*Engineering the Financial Crisis*

by on October 30, 2011 at 12:20 pm in Books, Economics, History | Permalink

This is an excellent conceptual book on the financial crisis, full of deep research and intellectual honesty.  The authors, Jeffrey Friedman and Wladimir Kraus, are not in the usual loops of the economist elite, so I hope it is not ignored.  They place central importance on the Basel capital regulations and mark-to-market accounting, complemented by a credit channel, in their narrative.  Arnold Kling has much more on the book.  You can buy the book here; anyone interested in the financial crisis should read it.  The authors have some of the best arguments against the “moral hazard” interpretations of the crisis, preferring instead knowledge and calculation arguments.  My main worry is about how much the Basel regulations mattered, given that many banks held more mortgage-backed securities than Basel regulations required.

Here is a blog post on their most controversial claim in the book.

Ashwin October 30, 2011 at 12:57 pm

I have made the same argument to Jeff Friedman. The moral hazard explanation does explain all the relevant facts – contrary to conventional wisdom, a moral hazard outcome is characterised by a levered portfolio of negatively skewed bets, not volatile bets. And bankers are smart enough to hide the leverage off the balance sheet as UBS did so effectively so balance sheet leverage tells us nothing.

I have paraphrased below some arguments that I made in this post http://www.macroresilience.com/2010/01/06/implications-of-moral-hazard-in-banking/ :

Bank creditors factor in a less than 100% probability of a bailout and adjust their required rate of return downwards. Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value. If each incremental unit of debt issued is issued at less than its true economic cost, it adds to firm value. The optimal leverage for a bank is therefore infinite.

Regulatory capital requirements force banks to choose from a continuum of choices with low leverage and risky assets combinations on one side to high leverage and “safe” assets on the other. Given that high leverage maximises the moral hazard subsidy, banks are biased to move towards the high leverage, “low risk” combination.

High-powered incentives encourage managers/traders to operate under high leverage. Bonuses and equity compensation help align the interests of the owner and the manager.

Risk from an agent’s perspective is defined by the skewness of asset returns as well as the volatility. Managers/Traders are motivated to minimise the probability of a negative outcome i.e. maximise negative skew. This tendency is exacerbated in the presence of high-powered incentives. Andrew Lo illustrated this in his example of the Capital Decimation Partners in the context of hedge funds (Hedge fund investors of course do not have an incentive to maximise leverage without limit) http://www.alphasimplex.com/pdfs/RiskMgmtForHF.pdf .

Moral hazard explains the key facts of the crisis – high leverage combined with an apparently safe asset portfolio of AAA assets such as super-senior tranches of ABS CDOs.  The best piece of evidence on the crisis I have found so far in the public domain is the UBS shareholder report. It is quite technical and jargon-laden but I have analysed the relevant sections to justify the above assertions at the end of this post http://www.macroresilience.com/2009/11/06/a-rational-explanation-of-the-financial-crisis/ .

Andrew' October 31, 2011 at 12:27 am

And when Sam started the ad hoc bailout program the probability of bailout was revealed to go from less than 100% to MUCH LESS than 100%. But was there an increased cost of borrowing or could funds not be found at any price?

Bill October 30, 2011 at 1:35 pm

So, their argument relies upon showing that they could originate poor loans, sell them to Freddy and Fanny, and buy Freddie and Fannie paper to reduce their portfolio risk, which they had a hand in generating in the first place.

“The risk-aversion claim rests on two facts: the much-higher-than-legally required capital ratios of commercial banks and savings and loans before the crisis; and the fact that commercial banks and S&Ls overwhelmingly bought the least lucrative and supposedly “safest” mortgage-backed securities: those implicitly guaranteed by the federal government through Fannie and Freddie’s congressional charters; and those rated AAA vs. those rated AA or lower.”

So, to show that banks were rationally risk averse from eating their own stew they transfered their risks to a guarantee entity, and bought equivalently termed instruments, now with a guarantee, and went on creating bad mortgages.

I suppose you could argue that Basel III is irrelevant under this scheme.

But, maybe you should ask about origination and no doc loans in the first place.

Bill October 30, 2011 at 5:58 pm

This also argues for a rule that banks retain a portion of what the originate.

msgkings October 31, 2011 at 2:59 pm

+1

Jeffrey Friedman October 30, 2011 at 4:17 pm

Ashwin–Please read the book. (I know Amazon is making that difficult, but it is available from the University of Pennsylvania Press.) We show that leverage was actually low and that there was no discernible reduction in large banks’ borrowing costs because they were supposedly too big to fail. We also discuss the UBS shareholder report.

Too much of the debate about the crisis (in fact, almost all of it) has been conducted solely on the basis of theory, not evidence. But we welcome challenges to our evidence and analysis on our blog, “Causes of the Crisis.”

Jeff

Ashwin October 30, 2011 at 5:27 pm

Jeff – Thanks for the reply. I will read it soon. My point is that you can’t ascertain the leverage positions of any of these TBTF banks from their balance sheet. For example, most of UBS’ losses came from what they called “Amplified Mortgage Portfolio (“AMPS”) Super Seniors” – essentially delta-hedged super-senior positions on their trading books which showed up as zero-risk positions. As hedged swaps, they literally were invisible to the eye and caused 63% of their losses. And this is the most trivial of the ways to hide such a position – I’m not even getting into the gamut of off-balance sheet vehicles that help banks achieve similar results. Remove the implicit guarantee and every large derivatives house should and will trade at credit spreads far above a comparable bank without a derivatives business.

Frank October 30, 2011 at 5:11 pm

The introductory chapter is an intellectual, theoretical, and empirical tour de force. Should be required reading for anybody who ever wants to learn to spell “finance”. It is difficult to express gratitude properly to an author, so I thank Tyler for posting, profusely.

Scott Sumner October 30, 2011 at 7:14 pm

Sound interesting. But here’s what confuses me. The Federal government bailed out the GSEs, didn’t they? So the big banks shouldn’t have lost money on the GSE debt. Why then did they lose so much money? Was it ordinary loans that went bad in the recession, not MBSs?

Tom October 30, 2011 at 8:11 pm

This is one of these libertarian economics books (The Critical Review Foundation?, another one of these right wing groups designed to propagate ideas while not having to withstand peer review). Not worth my time and not worth the price.

TGGP October 30, 2011 at 8:38 pm

Funny, since this guy accuses Critical Review of being a lefty entryist organization.

Frank October 30, 2011 at 11:52 pm

There is an old joke about why God was kicked off of the university faculty:

He wrote only one book, and it wasn’t peer reviewed!

Andrew' October 31, 2011 at 12:21 am

Because it’s way better to have 3 guys read it before the internet does…

Jeffrey Friedman October 31, 2011 at 9:43 am

For God’s sake, it was published by the University of Pennsylvania Press. Obviously it was peer reviewed.

More important: it is now available as an ebook from Google Books.

Troll Tom November 1, 2011 at 2:20 pm

No, it wasn’t peer reviewed, because that would destroy my argument. Besides, I am of that class of persons who can confidently judge the quality of an argument by a cursory scan of its conclusions and an imaginative assignment of ideological agenda.

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