“Why did U.S. banks invest in highly-rated securitization tranches?”

by on August 19, 2011 at 8:12 am in Economics | Permalink

That is a new paper by Isil Erel, Taylor D. Nadauld, and Rene M. Stulz, and it is one of the more instructive papers on the financial crisis:

We estimate holdings of highly-rated tranches of mortgage securitizations of American deposit-taking banks ahead of the credit crisis and evaluate hypotheses that have been advanced to explain these holdings. We find that holdings of highly-rated tranches were economically trivial for the typical bank, but banks with greater holdings performed more poorly during the crisis. Though univariate comparisons show that banks with large trading books had greater holdings, the holdings of highly-rated tranches are not higher for banks with large trading books in regressions that control for bank size. The ratio of highly-rated tranches holdings to assets increases with bank assets, but not for banks with more than $50 billion of assets. This evidence is inconsistent with explanations for holdings of highly-rated tranches that emphasize the incentives of banks deemed “too-big-to-fail”. Further, the evidence does not provide support for “bad incentives” theories of holdings of highly-rated tranches. We find, however, that banks active in securitization held more highly-rated tranches. Such a result can be consistent with regulatory arbitrage as well as with securitizing banks holding highly-rated tranches to convince investors of the quality of these securities. Our evidence supports the latter hypothesis.

In other words, it was not “too big to fail moral hazard” and it also was not venal corporate incentives.  It was possibly some regulatory arbitrage but also just plain, flat stupidity and complacency.

1 John Thacker August 19, 2011 at 8:30 am

Sounds to me like a little bit of evidence for Arnold Kling’s preference for a wide variety of ratings mechanisms.

The problems with everyone using the same ratings metric is that it almost surely has a systematic flaw somewhere, and if everyone has the same systematic flaw, then eventually you’ll get a systematic crisis.

2 dearieme August 19, 2011 at 8:38 am

Wouldn’t you tend to be stupid and complacent if you got the huge paypackets those bozos got?

3 Rahul August 19, 2011 at 9:44 am

I don’t get this. Stupid people get paid more? Getting paid more makes you stupid? What’s your point?

4 babar August 19, 2011 at 10:32 am

if you get paid proportionally to the size of the portfolio you manage, then stupidity and high pay reinforce each other in the 2006 environment.

5 Andrew' August 19, 2011 at 11:02 am

Easy money makes you think you are getting it because you are a genius, when you are just getting it because it is easy.

6 Bernard Yomtov August 19, 2011 at 7:45 pm

I’m pleased to agree with Andrew’ here. Let me add that if you are as entrenched in your job as some of these guys were, it takes an awful lot to get you out, no matter how stupid you are.

7 anonymous August 19, 2011 at 10:52 am

It’s hard to get a man to not be complacent about something, when his salary depends on his not not being complacent about it.

8 derek August 19, 2011 at 8:51 pm

Isn’t that the definition of an asset bubble? It is, at least for a while, more profitable to do something stupid.

9 The Anti-Gnostic August 19, 2011 at 8:49 am

I’m not understanding the argument. They bought “highly rated” tranches of a security premised on housing values that always went up, up and up? Sounds like moral hazard and OPM to me.

10 Don Brown August 19, 2011 at 8:59 am

It was probably more driven by securitization “arbitrage” combined moral hazard. If you can place the lower tranches and hold the higher tranche at L+20 to 50 (depending on whether it’s sumprime RMBS or Mezz CDO), you book fees of 2-8MM on the securitization. Doing this a few times a month, a trading/securitization operation can make a lot of P/L (and traders are paid annually) … until it blows up.

11 Andrew Edwards August 19, 2011 at 9:13 am

This topic fascinates me. How does the existence of “plain, flat stupidity and complacency” modify our understanding of microeconomic theory? It is an important fact notably absent from the basic building blocks, and I often wonder how we would go about re-working economic theory to account for it, and how our conclusions may differ if we did.

12 derek August 19, 2011 at 9:06 pm

Very simple. Capitalism’s strength is failure. Stupidity or bad decisions are endemic, a constant. Only the discipline of the market keeps it in check. Stupidity is usually swiftly punished.

The idea of moral hazard is similar to conspiracy theories; it assumes a thoughtful process. For stupidity to become the institutional norm in as large an industry as the financial sector of the US and Europe tells us something. I would suggest that the efforts to prevent economic downturns by both monetary and fiscal activity has created a situation where stupidity is encouraged. Many of the things that contributed to the 2008 failure had caused failures in the past. The failures prompted intervention which limited the consequences of the stupidity. Instead of ideas being discredited by failure, they remained and became common practice.

The consequences of the bailouts and central bank action to prevent the failure of banks will end up in even larger catastrophes. We are seeing one right now in Europe.

13 steve August 19, 2011 at 9:17 am

We are making lots of money. Don’t rock the boat. Sounds like a common management approach. Complacent fits well. Stupid? Everyone else was doing it.


14 Bernard Yomtov August 19, 2011 at 7:48 pm

Stupid? Everyone else was doing it.

Do you remember your mother asking, “Well, if Johnny jumped out the window, would you jump out the window?”

15 George August 19, 2011 at 10:07 am

Occam’s Razor suggests that, when it comes to human affairs, we look to stupidity & complacency before anything else.

16 Attorney at Flaw August 19, 2011 at 1:17 pm

I’ve heard it called “Hanlon’s Razor”: “Never attribute to malice that which is adequately explained by stupidity.” It’s what I always counsel clients who think that somebody is committing fraud. What I really like is Clark’s Law: “Any sufficiently advanced cluelessness is indistinguishable from malice.”

17 JasonL August 19, 2011 at 10:22 am

Don’t we need an explanation for why everyone’s stupidity took the exact same shape?

18 Michael Cain August 19, 2011 at 10:39 am

After consolidation has reduced the industry to a few very large participants, upper management at those firms all go to the same conferences, listen to each others’ speeches regularly, answer the same questions asked by the same stock analysts, etc, etc. In that sort of environment, some degree of groupthink would seem to be inevitable.

And it’s not just banking. I spent a decade watching a different industry consolidate innovation out of the business.

19 Rahul August 19, 2011 at 10:44 am

Groupthink has become a mode of corporate risk averseness. If a manager is going to make some mistakes anyways, he’d rather that his competitor fell into that pit too.

20 dearieme August 19, 2011 at 11:29 am

Quite: in big institutions you’re always safer being wrong in company than being right on your own. Keynes said something to that effect too.

21 derek August 19, 2011 at 9:07 pm

Everyone learned the same things at the same schools.

22 TallDave August 19, 2011 at 10:24 am

So, they bought the tranches to help ensure the tranches would be highly rated. Interesting.

OTOH, I think it’s worth asking whether this would evolved into this serious of a problem absent the deliberate pushing of securitization into the marketplace by the GSEs (with the goal of thereby expanding credit access). I believe Megan has linked the actual working papers laying out the plan to do this.

23 The Anti-Gnostic August 19, 2011 at 10:29 am

That would be getting to the root of the problem. There are powerful interests aligned to prevent ever getting to the root of the problem.

24 Andrew' August 19, 2011 at 10:45 am

But still, why? Did higher rated debt allow them greater leverage? Again, why? Was higher leverage required due to the low interest rates on debt? Again, why?

25 The Anti-Gnostic August 19, 2011 at 10:59 am

Because they’re human. Because they could. I think the more important question is why this became everybody’s problem instead of just a problem for the players in the sector to take their well-deserved haircuts and life to go on. But again, more of that getting-to-the-root stuff that we’re not supposed to mention in polite company.

26 Silas Barta August 19, 2011 at 1:15 pm

I’m just glad that we allowed market processes to wipe out the idiots that invested so heavily in these crappy securities and let the more competent banks and credit unions take their place … oh, wait.

27 Rahul August 19, 2011 at 10:39 am

One of Carlo Cipolla’s five fundamental laws of stupidity says:

A person is stupid if they cause damage to another person or group of people without experiencing personal gain.

Did these bankers gain or lose?

28 anonymous August 19, 2011 at 11:37 am

The ones who worked for Bear Stearns and Lehman unquestionably lost, as much of their personal wealth was tied up in their firms.

Bearing in mind that the crisis that began in 2007 has never gone away and is in fact now entering a new and significantly worse phase, it’s fair to say that many more bankers both here and in Europe have met Cipolla’s definition of stupid, though that fact may not yet be apparent to them.

29 CIP August 19, 2011 at 10:52 am


Exactly. It was the agency problem. Individual bankers were making a lot of money risking mostly other people’s money.

30 Rob August 19, 2011 at 11:09 am

I don’t get what Tyler’s saying … regulatory arbitrage is moral hazard. The only reason to play with the regulators is because of too big to fail moral hazard. I haven’t read the paper, but the conclusion and Tyler’s comments make no sense.

31 Tim S August 19, 2011 at 11:48 am

Ding ding ding.

32 Donald Pretari August 19, 2011 at 11:18 am

I’ll put my faith in actual investigations of their motives.

33 Sean Brown August 19, 2011 at 11:33 am

There is a TON of “dumb money” capital allocation going on at money-market funds and to a lesser extent banks and some insurance companies and mutual funds. Instead of giving incentives for people to put their money into “smart money” funds (think Berkshire Hathaway, Fairfax Financial, or several analysis-based mutual funds and hedge funds; as well as SOME units of investment banks and some banks) the government is railing against high salaries in finance – which is fair in some cases but not others. For example, getting paid in carried interest with a multiyear lockup is an excellent way to incentivize a good, in-depth research process – which these banks (financed by deposits and other “dumb money” mostly) obviously lacked.

34 Bill August 19, 2011 at 2:18 pm

I am in favor of carried interest because it is investing by the owner of the hedge fund, just like a lawyer investing in a contingent fee case which he carefully investigated and put in a lot of time.

That is why I am seeking your support of my modest proposal to treat contingent fee lawyers the same as we treat hedge fund operators.

Thank you for your support and arguments in favor of my position.

35 Tom Grey August 19, 2011 at 11:42 am

Their job, and paychecks, were dependent on them doing exactly what they did — until it blew up.

The rating agencies are most to blame; with near monopoly power granted by gov’t Tier 1 capital requirements. Where are the metrics for “how good” a rating agency is? Where are the penalties to the raters, whether agency or regulator, for being “wrong” — for calling something AAA one week, AA, A, B, then C, then junk, within a month?

Where is the history of the rating agency ratings of the specific “assets” which blew up?

Everybody who invests wants the best risk-adjusted return. There was almost nothing better than the rating agency’s ratings (Dr. Michael Burry, reading the actual contracts, did a better “rating” job than the agencies, and successfully shorted some of the worst).

Why didn’t all the ratings start falling in 2006 when the house construction bubble popped, and prices stopped rising????
The 2006-early 2008 GDP growth after the construction bubble is the biggest macro-unexplained phenomenon. Despite Sumner’s good NGDP monetary emphasis, I’m certain the Kling Recalculation (with lags) is more important, but more difficult to model and test for; and with far less power to the Fed or gov’t.

36 Lou August 19, 2011 at 12:01 pm

You’re starting with the assumption that those senior tranches suffered anything other than temporary mark to market losses when liquidity vanished in 2008. You might want to reexamine that assumption. The question you should be asking is not why they invested in these securities, but why they failed to hedge tail risks like a severe liquidity crisis. For all I know it may not be possible. I’m not a bank manager, and I don’t pretend I could be one.

37 Shamrock August 19, 2011 at 12:23 pm

Try with this movie “The Inside Job” and many doubts will dissapear

38 Floccina August 19, 2011 at 12:41 pm

But why did people lend money to stupid complacent the banks?

Maybe they were thinking “It is insured by FDIC so why do I care”.

39 Glen August 19, 2011 at 1:12 pm

“The ratio of highly-rated tranches holdings to assets increases with bank assets, but not for banks with more than $50 billion of assets. This evidence is inconsistent with explanations for holdings of highly-rated tranches that emphasize the incentives of banks deemed ‘too-big-to-fail.'”

I haven’t read the paper, but this doesn’t seem to follow. From the description, it sounds like we have a plateau: the ratio of highly-rated tranches holding to assets rises up to $50 billion in assets, then flattens out. But that plateau still represents the highest level of holdings. Thus, the banks with the most assets also had the greatest holdings of the securities in question, which is just what too-big-to-fail says. We might therefore conclude that $50 is the too-big-to-fail threshold, and that all banks meeting or exceeding that threshold held about the same ratio. Why should the slope continue to be positive, if all banks in this category face the same incentives?

40 Doug Mortenson August 19, 2011 at 2:52 pm

Guys! Why are you wasting your time on the salesman? The banks are in the business of making money for their investors, whether it’s the feds or Grandma Grunt. All this talk of whose stupid or malicious and whether or not ‘moral hazard’ was involved does nothing but give politicians the wrong reasons to increase regulation. These tranches were built on what? Real Estate Mortgages. Why? Their value was tied to their stream of income, the payments made by Mr and Mrs American who just bough a new house. The question is why nobody gave a damn about whether the buyers could make the payments. And who would that be? The Feds. Not the banks, not the rating agencies, not AIG. Ever hear of “Office of Federal Housing Enterprise Oversight?” It doesn’t GET any simpler than that. Oh, and shamrock, the movie is nothing more than an “i hate capitalism” diatribe that completely leaves out the real crooks: The feds who let it all happen.

41 Shamrock August 19, 2011 at 3:46 pm

I agree but I also think that people should be more prepared and try to understand how things works. For example Gold is skyrocketing and that’s a bubble too… Despite the flight to safety, experts warn that time may be up for this current rally.

42 Doug Mortenson August 19, 2011 at 4:10 pm

I agree. if you have gold sell above 2100, I think it will go to 2500, then crash and leave all the shoe clerks broke.

43 DWAnderson August 19, 2011 at 4:17 pm

“it was not ‘too big to fail moral hazard’ and it also was not venal corporate incentives. It was possibly some regulatory arbitrage but also just plain, flat stupidity and complacency.”

Aren’t stupidity and complacency second order consequences of being too big to fail?

44 txslr August 19, 2011 at 4:54 pm

I haven’t read the paper either – I have a stack of papers to read that I despair of ever getting to – but it is nice to see someone looking at the data and testing hypotheses regarding the episode.

Now, what are the falsifiable implications of “plain, flat stupidity and complacency” that we can test?

45 Jeff August 19, 2011 at 9:01 pm

Hmmm, were the big banks venal or just stupid? In any sensible system, either one is good enough reason to let them fail. And as William Black has pointed out any number of times, you only find out about the venality after the institution has failed, for only then do the control frauds lose their ability to cover their tracks.

During and after the S&L crisis, hundreds of frauds were discovered and successfully prosecuted. Not one of these frauds was brought to light by an audit of a going concern. All of them were only uncovered after the institutions being looted had been shut down and the previous management fired.

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