing models are often flawed. There has to be adequate pay for servicing and special servicing, or else loss mitigation efforts will be poor.

Risks were taken and avoided, but many of the seemingly avoided risks come back when the one guaranteeing the avoid risk cannot perform.

Anonymous says:

Excellent post! I would suggest that “investing” in the status quo results from deeper social problems. The primary cause of our problems was that investing decisions were guided by a combination of ignorance about causes and effects (not ignorance about stochasticity) and faulty economic and social values (i.e., immorality). Even investors who knew that the social effects of their allocations might be negative made those investments anyway.

Anonymous says:

The comments on this thread all look like they come from groupies from some other blog board, or the same person. Where is Yves?

tyaresun says:

Steve,

I beg to differ. To me, it is not a question of too much or too little risk, it is more of a mismatch between the time period for risk and rewards. If you have two investments, 1) the rewards are immediate but the risk is spread over a long period of time, and 2) where the risk is immediate but the rewards are spread over a long period of time, what will you choose?
1) is an example of all that went into securitization, 2) is an example of alternate energy.

We all know the answer of course.

Anonymous says:

Lenders forgot the fundamentals! Credit must be put to productive use. It must generate enough new wealth to extinguish the debt, pay the interest, and generate profit. Seen in this light, mortgages are not such a great investment since housing is basically a non-productive asset. IMO, this is why over the years so much gov’t intervention has been necessary in the mortgage market. Without sweetening the pot, creditors and entrepreneurs could always find more sensible places to deploy capital. Exactly how we got to the point where so many believed that it made more sense to lend money to people to buy non-productive assets without assessing the likelihood that they could repay the money will, I suspect, be a subject of intense study by economists for decades to come.

Anonymous says:

Great article

It seems I drew something different out of it than others.

My take was that the current financial system is unwilling to take a risk on an actual physical product. There is a love affair with investing based on financial models, not products. The financing then drives the products.

The housing bubble didn’t arise because lots of builders had marketing plan to build the burbs. It arose because financers felt home mortgages were a safe bet. This gave the builder the money to build the safe product.

No one risked money trying to actually make anything (or at least not anything new.) Financers won’t “risk” their money on anything that does not fit into their mathematical models, things like new products, new technologies, or actual production plants. In today’s market, the funding that years ago helped start Ford would have gone instead to the buggy whip makers and horse farms (based of course on triple AAA solid gold multi-variable analysis of historical returns for buggy whips versus the unquantifiable returns for the newfangled car.)

Richard Kline says:

Americans want the returns of speculators and the risks of investors; the continual mass media metonymy of the two concepts only amplifies the conitive disconnect. In a mature economy such as in the US, we cannot achieve the linkage suggested. Attempts to do so simply get us the returns of investors with the risks of speculators. . . . As we see again. It’s live small or bust, which evidently is ‘bust’ in the present configuration.

Steve Waldman says:

JKH -— You really should start a blog. I don’t say that to insinuate that your long and thoughtful comments are unwelcome. On the contrary. They are thoughtful and thought well, and you clearly enjoy the conversation. It’d be a public service.

There’s a tension, when discussing the financial system, between positive and normative aspects. You are right, as a positive matter, that what I ask of the financial system is more than what the professional class standing beneath the banner “Finance” would consider part of their job description. As a normative matter, I think that’s a bad thing. I’m too familiar with what “financial analysts” do, as a profession. Generally speaking, they develop independent opinions tightly constrained by professional norms, in terms of what are reasonable asset classes and assets within classes, that severely limits the possibility that professionally manged capital — that is, most capital — will be deployed outside of what are deemed safe harbors. The “physical and intellectual separation of the real economic system from the financial system, and a separation of real economic investment from financial asset investment” is a bad thing, from my perspective.

“[T]he counterfactual would seem to involve at lot more central planning in the economy. Otherwise, how can we say that business was responding to anything other than the invisible hand that was dealt to it?”

I don’t think that’s reasonable. That an outcome occurred in an environment largely free of central planning does not imply that the same outcome would always have occured in similar circumstances absent central planning. The fact that demand for safety translated to a housing boom had everything to do with an institutional environment, with both public and private aspects, that is by no means predetermined. The existence of Fannie and Freddie, and the infrastructure and expertise devoted to generating and securitizing conforming mortgages, served as the seed and template for much of the innovation in the sub-prime, alt-A, and jumbo sector. Housing seemed a good candidate for “instasafety” because it was the only asset conventionally securitized, and had a pseudohistory of “never” having declined on a national basis. It would be quite possible to define tranched paper secured by pooled sector-specific inventories, plant, intellectual property, or subsidiary securities that would have allowed moderate-risk fixed-income investors to make qualitative choices about where their capital would generate the highest margin of safety. Of course none of those would have had the quantitative characteristics to simulate out as AAA paper in rating agency models. But those models were foundationally wrong, and surely not a necessary outcome absent central planning. The scenario we observed was a collaboration between the invisible hand and a set of institutions, habits, conventional assumptions and shortcuts. It was not what “the” invisible hand foreordained.

That said, the relationship between central planning and free markets in a “good” economy is a challenging one, and I don’t want to accept an implicit assumption that more central planning is always worse. I’m very biased towards market solutions to informationally challenging problems. But there is a “superstructure” (I know! That’s a Marx-word!) that generated constraints and biases under which the “invisible hand” operates, and there’s little evidence to suggest that relying on a meta-invisible hand to get those biases right is better than even very flawed state actors. Of course, I’d be very glad to improve upon flawed state actors, but one must make a case for how, not just hurl epithets about socialism and central planning, to do that.

When savers finance the current consumption of negative-savers, absent agency costs, they do so only contingent upon assurance that the negative savers will generate suplus future production a portion of which they can skim. That is to say that you are right that current savers are happy to transfer dis-savers future production to current consumption, for a price. And that’s fine, so long as they can discriminate wannabe current consumers with surplus future production from wannabe current consumers without. Rational savers absolutely do not finance the latter party’s consumption, but a lot of savings did in fact go to dissavers without expected surplus production. That was not a matter of volunatry allocation by invisible hands, but uninformed investors and malfunctioning agencies. Depositors would not have made the same loans their banks did. I’m glad to question those outcomes, and againwon’t concede that what flawed institutions have wrought was the only possible outcome absent central planning.

I agree that there was lots of intrafinancial risk, in terms of leverage and the structure of a variety of assets and derivatives. I framed this piece as “too little risk?” to be provocative. I’d suggest that there was too little risk taken along certain dimensions, and too much risk taken along others. However, even synthetic assets impact the real allocation of capital. If I buy a synthetic bond built out of Treasuries and GM CDS contracts, the teentsy little firm I’m funding is selling protection on GM bonds, driving down the cost of that protection, which affects the credit spreads demanded on “real” bonds, which affects GM’s cost of capital. I won’t make the strong claim that purchasing such a bond is equivalent to actually lending GM money. But broadly and in general, derivative transactions are “passed through” to the real economy by arbitrage and equilibrium, they are not a cul-de-sac unto themselves.

I’m mostly with the Austrians, by the way, on commercial banks and deposits. There’s this myth that there’d be no investment without highly leverage commercial banks and “maturity transformation” (which is the ultimate juvenile demand for safety that should not in general be accommodated). If all the funds deposited in checking accounts, savings accounts, and CDS were kept as cash in mattresses, that wouldn’t affect the quantity of real capital available for investment. It would undermine the system that we currently have for allocating capital, and the system that we currently use to mediate current exchange. I won’t quarrel that it would be disruptive. But the usual justification for leveraged, fractional reserve banking is that they are necessary to persuade the masses to invest society’s resources, which otherwise would sit unused. That’s BS. As long as wealth is stored as money or future claims, savings does not deplete the capital available for investing. the current banking system has more to do with who decides how capital is allocated than with making capital available.

I’m not sure if we’re disagreeing at all about the “global savings glut”. Contingent upon certain policy choices, China and the Gulf states have no choice but to invest in USD assets, and they prefer safety to risk with the vast majority. That was my point, it seems to be yours too. They drove up the price of safety, which created a great demand for cheaper (that is higher yielding) safe assets from the private sector, which also largely wanted safety.

Again, I do agree that the financial system took all sorts of “intrafinancial” risk, and that had much to do with the crisis. That’s why I used the formulation “equally accurate to suggest that the financial system took on too little risk.”

Steve Waldman says:

Tom Lindmark — I don’t get the rave reviews either… the more I reread my own crap the more cringeworthy I inevitably find it.

What I really mean to suggest is not that somebody should take more risk or less risk, but different people should be taking more or less risk. I absolutely don’t want intermediaries to be taking greater financial risks. On the contrary (and mostly in agreement I think with Yves), I think loan originators and securitizers and SIV managers etc took “too much” risk on behalf of investors, while representing their products as safe. Looking only at these actors, sure the problem was “too much” risk (adroitly foisted onto third parties). But intermediaries generated these problems because there was incredible demand for a category of assets that investors should be smart enough to know can’t really exist: safe, “high yield” assets. There was not a continuum of demand, accepting higher risk for higher potential returns. There were large clienteles who demanded only assets that were deemed “safe” by standards presumed authoritative, but then chased yield within that category. Intermediaries bent rules and invented false magic, sure, but they did so in the service of investors who demanded what could not be delivered.

Investors can demand all the safety that they like, but they cannot have it. Wealth does not magically go forward through time, and therefore claims on wealth must be perishable unless we succeed at regenerating it. Investors can have a sort of safety, default-free debt, but in any given currency they can have no more than the currency-printing government offers, and they can have it at only one price (yield). Even these assets are not safe, currency/purchasing-power risk is real. Investor expectations that they could “shop around” for “enhanced yield” “safe” assets were entirely unreasonable, and that our financial system encouraged those expectations to the point where we feel compelled to ratify them ex-post with taxpayer dollars and/or inflation is an error we should never repeat.

The general public should keep small amounts of money in FDIC insured bank accounts. But wealthy people cannot shirk their responsibility to help direct the use of the resources they control and expect to carry their wealth into the future, let alone multiply it. The job of the financial system is to facilitate the matching of owners of capital with wealth-generating projects. I’m sure owners of capital would prefer to multiply their wealth without doing that work, and intermediaries can earn fees by pretending to offer safe, zero-work, zero-risk returns. Pretenses eventually fail, and it is not only the gullible who are harmed.