Wednesday, November 11, 2009

Creating Incresed Risk by Trying to Limit Risk

Yes, there are a lot of “greed merchants” on Wall Street, agrees high rolling economic forecaster Ted Forstmann in an interview with CNBC’s Charles Gasparino reported in this WSJ op-ed. But these greed mongers don’t act alone, says Forstmann, who has “been calling them on the carpet for years….”

Gasparino writes, “The greed merchants needed a co-conspirator, Mr. Forstmann argues, and that co-conspirator is and was the United States government.” He quotes Forstmann as saying, “They're always there waiting to hand out free money. They just throw money at the problem every time Wall Street gets in trouble. It starts out when they have a cold and it builds until the risk-taking leads to cancer.”

Right now the Fed and the Treasury are engaging in shockingly unprecedented activities that are presented as necessary “to ameliorate a once-in-a-lifetime financial "perfect storm."” Gasparino argues that the only thing that makes these actions unique is their size. He documents how the federal government has been subsidizing risk for three decades “on the taxpayer dime.”

Pricing down risk
One of the ways the government has done this is through easy money — a policy to which the Fed has repeatedly turned since the 1980s to lessen “the pain of the risk-taking gone awry.” They did this with the junk bond crisis, the 1980s mortgage meltdown, the 1994 Orange County bankruptcy, when LTCM “blew up” in 1998, and again in the current crisis.

This easy money policy “opened the door for increased risk down the line.” The use of this tool, which essentially subsidizes improper risk on the backs of savers, is now so common that its effectiveness is diminishing.

In addition to this, “policy makers transformed home ownership into something that must be earned into something close to a civil right.” They made this work by creating the mortgage bond, “which allowed banks to offload the increasingly risky mortgages to Wall Street, which in turn securitized them into triple-A rated bonds thanks to compliant ratings agencies.” Gasparino asserts:
“This is where the real sin of Fannie Mae and Freddie Mac comes into play. Both were created by Congress to make housing affordable to the middle class. But when they began guaranteeing subprime loans, they actually began pricing out the working class from the market until the banking business responded with ways to make repayment of mortgages allegedly easier through adjustable rates loans that start off with low payments. But these loans, fully sanctioned by the government, were a ticking time bomb, as we're all now so painfully aware.”
The bailout of LTCM in 1998 cemented understanding among investment bankers that the government would step in to stanch the pain anytime big time risk produced big time pain. It just had to appear to be “too big to fail.” This created tremendously perverse incentives for excessive risk taking. Gasparino opines that had LTCM been allowed to fail, the resultant pain would have imposed sufficiently severe costs to prevent the kind of risk taking that led to the recent crisis.

When the picture of the most recent financial market meltdown is considered as part of a collage that includes financial crises throughout the past three decades, there is no question that the big investment firms are as guilty as sin. But they could not have brought the market to its knees on their own. They are like druggies yearning for their next hit. They needed a pusher. And that pusher — the greedy bankers’ willing partner — is our federal government.

In essence, successive financial crises became increasingly severe because the clear message was sent that improper risk would be rewarded. Finally we reached the 2008-9 crisis. The pain has been heavy. But true to its form, government has come to the rescue, ensuring that there will yet be another even more severe bubble in the future.

Why would government do this?
We understand the incentives of the investment bankers. But what incentives does government have to engage in this kind of destructive co-dependency? Campaign contributions, lobbying dollars, and special perks no doubt play a large role here. But that alone is not enough. Among the other factors are the elitist mindset that pervades politics, maintenance of what I will call “the club,” and the rise of the investor class.

Almost all politicians today see their role as saving people from themselves. They play the hero; we play the victim. They see themselves as uniquely qualified to rule. Many of us feed this ideology. Sometimes we are pleased to erect windmills for our elected and appointed Don Quixotes to battle.

Many in the political class also buy into the view of economist John Maynard Keynes, who famously said, “The long run is a misleading guide to current affairs. In the long run we are all dead.” Thus, the compulsion to “do something” right now, regardless of long-term consequences is somehow justified in their minds.

“The club” refers to the society that exists among those involved in high finance. Some of these people are in the private sector. Some are in the public sector. Some move back and forth between these sectors. Even if these people don’t personally know each other, they enjoy a relationship that is akin to that of belonging to an exclusive club. They share a similar view and are quick to come to the aid of another club member, as it were, even if that aid involves taxpayer funds.

Nowadays most Americans have assets tied up in various investment instruments. If the financial market is hurting, so are they. When they feel negative consequences from taking financial risks, many are quick to appeal to government for relief. As mentioned above, government officials sit astride their white stallions ready to play the role of hero and eager to quell earned consequences in apparent righteous indignation.

Please understand that this is not a partisan thing. Both parties have a deep history of turning government into the pusher for the high finance community.

Slow learners
I believe it is abundantly clear that the most important players in this game have not yet learned their lesson. Everyone will be happy as soon as the current pain passes. Government officials, investment bankers, and investors will all breathe a sigh of relief and be happy to have things ‘back to normal.’

But that state will necessarily be temporary. When the bubble that is currently being constructed bursts (as it must), it will be a much larger deal than our recent crisis. Perhaps the pain will be sufficient to teach us that subsidizing risk creates a faux vision of limited risk that ultimately causes more pain that simply accepting the natural workings of the risk mechanism.


RD said...

The 1999 repeal of the glass-stegall act, refusal to regulate OTC derivatives, and the 2005 bankruptcy abuse prevention act is what created the latest crisis. The Republican's regulation witch hunt, and anti-government policy's created the crisis not an over abundance of government excess.

The 1980's mortgage meltdown was cause by the removal of regulations and oversight, again not the fault of government but rather the fault of not enough government.

The bailouts do need to stop, but we need to bring back fiscal policy that protects the national from the reckless behaviors of unchecked business excess.

Return depositary requirements, force consumer and investment banks to separate, split up any institution large enough to pose a systemic risk to the nations finical system, regulate the OTC derivatives market, remove the corporation from the wealth-fare state(referring to all forms of health care, retirement, life insurance, unemployment insurance, etc).

y-intercept said...

RD, so you are saying the 1999 repeal of the Glass-Steagall Act caused the junk bond crisis of the 1980s and the 1994 OC bankruptcy?

GW Bush really was a bad man for repealing that act in 1999. Too bad, Clinton wasn't president in 1999. He could have averted this whole thing.

BTW, if one looked behind the scenes one would find the justification for the repeal of Glass-Steagal came directly out of elite progressive universities. A slew of technocratic professors were pushing exciting new mathematical formulas for the market. (Austrian Economists tend to favor logical analysis and value investing over mathematical formula).

Reach, the reason I wanted to post is that I had actually come to the conclusion that we can parse out some of our woes just by looking at the language being used in investments these days.

Investment strategies are almost entirely consumed with questions about abstract risk and not about the intinsic value of the equities being traded.

In my personal carreer, I've been with companies where the MBAs in finance were so consumed with their talk about risks and rewards that they failed to notice that the company was not creating things of value.

It is very interesting that investment paradigms centered on abstract models of risk have created systemic risk for society. Hedge Funds and the reinsurance schemes like credit default swaps were all designed around risk models and they all lost sight of the underlying value of the equities in the economy.

In other words, our problems may not lie simply with the configuration of the laws, but with the ways people are taught to think about finance.

Enron was a disaster, but our institutes of higher education teach MBAs all the theories behind the complex Enron scheme as if the leveraging of risk was the foundation of the free market.

The foundation of the free market as discussed by Adam Smith (or even the value investing of Warrent Buffet) is a completely different world than what people learn in school.

It is interesting that a market pre-occupied with risk created systemic risk that blew down the whole house of cards.

This tells us simply that the mathematical formulas centered on risks are fundamentally flawed.

The solution is to change our thinking and not harking back to the illusion that there was once a perfect set of laws that kept Wall Street in harmony.

RD said...

In 1999 the congress was controlled by the Republicans, and yes i agree Clinton never should have signed that bill all the true progressives in congress voted against it.

I didn't mention the junk bond crisis or the 1994 OC bankruptcy in my comment, nor did i comment about good ole GW Bush(haven't we beaten him up enough?).

In 2006 the OTC derivatives market exceeded $729 Trillion dollars in annual volume, Do you have any idea how much damage even a 3% loss of value in the OTC market can do? How much pretend money should we allow out their? Regulation can stop this type of nonsense.

Charles D said...

There is plenty of blame to go around here, but I think we have to point the primary finger at the government and to some extent, ourselves.

Bankers, investment house and mortgage brokers are in it for the money. They can be counted on to do anything and everything to increase their profits as long as it's legal or they can be pretty sure they won't be prosecuted. If they know that the government will bail them out, their appetite for risk will know no bounds. That's how the capitalist system works and we should not expect them to act otherwise.

Government however, has been irresponsible. Or to be more precise, our government has been captured by the large financial institutions and works for them rather than for us. Both parties work primarily for the same Wall Street interests and they have joined together to repeal Glass-Steagal, avoid regulation of derivatives, avoid prosecuting clear cases of fraud, and finally emptying the Treasury into the coffers of the criminals who caused the economy to fail.

As long as we voters continue to vote for Congressmen and Senators who support financial deregulation, bank bailouts, and leniency for corporate criminals, our tax money will continue to support the rape of our economy. I would submit that it is relatively easy to figure out which candidates not to vote for. Any candidate who runs as a Republican is obviously part of the problem not the solution. Any Democratic candidate who has enough campaign money to blanket the state with TV ads is in the pocket of the same interests. If we keep returning these crooks to Washington, we get what we deserve.

y-intercept said...

RD, You wrote a response to Scott's post. Scott's post was about a long history of things going wrong in the financial markets. A response to a post assumes the facts stated in the post.

Your insights would have made a good blog post, but was not a good reply to Scott's post. Scott's post was about a mindset. Your post tried to lay blame on a single regulation ... and came off as a partisan talking point.

I was hoping the comments would lead to a more substantive conversation.

I actually agree with Charles D. There is plenty of blame to go around.

The one group that is rarely mentioned in the blame game, however, is the real source of our problems: The Schools.

The elite schools are the things that create the mindset of "the club."

The ideas people learn in school become manifest in the market.

I had noticed that schools were consumed with the idea that one could regulate the market through advanced mathematical models of risk.

The idea was that people could take the thinking of the insurance industry and use complex derivatives to create a self-regulating market.

This self regulating market envisioned by the University is something entirely different from "deregulation" espoused by the Austrian school.

This idea that one can create a perfect stable market with programmed electronic trades is the very essense of the technocratic dream.

The Commodity Futures Modernization Act of 2000 was written by the Presidential Working Group then passed by a Republican Congress. This along with the repeal of Glass Steagal the year before were bipartisan efforts to realize the thoughts coming out of the university.

So, my reply to Scott's post is that it's the ideas coming out of the schools that we need to confront.

We use the term "deregulation." The ideas coming out of the schools was that one could create a complex system of derivatives that would result in self-regulation.

The Commodity Futures Modernization Act was a regulation that was substantially more complex than Glass Steagal.

The idea that one can create a self-regulating economy with complex derivatives is something entirely different from a free market. Most of the derivatives are based on the short sale which I contend is inherently anti-market as they violate the fundamentals of property rights: Two people can't own the same property at the same time.

Scott's analogy of the club seems to be correct. The universities, regulators, the centralized market and big government are all working on concert in creating a purely technocratic market.

Countering this trend involves something more than just a new regulation. It has to be countered by fundamental thinking.

One of the biggest blocks to discussing the fundamentals is that all such arguments seem to get immediately diverted by partisan sniping about regulations.

Scott Hinrichs said...

The regulatory arguments are discussed in a fair amount of detail (some of it useful) in the WSJ article's comments section. I see no need to rehash that here.

I found the comments regarding organizations that seek to game the market without actually producing value to be interesting. In our quest for cleverness in financials we have left fundamentals in the dust and have become too clever by half.

It is important to recognize, however, that there are many ways that individuals and organizations can add actual value. For example, it has been myopically argued for centuries that value is only created via direct agricultural and manufacturing labor and that all other activities constitute overhead that takes a cut from this value. But this view is contradicted by reality. Knowledge workers and merchants add transformative value to many products and services, often dramatically increasing the value of these.

So it is important that efforts to return to market basics do not deny the reality of the market's value creation mechanisms.

Charles D said...

If by the schools, y-intercept is referring to the economics departments of our major universities, then he is quite correct. Economics is a social science, not a branch of higher mathematics. Economic decisions are made by human beings not by computer models and the leading economists of the last few generations have spent far too much time trying to create models to fit their pet theories and too little time worrying about the effect economics has on the general populace.

We tend to worship the market and try to get people to act in ways that help the market - which generally means, help those who run the markets. The market exists for the people, not the people for the market. The marketplace is a means to an end, not an end in itself.

Scott Hinrichs said...

I think that this is true of many economists. Other economists explain their role merely as discovering the actual principles by which markets operate. These offer few policy prescriptions.

RD said...

I don't think the removal of the regulation is the sole cause, however most of the insanity that happened on the market was enabled by it, that derivative schemes would never work under pre 1999 regulation. Certainly deposit requirements in regards to home loans would have preventing them from ever becoming an easily tradable derivative product.

I wouldn't be surprised if some of this derivative non-sense would have happened anyway, I am sure that sooner or later someone would have figured out how to use consumer lending products as a insurance backing for options on other lending products.

However the scope of all of this derivative non-sense would have been limited by deposit requirements.

For example at the time of the Bear Stearns bankruptcy they had a leveraged ratio of 35.5 to 1.
They had $13,400 Billion in the derivatives market with assets at around $395 Billion and another $11.1 billion in cash. The old deposit requirements of 10 to 1 and this non-sense would be no where near as damaging to the American market. note the 3-4trillion in loss's where eaten by their investors, the FDIC, and AIG(they insured a bunch of this stuff). Although they never directly received a bailout its still the American tax payer eating the grand majority of it all.

I will note that their is only 3.9 Trillion dollars in printed money.

I won't agru the economics is a social science thing, and that their was no thought put into this non-sense. But it was deregulation that enabled it, And I am more then happy to point out the enablers.

I suggest watching FrontLine: The Warning.

Scott Hinrichs said...

In Canada 20% down payments are the norm and regulations require that mortgage payments not exceed 38% of expected NET income.

It's a lot harder for people to qualify for their first home. That means more renters and some that rent their whole lives. But Canada's financial markets didn't melt down and have continued to operate normally throughout our crisis.

We are 'solving' the problem by having the federal government give first time home buyers their down payment. That's what happens when politicians (and their business cronies, as well as constituents) think that the political class has to fix everything.

RD said...

20% down payments eh, that sounds like one of the regulations to me.

This works just like a bank deposit requirement, in the effect the property insuring the the mortgage loans can take a 20% devaluation and the bank is still covered in the event of a bankruptcy.