Too much risk?

One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on “too much risk” in recent years. I think it is equally accurate to suggest that the financial system took on too little risk.

Consider the risks that were not taken during the recent credit and “investment” boom. While hundreds of billions of dollars were poured into new suburbs, very little capital was devoted to the alternative energy sector that is suddenly all the rage. Despite a “global savings glut” and record-breaking levels of “investment” in the United States between 2005 and 2007, capital was withdrawn from a variety of industries deemed “uncompetitive” in large part due to obviously unsustainable capital flows. Very few brave capitalists took the risk of mothballing rather than dismantling factories and maintaining critical human capital through the temporary downspike. Under the two to five year time horizon of our most far-sighted managers, whatever is temporarily unprofitable must be permanently destroyed. To gamble on recovery is far too great a risk.

I don’t pretend to know where all that capital, that incredible swell of human energy and physical resources, ought to have gone. But it doesn’t take an Einstein to know that it probably should not have gone into building Foxboro Court. Sure, hindsight is 20/20. But lack of foresight really wasn’t the problem here. In 2005, how many macroeconomists or big-picture thinkers were arguing that the US economy lacked suburban housing stock of sufficient size and luxury? We gave the building boom the benefit of the doubt because it was a “market outcome”. But the shape of that outcome was more matter of institutional idiosyncrasies than textbook theories of optimal choice. It resulted as much from people shirking risk as it did from people taking big bets.

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. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed ’em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was “safe”, so who cared what it was funding?

Finance is not a closed system, a zoology of exotic contracts and rocket scientist equations. The job of a financial system is to make real-world decisions, “What should we do?” A good investment is a simple answer to that question, with clear consequences for getting it right or wrong. Mom and Pop can have FDIC insured bank accounts, and imagine that there is such thing as a “risk-free return”. But that’s a lie, a sugarcoated subsidy. Foregone consumption does not automatically convert itself into future abundance. People have to make smart decisions about what to do with today’s capital. If they don’t, no amount of regulation or insurance will prevent all those savings accounts from going worthless. When huge institutions treat the financial system like a bank, depositing trillions in generic “safe” instruments and expecting wealth to somehow appear, they are delegating the economic substance of aggregate investment to middlemen in it for the fees, and politicians in it for whatever politicians are in it for. And we are surprised when that doesn’t work out?

Of course we should regulate and manage the risks that were the proximate cause of the credit crisis. Anything too big to fail should be no more leveraged than a teddy bear, and fragile, poorly designed markets should be fixed. But that won’t be enough. We’ve trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I’ve nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.

Investors’ childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.

Crossposted from Interfluidity.

Print Friendly, PDF & Email


  1. Lune

    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! :-)

  2. Alan von Altendorf

    Really great thesis, Steve. Risk aversion as fundamental cause of failure. I mean it, well done. Deserves to be cross-posted in every newspaper.

  3. Ingolf

    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.

  4. Excariot

    The risk aversion also permeates the marketing world…why innovate when we can “safely” just pump out more of “what people want”. This has caused the current glut in car lots and subdivisions filled with identical (or near identical) inventory that lacks demand.

    The innovators in housing, smaller square footage, wlakable communities, infill projects, rehabs and brown fields are better positioned now. Not to mention the green housing initiatives that produce healthier environments that cost less to operate and use less resources (like water).

  5. JKH

    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

  6. Peripheral Visionary

    Well put. But “risk” alone is not enough to drive the financial system–there needs to be a real understanding of the concept of investment. Your comment about taking “responsibility” is really the difference–risk without responsibility is speculation, risk with responsibility is investment.

  7. David Merkel

    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.

  8. jm

    Mercantilist exchange rate manipulation and vendor financing fraud by the Asian nations, esp. Japan and China, have fundamentally falsified and subverted the pricing mechanisms on which markets depend for efficient resource allocation. It is that subversion of the markets that underlies all these problems.

  9. Anonymous

    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.

  10. Anonymous

    I think your story is way off base and obviously takes the spot light off fraud and collusion, which is why we are where we are today!

    The risk models were fraudulent and based on smoke and mirrors. You forget the safe derivative type bets that Enron made in a web of confusion that was designed to evade accounting honesty and to defraud investors, as they built multiple layers of entities that were off the balanace sheets and off shore and out of sight!

    These accounting practices are the foundation of your safe investments, so what in the hell are you talking about with taking on risk? This bubble was about fraud, just like every bubble and perhaps you can point a finger at housing as being a safe bet, but what about people that invested in sure things like JDSU that had enough fiber optic cable to wrap around the moon a few times? There is no doubt that there is confusion between safety and risk, but your story makes no sense, because there is no reason to invest in a stock, security, entity or product if there isn’t some hope of cashfow or reward. There were tons of opportunities to invest in photcells in the dotcom bubble and lots of new ideas for energy saving devices, but poorly run risky businesses have a very high failure rate. Where is there opportunity in failure?

    At least in a housing bubble, homes eventually will be occupied and used, so in that, I see safety and reality, versus holding on to a stock certificate linked to some CEO that was selling snakeoil and bullshit.

    In a macro sense, your story is about socializing taxpayer funds to help with research for alternative products or services that will help society and that is apparently part of the latest Obama pitch, which sounds good, but may end up failing if it’s run like a small snakeoil startup….

    I also think your missing the point of hedging bets and building a portfolio and finding balance in future value. Greed in either the form of risk or safety results in the same outcome!

    Bitch, bitch, bitch….

    I’m going back to the panda picture!

  11. Anonymous

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

  12. Anonymous

    At least in a housing bubble, homes eventually will be occupied and used, so in that, I see safety and reality,

    Are you sure about? Have you seen any of the housing inventory statistics recently?

    In a macro sense, your story is about socializing taxpayer funds to help with research for alternative products or services that will help society and that is apparently part of the latest Obama pitch, which sounds good, but may end up failing if it’s run like a small snakeoil startup….

    I have to disagree. You’ve projected your own interpretation on this post, and I believe you are wrong. Of course, your need to throw Obama into the mix is only more evidence of your intentional over-interpretation.

  13. tyaresun


    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.

  14. aaron

    Perhaps Steve and Yves should have a debate on this issue–I’d be curious to see what they come up with and they have diametrically opposed positions on this issue.

    Wasn’t it not long ago that investors had brazenly ignored risk in the hopes of higher profits. Subprime mortgages, overleveraged investments, commodoties, etc were not risk-free or risk-averse. I have to side with Yves here…it seems as though investors knew that there were risks present, although they might not have accurately assessed it.

    In addition, I’m not sure how accurate your argument about real estate is. Real estate had ceased being a big draw for investors before the current crisis even started, 2-3 years ago. Obviously real estate was less “safe” than we thought it was, but it wasn’t exactly a high growth area either.

  15. Anonymous

    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.

  16. Anonymous

    Perhaps Steve and Yves should have a debate on this issue??

    Why, so that Steve can pump himself up on a weak story?? Dah…

  17. Anonymous

    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.)

  18. Anonymous

    Amen, amen–great article. I think it was Tocqueville who had a quote about Americans being willing to speculate on anything in the hopes of becoming rich, and gladly accepting the possibility of impoverishment in return. This is a characteristic of a young country–our investors are now old (in the main) and they think old. They want a safe steady return and that’s it, so that is what is sold to them (whether the product is safe and steady is another question). Where are the people willing to blow $100 million or a $1 billion on solar energy or new electrolysis catalysts that might not work but would make a huge return if they did? Why don’t Bill Gates and Warren Buffet spend their money on this???? Sure, there are con artists and crooks in the dream business but don’t any of the big money guys get excited about new technology? A safe investment is rarely that.

  19. Richard Kline

    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.

  20. Tom Lindmark

    This article got rave reviews all over the blogosphere which I couldn’t understand. So I went back and reread it several times. I am still not sure what you propose other than someone has to take more risk. Do you mean financial intermediaries or private capital?

    If you suggest that financial intermediaries should then I would disagree strongly. They are proscribed in the type of risk they can assume for good reason. If you mean that private capital has been AWOL then I might agree. They probably would serve their clients better over the long term by taking some reasonable venture risk rather than playing with paper.

    I will grant the premise, I think you make, that too much capital was diverted to the housing market. However, this is both a political and economic problem. Unless you attack the forces promoting housing you can’t expect the intermediaries to do much else but continue to invest in the sector.

    You say this in your last paragraph:

    Investors’ childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.

    I would respond that:

    1. Investors have every right to demand whatever level of safety they like. It’s their money. How society decides to give them that measure of safety is both a political and business decision.

    2. Who is the royal “we” that will demand that investors accept some designated level of risk and who is going to divine that level of risk?

    3.We always need more risk taking by the appropriate risk takers. Those are few and far between. The general public is ill equiped for that job. The banks and the investment banks should not be using the capital that they possess to direct the funds of risk averse investors into investments they have no ability to analyze.

    To the extent that I may have misinterpreted the points you were trying to make, I apologize in advance.

  21. Steve Waldman

    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.”

  22. Steve Waldman

    lune — The nice thing about the Internet bubble Pez dispensers is that while we all thought those plastic bobbleheads would be worth zillions, we also knew they were risky stock investments, not safe bonds.

    There was much waste and awfulness about the dot com bubble, but one of its redeeming features was that everyone always knew it might all come apart. During the credit boom there was lots of cynicism and carping on the outside, but professionals treated magically high-yielding safe assets as though their failure was unthinkable, which really set up the hurting.

  23. Steve Waldman

    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.

Comments are closed.