Why did the U.S. financial sector grow so large?

by on May 19, 2012 at 6:15 am in Books, Economics | Permalink

Edward Conard, author of Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong, offers a hypothesis.  He suggests the underlying cause is the (relatively recent) prevalence of risk-averse foreign capital:

With an abundance of risk-averse offshore capital, the constraint to increase investment and risk taking has been the capacity of risk underwriters, not capital providers.  Today, Wall Street uses financial innovation to decouple risk from investment capital and predominantly sells risk to risk underwriters, which is no different from an insurance broker or insurance company.  Wall Street deconstructs, prices, underwrites, syndicates, trades, and makes markets for risk.  Because Wall Street now performs the more abstract function of syndicating risk rather than merely raising capital, people — even people as well informed as former president Bill Clinton — have naively concluded that these transactions serve “no economic purpose.”  Risk underwriting is every bit as important as funding investment, perhaps even more so in today’s economy where the trade deficit leaves us awash in risk-averse short-term debt to fund investment provided someone else underwrites the risk.

So far I find parts of this book brilliant and other parts dead wrong.  In any case it is full of substance, it is one of the must-read books of the year, and once I finish it I will be giving it a second read through right away.

Steve Sailer May 19, 2012 at 6:24 am

America is the world’s military hyperpower, so foreigners treat our rich and powerful people really nice.

Greg G May 19, 2012 at 7:33 am

Yes, “risk underwriting is every bit as important as funding investment, perhaps even more so.”

The problem is Wall Street’s financial innovations have provided many pernicious mechanisms for transferring risk from those who understand it best to those who understand it least.

Norman Pfyster May 19, 2012 at 8:17 am

You mean other banks?

Greg G May 19, 2012 at 8:32 am

“You mean other banks?”

Among many others. It has become easier and easier for people and institutions of all types to take on risks they don’t understand and which were previously unavailable to them. And it has become possible for many people who are not parties to a transaction to bet on that same transaction. This increases systemic risk in unpredictable ways.

Norman Pfyster May 19, 2012 at 9:10 am

Many others who? These instruments are purchased by large institutional investors (bank, insurance companies, hedge funds, pensions, etc.) who should be able to evaluate risk. That they often don’t should come as a shock. Think of those companies who sole business function is to purchase risk and who failed: AIG, Ambac, MBIA.

Think also of the Wall Street firms packaging risk transfer instruments who were themselves burned by investing in those very instruments: Lehman, Bear Stearns and Merrill Lynch are no longer with us.

The Original D May 19, 2012 at 12:00 pm

Yes, but the money they lost was not their own. When you have a billion dollars to play with, evenif it’s not yours (especially?), you start to act like you’re smarter than the average guy.

Norman Pfyster May 19, 2012 at 12:41 pm

Pretty much any company that goes bankrupt is losing other people’s money: that’s what bankruptcy is.

The Original D May 19, 2012 at 7:41 pm

Yes, except in a TBTF bank bankruptcy means taxpayer bailout.

The Original D May 19, 2012 at 11:59 am

Do you really think the average AIG employee understood risk as well as the average Goldman Sachs employee?

Norman Pfyster May 19, 2012 at 12:43 pm

Better. AIG is an insurance company. If insurance companies don’t understand risk, who would?

Greg G May 19, 2012 at 1:09 pm

“Better. AIG is an insurance company. If insurance companies don’t understand risk, who would?”

This might be the single worst argument I have ever seen on Marginal Revolution. The mere fact that they are an insurance company means they had to understand CDS better than Goldman Sachs? Really?

Does the fact that George W. Bush was a President mean he understood how to be President better than any non-president? Wait. Don’t answer that. I am afraid you will say yes.

Ray Lopez May 19, 2012 at 5:52 pm

In general Norman Pfyster is correct, but in the case of AIG, because of historical reasons related to Maurice Raymond “Hank” Greenberg’s strict controlling of information and “silo” management style, in fact the average executive at AIG knew very little outside their own department.

Norman Pfyster May 19, 2012 at 6:04 pm

No, that George Bush analogy is a much worse argument.

I work in the industry. I work with banks. I work with insurance companies. I’ve worked with both Goldman and AIG. I’m pretty sure I know more than you about their relative capacities to model risk.

The Original D May 19, 2012 at 7:44 pm

I’m pretty sure I know more than you about their relative capacities to model risk.

So you predicted the 2007-2008 meltdown? You predicted the resulting shocks to the economy? If not, then it doesn’t matter what your assessment of their capacity is. The indisputable fact is their models did not work and the economy is paying the price for that failure.

Jonathan May 19, 2012 at 8:33 am

Interesting hypothesis, Greg G. Maybe we all have exacty the same appetite for risk, so the only people who bear it are those too dumb to know they have it. It’s like a game of hot potato in which the potato ends up in the hands of the guy with no burn receptors every time.

High rates of return ought to be always regarded everywhere as one of two things: (a) an unexploited opportunity; or (b) risk. It is a pretty arrogant person who thinks that it is (a). And this has been true forever, not just since the rise of finance.

Greg G May 19, 2012 at 8:45 am

Jonathan, I doubt that we all have exactly the same appetite for anything and I also doubt that the fact that you and I may be able to agree on what people ought to do will change their behavior in any way.

Jonathan May 19, 2012 at 8:53 am

“Exactly the same” was intended as a polar case, of course, not reality. But if you agree with me on the second point, how are you going to stop people from making bets they don’t understand without stopping people who understand the bet they’re making and and are willing to take on the risk (see, I don’t believe that “exactly the same”) and fulfill a hugely valuable social function?

Greg G May 19, 2012 at 9:06 am

Jonathan, I have not formulated some fully worked out system of financial reform. But I do think that the system we had in place for most of the second half of the 20th Century worked a lot better than the one we have now. I think the “hugely valuable social functions” of financial “modernization” have been vastly oversold by the people who profit from selling them. I think many so called hedging investments increase, rather than decrease, systemic risk. Any new limits would indeed limit the options and profits of those who best understand “the bet.” That is a price that I think is worth the benefits.

Ricardo May 19, 2012 at 10:15 am

“how are you going to stop people from making bets they don’t understand”

I’m not sure this is the right question to start with. Conard is making the case that Wall Street firms are increasingly in the risk management business. Well, OK, but it turns out that insurance companies really are in the risk management business and they have been subject to strict regulations and capital requirements for decades if not hundreds of years. The reason is that it is simply too easy for someone to set up shop claiming to insure other people’s risks, take money in exchange for this service and then disappear when it comes time to pay up. And, mind you, insurance companies typically operate in areas where risks are well-understood and can be priced by actuaries.

So if Wall Street firms or at least the firms they off-load risk onto want to act like insurance companies, what is wrong with regulating them like insurance companies? Some of the growth of the financial sector here is arguably the result of regulatory arbitrage: AIG, for instance, got bored of its staid, traditional insurance products and realized there was far more money to be made by selling CDSs. Might this have something to do with the fact that CDSs operate on the buyer beware principle?

The Original D May 19, 2012 at 7:46 pm

+1

“Collateralized debt obligation” is a weasel-word for insurance. Calling them CDOs allowed AIG to evade insurance regulators.

Norman Pfyster May 20, 2012 at 12:36 pm

They are called credit default swaps (cds). If you are going to get righteous, at least learn the right lingo.

Also, everyone can offer a credit default swap and it wouldn’t be regulated as insurance. Banks do it all the time. That is the law, not an evasion of the law. New York offered to regulated cds’ as insurance, an offer that was quietly withdrawn after the banking industry said it would leave NY and the feds told NY to back off; there’s an odd provision in Dodd-Frank, added at the last minute, which exempts swaps, including cds’ from insurance regulation, which was added precisely to prevent NY and other states from regulating cds’ as insurance.

The Original D May 20, 2012 at 9:11 pm

everyone can offer a credit default swap and it wouldn’t be regulated as insurance.

So…. What AIG did is just hunky dory? Methinks the fact that everyone can offer a CDS is a bug, not a feature.

Willitts May 19, 2012 at 12:18 pm

Such pithy nonsense.

Those who get burned are typically the most sophisticated entities that fall prey to overconfidence in their own risk management capabilities. The risks to which they are exposed are not the risks that the issuer aimed to reduce.

Greg G May 19, 2012 at 2:53 pm

What if the issuer is aiming to make as much money as possible rather than aiming to reduce risk?

steve May 19, 2012 at 7:59 am

Thanks , it is now on the Kindle. Is it just coincidence that it comes out this year during the election?

Steve

Ricardo May 19, 2012 at 8:26 am

“Wall Street uses financial innovation to decouple risk from investment capital and predominantly sells risk to risk underwriters”

Rather, Wall Street claims to do this. The notion that Wall Street firms actually do this in a consistent and reliable manner is empirically false.

Jonathan May 19, 2012 at 8:48 am

While that is empirically false ex post, it is almost by definition true ex ante. The problem is in recognizing risk ex ante.

Ricardo May 19, 2012 at 9:24 am

It’s a problem some of the time but hardly in this particular context. We aren’t talking about asteroids hitting the earth or the Yellowstone caldera wiping out the West Coast.

Instead, we are talking about the fact that things like housing loans carry risk with them. Indeed, if this was not fairly clear already, risk averse investors would have poured money directly into the mortgage market instead of insisting on investing in highly complex financial instruments several times removed from mortgages.

The lesson I take from this is that most investors are, in fact, risk averse but can be convinced through a mix of fraud, fuzzy thinking (Powerpoint presentations and jargon), ridiculous gimmicks like the AAA ratings attached to these assets, and sales skills that a risky investment is not risky. The difference is that Conard appears to consider this a valuable service to the public.

Norman Pfyster May 19, 2012 at 9:38 am

If investors were so eager to “pour money directly into the mortgage market,” why didn’t they? A lender could just as easily bought a security directly from Countrywide as purchase a security backed by a pool of Countrywide loans, and Wall Street bankers would have been just as happy intermediating the sale of the one as the other.

Anyway, that example is a form of risk decoupling (i.e., isolating the risk exposure to the mortgage market), but its not the important forms the author is describing.

Ricardo May 19, 2012 at 9:56 am

It’s not clear whether you are disagreeing with what I wrote or how “the important forms” Conard describes differ from the salient example of risk decoupling in the mortgage market.

Conard is asserting that Wall Street firms can transfer risk from risk averse investors to risk-taking underwriters. I don’t see how someone can make such a claim without confronting an example like that of AIG.

The Original D May 19, 2012 at 12:05 pm

They did poor money into the mortgage market. See The Giant Pool of Money

Norman Pfyster May 19, 2012 at 12:54 pm

I don’t follow how AIG undermines the author’s point; they acted as a risk-taker. They were sellers of risk protection, and thus taking the risk onto their balance sheet. The risk-averse parties were the banks and other investors in MBS who were purchasing the cds protection from AIG on the MBS. The fact that AIG priced the risk poorly and failed (or more accurately, got caught in a liquidity crunch as the derivatives and securities lending transactions went out of the money) doesn’t undermine the author’s point.

Ricardo May 19, 2012 at 1:32 pm

The failure of AIG posed a credible threat to the financial system and resulted in a government bailout. What this means is that investors who purchased CDSs issued by AIG were either a) still holding arguably as much risk as they held before except in the form of counterparty risk or b) were off-loading risk onto the Federal Reserve.

The hypothesis that AIG was engaged in some socially beneficial activity is not supported and given the opaque nature of derivatives markets and the way risk is shifted around in ways that can increase systemic risk, it is not at all clear most other firms out there are either.

Norman Pfyster May 19, 2012 at 6:28 pm

You are still confusing risk-taking with the financial innovation the article is describing, which is risk disaggregation (i.e. “decoupling”) and intermediation.

Also, derivatives (and repos and securities lending) cause systemic risk not because they are opaque or hard to understand, but because they are executory contracts with a unique position in the bankruptcy process, a position that leads to runs on banks and liquidity failures. AIG suffered a classic run on the bank (in the form of collateral calls) where they could not liquidate enough assets quickly enough to satisfy creditors.

Norman Pfyster May 19, 2012 at 9:26 am

“Decouple” might be too strong a term; mitigate and isolate would be more accurate. There are no riskless assets and no riskless positions.

8 May 19, 2012 at 8:39 am

I thought the risk averse foreigner were buying Treasuries.

Zachary May 19, 2012 at 12:22 pm

They don’t buy treasuries only. They also buy other variously rated securities. And for the lower ratings, or for all ratings for that matter, they demand insurance.

CPV May 19, 2012 at 9:22 am

Here’s a better analysis.

1. First we need to define what it means for the “financial sector” to get “large”. But lets say that means the profitability of investment and commercial banks? IE this is what is meant by “Wall Street”. This excludes insurance companies, asset managers, pension funds, hedge funds, etc. They are a big part of the “financial sector” as well. In fact they are the front men for “Wall Street”, generally facing the ultimate source of the profits.

2. Let’s posit that conventional debt and equity underwriting is not what we are talking about here..

3. So we are talking about profits from brokerage and derivatives transactions (including mortgage bundling) with counterparts like insurance companies, asset managers, pension funds, hedge funds, as well as corporate entities.

4. The profitability of these transactions increases with volume and complexity (ie lack of transparency). Interestingly, Information technology has been a huge enabler of both of these in different ways- volume on the vanilla brokerage end, and complexity on the structured derivatives end.

5. The demand for these transactions largely comes from other financial entities with arrangements with “consumers” that are not to their benefit. IE mutual funds that trade excessively and don’t outperform indexes, underfunded pension funds investing in hedge funds with option like fee payouts and below average risk adjusted performance who then project higher portfolio returns and reduce current contributions, carry trades to boost corporate profits, structured insurance annuities with huge costs and lower performance than simple investment strategies, mortgage backed securities rated by paid off ratings agencies, etc.

6. If consumers owned the revenue stream from these transactions done in their name (via investment bank stocks in their portfolios) it could be argued that it’s just harmless or a valuable transfer of risk, but in fact the preposterously high compensation rates on Wall Street defeat that argument.

7. This is not to argue that all risk management transactions done by “Wall Street” are without value. Just most of them.

3.

Arun May 19, 2012 at 9:36 am

So can JP Morgan’s 2billion$ loss be explained as losses made while trying to syndicate the risk of risk-averse short term offshore capital?

Norman Pfyster May 19, 2012 at 9:44 am

No, they were listening to Tyler and made a big bet that the Euro would collapse this past spring.

derek May 19, 2012 at 4:06 pm

If you listen to what they say they were doing, yes. It was some sort of hedge between high and low yield securities.

It didn’t work however. Wall street has a tendancy to believe their own BS. They have sold themselves as masterful managers of risk. But they are not.

As to the Cowan’s post, the reason the financial industry got so big is simple. Worldwide debt has more than doubled in the last decade, and someone needs to be around to handle it. How much of Wall street is simply serving the need of the US treasury trading the couple of trillion in bonds issued or rolled over every year?

The Original D May 19, 2012 at 7:52 pm

Not just debt, but capital in general. Worldwide capital went from something like $35 trillion to $70 trillion between 2002 and 2006. That is, all the capital accumulated in human history up to 2000 doubled in just six years.

spencer May 19, 2012 at 9:54 am

We use to think it was wall street’s job to allocate capital

But after the 1990’s and 2000’s bubbles it became obvious that Wall Street was doing a horrible
job of allocating capital.

So they came up with a new job for Wall Street –managing risk.

But day by day it is becoming more obvious that Wall Street is not any better at managing risk than at allocating capital– witness JPMorgan.

I wonder what new role will they will come up with next for Wall Street.

Norman Pfyster May 19, 2012 at 12:59 pm

“Wall Street” (or any type of bank) doesn’t allocate capital; they intermediate between people who have capital and people who want it. Sort of the same way a grocery store intermediates between people who want to buy food (like me) and people who have food to sell (like farmers).

Jonas May 19, 2012 at 5:05 pm

There’s a problem with transferring risk that’s different from just raising capital. One of the benefits of the capitalism is to align the incentives of the capital class with sustainable growth. That’s because the capital class bear the risk and the gain. That’s how you get the elites to behave in a way that benefits everyone.

If you transferred the risk away, the capital class would have no vested interest in ensuring growth or sustainability. They start demanding things (full bond repayment) without understanding whether or not there’s money there to do so, and don’t mind tearing stuff apart to get theirs. The new risk underwriter class just doesn’t have enough power to stuff them, and realizes the better strategy is just to get out fast.

Jonas May 19, 2012 at 5:07 pm

There’s a problem with transferring risk that’s different from just raising capital. One of the benefits of the capitalism is to align the incentives of the capital class with sustainable growth. That’s because the capital class bear the risk and the gain. That’s how you get the elites to behave in a way that benefits everyone.

If you transferred the risk away, the capital class would have no vested interest in ensuring growth or sustainability. They start demanding things (full bond repayment) without understanding whether or not there’s money there to do so, and don’t mind tearing stuff apart to get theirs. The new risk underwriter class doesn’t have enough power to prevent this, and realizes the better strategy is just to get out fast.

Matthew C. May 19, 2012 at 10:02 am

Because it is (by far) the easiest place for the cognitive and social elite to skim the nation’s surplus via back-scratching social connection networks, regulatory capture and control of the money production, and the TBTF heads-I-win-tails-the-taxpayer-loses socio-political structure.

The vast growth of DC over the past decade can be seen in the same light. Who else has trillions of dollars of money available at the click of a mouse and no incentives for making cost-benefit calculations.

In fact, a similar argument can explain the obvious market failures in the bloated and inefficient education and health care sectors as well.

Brian Timoney May 19, 2012 at 10:35 am

Even more insidious is the political class “protecting” the public from making bets they do understand: NFL point spreads.

The Original D May 19, 2012 at 12:07 pm

Ha, this is a clever point. If betting were legal nationwide AIG would probably start insuring against losses.

Highgaama May 19, 2012 at 10:41 am

I thought that this was what banks always do. This take in low risk deposits and make risky investments. What’s new here?

Ricardo May 19, 2012 at 12:05 pm

That’s what commercial banks do and because of the risk they hold, they are heavily regulated by governments. In the U.S., the ultimate “risk underwriter” is the federal government through the FDIC.

Investment banks, on the other hand, were traditionally in the business of underwriting securities. Securities underwriting is in very broad generality a pretty straightforward affair: an underwriting syndicate buys up a huge chunk of shares from the original owners and resells them to other investors. That’s it. Once those other investors buy the shares and all relevant SEC regulations have been followed, those investors are on their own. There is no pretense of insuring investors against risk. The idea of selling an investor a security and then offering to off-load the risk of the investment onto somebody else is a new one. And the problem is when those “somebody else”s all turn out to be the same few firms and they do not have nearly enough assets to pay out when markets go bad.

Willitts May 19, 2012 at 1:56 pm

There is no “pretense” of insuring investors against risk. Every investor with the slightest level of knowledge or sophistication understands that not all risk can be diversified to minimal levels or hedged. Hedges themselves expose one to risk because there is seldom a perfect hedge.

Risk syndication is extremely important to the functioning of capital markets. Your appeal to “tradition” is precisely the naivete he’s talking about. Unlike capital markets decades ago, we now have the capability to identify, monitor, and manage risk. Financial derivatives in particular and financial innovation in general are extraordinarily important to creating more efficient markets.

One could make a cogent argument that the innovations have become so complicated that nonfinancial risks such as operational risk, model risk, and sovereign risk have more than offset the gains.

Consider, though, every other technological innovation throughout history. Many of them presented risks that seemed to outweigh the reward, in the beginning. Things like ocean-going vessels, airplanes, electricity, and automobiles were extremely dangerous in their early years. We are quite comfortable with all of these innovations now, even though ships still sink, aircraft and automobiles still crash, and people still get electrocuted.

Greg G May 19, 2012 at 2:15 pm

Willetts, Yes there is a cogent argument to be made that the risks more than offset the gains. Thank you for acknowledging that.

The “sophistication” of investors at all levels is something I am growing more skeptical of daily. There are systemic risks from these derivatives that no one understands and that means we can add financial risks to your list of non-financial risks.

I am very skeptical that the rewards of financial innovation will be comparable with the value of things like electricity and automobiles.

Willitts May 19, 2012 at 3:02 pm

I agree with your points, although your terminology is wrong and your understanding limited.

Systematic risk is risk than cannot be diversified away. Systematic risk can be hedged through a market neutral strategy.

Systemic risk is the chance that a functioning market may collapse from a liquidity or confidence crisis.

In finance we are well aware of the broad classes of financial and nonfinancial risks, and risk governance is an important operational function. It’s not correct to say that there are risks “from these derivatives that no one understands.” We understand them very well. We just can’t always eliminate them, or we trade one risk for another.

For example, JP Morgan apparently hedged their risk exposure to a European debt default. When the situation did not get as bad as they expected, their hedges lost value. What they didn’t and couldn’t expect was that the governments of the Eurozone would be as effective as they were in allaying fears. This is called sovereign risk. It’s odd to call this “risk” because Europe took measures to reduce systemic risk. But because JP Morgan held an opposite position, this hurt them. Long Term Capital Management exploded from sovereign risk because they had not anticipated a Russian debt default that would cause a flight to safety into the very treasury securities they were shorting.

JP Morgan’s positions were being rolled over time, and when disaster didn’t happen, they were losing money every day. This is similar to owning a home in San Francisco, paying high earthquake insurance premiums, and never suffering a payable loss. At some point you might determine that the cost of insuring against the risk is too great for the risk you are willing to accept.

At some point JP Morgan determined that Europe wasn’t going to crash and burn, so they tried to unwind their hedge position. However, their position was so large they exposed themselves to liquidity risk – adverse price movements because their trades were big relative to the market. They also took on basis risk. Basis risk is when your hedge is imperfect; a perfect hedge is nearly impossible to create.

So it was not the case that JP Morgan didn’t know the risks or wasn’t sophisticated enough to handle them. The point I tried to make repeatedly in a previous post is that we cannot eliminate all risks. Someone has to bear them. Measures taken to mitigate risk are risky themselves. Businesses and investors make risk-return tradeoffs.

But there are risks that can be completely eliminated by financial innovation, and that has had a tremendous impact for our benefit. They have reduced the spreads and increased liquidity for many financial transactions. You take these benefits for granted the same way you take for granted the street lights and your headlights when you drive at night. You’re skeptical because, well, you’re ignorant. And I don’t mean to use that word in an insulting fashion.

I’m ignorant about electricity, and if an electrician tells me that my house needs a new thingamabob on the wattstabibble or my house might burn down some day, I am at the mercy of his expertise.

I am slightly more knoweldgeable about cars. When my mechanic says I need to replace the O2 sensor and TPS on my car, I’m completely familiar with what those things are, but I still cannot independently confirm that his recommendation is correct and in my best interest. The test on my O2 sensor might show that it is outside the “normal” range of operation as determined by a standard-setting body of automobile experts. The mechanic can say, with good conscience but to his benefit, that I should replace it, but I might be just fine not replacing it. I have to make a decision between the certain loss of paying for the new part versus the uncertain benefit of replacing it.

I manage portfolios for private wealth clients. They come to me because I have more expertise than they have. Some of them know a lot about finance, but they don’t have the time or the desire to manage their own wealth. Others know absolutely nothing about finance. They are at my mercy, and they must trust in my fiduciary responsibilities.

The layman is at the mercy of the professional.

You are worried that it isn’t just YOUR money that will be lost, but there might be a systemic collapse that affects you and everyone else indirectly. It’s a valid concern. In that case, though, you have to trust market discipline or your fiduciaries in Congress and government agencies to do their jobs.

The problem is that the people you trust are part of the problem. People in Congress don’t understand financial risk much better than you do, and they are opportunists who don’t let crises go to waste for the sake of political gain. It’s easy to get millions of people to distrust the guy making million dollar bonuses, but that doesn’t mean the distrust is warranted.

Do financially sophisticated portfolio managers and investors get involved with financial products they don’t understand? Yes and no. CDS on CDO-squared are complicated. We “understand” them very well; but some people just don’t exercise due diligence in identifying, monitoring, and managing the risk when they purchase the products. Don’t confuse lack of due diligence for lack of knowledge.

Joe Smith May 19, 2012 at 4:18 pm

To Willitts

When the situation did not get as bad as they expected, their hedges lost value. What they didn’t and couldn’t expect was that the governments of the Eurozone would be as effective as they were in allaying fears.

JPM bet there would be a disaster and could not anticipate that there would not be a disaster inside their predicted time horizon. Give me a break. Dimon has already admitted that they did not understand the trade.

The amounts the banks have at risk far exceed their capital. They have risks they do not understand. Large parts of that risk are simply side bets through the derivatives markets by parties who have no involvement in the base transaction. The result is a system ripe for a cascading failure.

Greg G May 19, 2012 at 4:23 pm

Willetts, I agree with most of what you wrote there. Thanks for taking the time for such a thorough response. I am not insulted. I do think we are talking past each other though. My apologies if that is because I got some of the jargon wrong.

Yes, it’s true that the big financial players do understand (now if they didn’t before) that the whole system can blow up. My point is that some of the very same instruments that make it possible for the smartest people to hedge and invest more safely for themselves add to the fragility of the larger system. You think this is a worthwhile (or unavoidable) tradeoff. I am more skeptical.

Like you, I invest cautiously and came through the crisis quite nicely. When I trade, I like liquidity and low traction costs as much as the next guy. But I would gladly accept higher costs for both in exchange for not needing to worry so much that the whole system could blow up.

The Original D May 19, 2012 at 7:54 pm

Re: sophistication of investors, isn’t that basically the fundamental error Alan Greenspan said he made?

Willitts May 19, 2012 at 9:30 pm

@Joe Smith

JPM bet there would be a disaster and could not anticipate that there would not be a disaster inside their predicted time horizon.

Let’s suppose I believe – no, I know for a fact that the Kodak corporation is going to collapse, but I have no idea when it will happen. I can short their stock, short their futures, or long puts. At each settlement, I could be losing a lot of money if they’re still hanging around. People might be buying their stock for value, and the market can be wrong longer than I can stay solvent. This is why hedge funds have lock in periods!

The problem was worse for JP Morgan because a European debt default would have greater reach than just their holdings of European debt. Their positions had to be large.

Dimon admitted what he publicly needed to admit, not what really happened. They still had positions that needed to be concealed from hedge funds. In the big chair, sometimes you apologize for things that weren’t your fault. It’s good politics. The more he objected, the more scrutiny he would get.

Investors clearly overreacted

The amounts the banks have at risk far exceed their capital.

Duh, all banks have assets at risk far in excess of their capital. A bank is well capitalized at, what, around 8% tier 1 capital to risk-weighted assets? JP Morgan is at 9.6%.

They have risks they do not understand.

No, they don’t. They have people who have spent their entire careers managing risks.

Large parts of that risk are simply side bets through the derivatives markets by parties who have no involvement in the base transaction.

No, they aren’t, and it doesn’t matter. When you are long exposure to a certain risk, you can’t always change your exposure to that risk directly or easily. If you try to do so, you signal the market that you want to sell and hedge funds will front-run you. Sometimes you have to find an offsetting position that isn’t directly related to your position.

Currency risk is the first example that comes to mind. If the market for a particular currency is illiquid, you might have to run a regression of that currency on several of the majors and trade accordingly. Then you are subject to basis risk and model risk.

Just because risk management is difficult and there are often losses, doesn’t mean you’re not doing it correctly.

The result is a system ripe for a cascading failure.

Hide under your bed, Chicken Little. You are long on words and short on contributions.

John David Galt May 19, 2012 at 6:02 pm

I see no problem with securitizing risk IF the entity accepting the risk is actually going to be capable of keeping its promises when the crunch comes. But if the entity that issues, say, CDSes can simply shrug and claim the protection of bankruptcy laws, then there is no reason for that entity to be trustworthy and no reason for anyone to buy CDSes.

This problem is why insurance companies are regulated.

I see only two ways to keep the crisis of 2008 from happening again. Either define all insurance-like products as insurance policies, subjecting them to insurance regulations; or ban all corporations and similar limited-liability entities from the derivatives markets, so that the person offering these dubious “guarantees” stands to lose his own home and life savings if he blows yours.

Norman Pfyster May 20, 2012 at 1:03 pm

Insurance companies go insolvent, too. You can’t regulate against taking too much risk (put another way, insurance capital is risk-based, but it’s built around the probability of an event occurring and regulators aren’t any better at guessing when catastrophes occur than anyone else).

In many respects, counterparty protection that evolved in the derivatives market is more protective of creditors than in the insurance industry. The systemic problem is that those protections can create liquidity issues for the lenders/protection sellers that simply don’t exist in the insurance industry.

Ricardo May 20, 2012 at 3:20 am

“One could make a cogent argument that the innovations have become so complicated that nonfinancial risks such as operational risk, model risk, and sovereign risk have more than offset the gains.”

Well, yes, this is precisely the argument I and others are advancing. You may not think the particular form of the argument is “cogent” enough but this is the comments section of a blog and not an academic seminar. You could start with Gary Gorton’s articles on the financial crisis, for instance. I don’t see you engaging with these ideas, though.

John B May 19, 2012 at 10:50 am

To my mind, the fact that some of the supply of capital was foreign is not particularly relevant. Instead, I hold that the important facts are that (a) individual suppliers of capital were large; and (b) risk averse. That characterisation therefore includes, at a minimum, large corporations (Apple) and the “cash” portion of pension/retirement funds in addition to foreign suppliers.

Whoever the supplier, that they were large meant that they could not hope to make use of the FDIC’s deposit guarantee and so went to their (investment) bankers and asked what high-liquidity, guarantee-backed (i.e. collateralised) assets were available.

Those bankers did what any sensible business person would do: they tried to help meet that demand.

Willitts May 19, 2012 at 12:55 pm

I get your point that the nationality of the suppliers of capital is irrelevant, but the fact that it was foreign capital is not irrelevant. Those dollar reserves were built up through our trade deficit, and the dollars had to come back home somehow – either through purchases of American goods or purchases of American assets. Otherwise, those dollars are nothing but useless, worthless, green pieces of paper.

The global capital glut appears to have been a significant factor in asset bubbles in several countries.

CPV May 19, 2012 at 10:55 am

I would add that unless one has worked on Wall Street, one is not remotely qualified to comment on the issues raised in this posting. Academics in particular have shown a real naivete in analyzing the functions of the Street. There is also the inconvenient truth that almost all finance professors make most of there income (many times their salary) from consulting for the “financial industry”, or run their own investment firms, hedge funds, etc.

A1 May 19, 2012 at 11:43 am

Right, and the naive child should not have shouted that the ‘emperor has no clothes on’

Willitts May 19, 2012 at 1:19 pm

You do realize that’s a work of fiction?

Greg G May 19, 2012 at 12:17 pm

CPV, So you believe that “unless one has worked on Wall Street, one is not remotely qualified to comment on the issues raised in this posting.”

I think you will find that argument sold better before those who worked on Wall Street blew up the economy. Do you also believe that unless one has been in the military they should have no voice in whether or not we go to war? I favor civilian control of the military and of Wall Street. If you do something that puts us all at risk we should all get a voice.

Fool me once, shame on you. Fool me twice, shame on me.

Norman Pfyster May 19, 2012 at 1:05 pm

Banks are heavily regulated and the government controls the money supply: how much more civilian control did you have in mind?

Greg G May 19, 2012 at 1:25 pm

“how much more civilian control did you have in mind?”

Enough for everyone to be clear that this is and should be a matter where the qualifications to comment are not limited to those who have worked on Wall Street.

Willitts May 19, 2012 at 1:34 pm

You and everyone else clearly has the right to comment.

His point is whether your comments are meaningful or merely noises you make with your throat.

If you don’t understand even the basics of finance, then you are unqualified to have an informed opinion. Policies made without informed opinions often, almost as a rule, have unintended consequences.

If the US experiences a tremendous surge in traffic-related deaths, I have a policy that can solve it: a zero mile per hour speed limit.

Do you foresee any problems with this completely effective yet naive policy prescription?

Greg G May 19, 2012 at 4:38 pm

Willetts, Yes I did understand that CPV was not challenging my right to comment. That is why I never complained that my rights were being violated. So let’s dispense with that red herring.

I was hoping that the quality of my comments, not the contingencies of my work history, might determine whether or not I was “remotely qualified to comment.”

Clearly I have failed CPV’s test of needing to have “worked on Wall Street.” Whether or not you will find me worthy remains to be seen. I remain hopeful but expect to soldier on either way.

I will be happy to oppose anyone who seeks a zero mile per hour speed limit or a financial system with zero risk. Please alert me if you ever find such a person. We will join forces and crush them.

The Original D May 19, 2012 at 6:08 pm

Interesting that Goldman Sachs only chose to become a bank holding company — and thus more regulation — after the shit hit the fan.

Willitts May 19, 2012 at 9:56 pm

@Greg G

The argument is that not only must you have industry-specific knowledge, actually working in the industry separates the book lernin’ from how things operate in the real world.

A finance major at a decent university might be able to understand the parlance, but he doesn’t have the experience of trading in the market. That’s CPV’s point. Work history matters which is why employers look at both your transcripts and your resume.

One can demonstrate a basic understanding and even a strong interest in the outcomes, but still not grok it well enough to be critical. You can join in the conversation, but certainly don’t try to speak from authority.

I’ve been working in finance for a very long time, and I don’t have the knowledge or experience to be a risk manager for a large Wall Street bank. Let’s just say I know what I don’t know. That’s why I’m not quick to judge people in the shoes of Jamie Dimon or Ina Drew. I would fail CPV’s test.

I’m a law school graduate, and I don’t even profess to know much about law anymore outside my narrow field. Always in motion, the law is.

Willitts May 19, 2012 at 1:28 pm

Those who worked on Wall Street didn’t blow up the economy.

Countrywide was not on Wall Street
IndyMac was not on Wall Street
Wachovia was not on Wall Street
Washington Mutual was not on Wall Street
Hundreds of problem and failed banks were not on Wall Street
Millions of home owners who defaulted on loans they couldn’t afford did not live on Wall Street
Their realtors and mortgage brokers did not work on Wall Street
The real estate developers were not on Wall Street
The surplus reserves searching for yield did not come from Wall Street
Fannie Mae and Freddie Mac were not on Wall Street
Congress and the president were not on Wall Street

Your analogy with war is inapt. The better analogy would be that unless you have been in the military you should have no voice on matters of military strategy and tactics.

Greg G May 19, 2012 at 1:43 pm

Willetts, I was using the phrase “those who worked on Wall Street” as a figure of speech to refer to the financial sector in general not merely those who literally worked on Wall Street. And the financial sector in general was the topic of Tyler’s original post. Maybe I should have been clearer.

Before the crash I actually was inclined to accept the claims of those who said “We are the financial experts. Leave this stuff to us because we understand it.”

Now, not so much.

Willitts May 19, 2012 at 2:02 pm

The problem is that your “figure of speech” has been taken far too literally. Too many fingers have been pointed toward a location in lower Manhattan instead of the carpenter living to your right, the mortgage broker living to your left, and you living in your McMansion.

Before the plane crashed, you were actually inclined to accept the claims of pilots, aircraft mechanics, air traffic controllers and the FAA who said, “We are the flying experts. Leave this stuff to us because we understand it. So sit down, shut up, relax and enjoy your flight.”

It wasn’t financial innovation that caused this recent crisis and financial services were only part of the story behind it.

Ricardo May 19, 2012 at 1:44 pm

So an investment banker has a one-night stand with a woman and gives her an STD. Since the woman did not insist on a condom, the banker had nothing to do with the woman being infected, right?

Bear Stearns was one of the largest purchasers of Countrywide mortgages and Bear Stearns was on Wall Street. Were Wall Street firms solely and 100% responsible for the crisis? No, and thanks for putting that strawman out of commission.

Willitts May 19, 2012 at 2:16 pm

Fannie Mae and Freddie Mac were, by far, THE largest purchasers of Countrywide mortgages, and neither of them was on Wall Street. It was the federal government that was subsidizing these mortgages by giving Fannie and Freddie affordable housing credits and by adding liquidity into the housing market.

It’s not a straw man, Ricardo, when “Wall Street” is belched out by every political opportunist in America. It would actually be novel if someone started blaming Main Street for the crisis. The bottom line is that without some middle-class couple on Main Street scrawling their signatures on a mortgage, there would be no developer building a house, there would be no increase in bank assets and leverage, there would be no increase in MBS volumes, there would be no credit default swaps, and there would be no derivative hedges to risk exposures.

Do we blame supply or demand? Well, when the demanders are squealing like stuck pigs, then I’m inclined to blame them for their own stupidity. I can, as an objective observer, assign blame to the suppliers for their role without diminishing the blame on the other parties. Blame doesn’t exist in finite quantities that must be apportioned to 1.

I hate the use of analogies, and yours falls prey to the usual fallacies. Yes, indeed, the woman is 100% responsible for her STD. Why? 1) because she had the means to avoid it through multiple means, and 2) blame and responsibility is not something that needs to be apportioned; both parties are responsible for the negative outcome.

And where did the “investment banker” in your analogy get his STD? From a different woman. So the woman can blame the other woman. The “investment banker” just got seduced by these two sluts. :)

Greg G May 19, 2012 at 2:37 pm

Willetts, As usual, you argue well but continue to make excuses for the financial industry and always paint the banker as the victim. Certainly many others outside the financial industry behaved badly too but do you really want to start that list with carpenters? If you go down that road you could blame the supermarkets that sold the food that fed the carpenters.

And if you want us to take seriously your hatred of analogies you really will soon have to stop telling us how financial innovation is comparable with the discovery of electricity and air travel.

Willitts May 19, 2012 at 3:27 pm

As usual, you misinterpret my comments. I am not painting bankers are victims. I am highlighting an inconvenient truth that is all-too-often ignored in the discourse: that the people being portrayed as poster-child victims of the crisis are the victims of their own greed and stupidity.

Nearly every story I hear of people who were “victimized” in this crisis made decisions that I consider imprudent or lacking in due diligence.

I am not “starting” the list with carpenters. I bring up carpenters because people wouldn’t associate this crisis with carpenters. They were just average Joes who were paid to build houses, and they were happy to collect overtime pay for several years. And when home building collapsed and they were out of work, and they defaulted on their own mortgage payments, the common narrative is that a tear must roll down our cheek in sympathy. To Hell with that.

I work in finance, and a lot of people I know are out of work. We all knew or should have known that we are in a cyclical industry. We all know or should have known that the fat bonuses we got during the boom were just an advance on future pay. I could say I’m one of the lucky ones, but I work for a firm that was relatively conservative and I manage accounts and provide services for people who are relatively conservative investors. Me and my clients fit the profile of someone who could weather this storm. None of us got rich, but none of us suffered terrible losses either.

No, you cannot blame the supermarkets who sold food to the carpenters. Supermarkets aren’t as prone to business cycles as the construction industry. Groceries are nondurable and houses are durable. Consumers don’t need a lot of debt to finance grocery purchases, but consumers do need debt to purchase a house. The grocer needs only short-term financing to stock his shelves, while the developer needs longer-term financing to build his housing development. The grocer doesn’t put himself out of work next year because he sold lots of groceries this year. In contrast, the carpenter who built lots of houses this year DOES put himself out of work in the future. See, you have absolutely no understanding of factor sensitivities!

Analogies that are transformed into metaphors are suspect. Referring to STDs, as Ricardo did, to discuss financial risks is beyond the pale. Comparing financial innovation to technological innovation in order to recognize that innovation is often risky in its infancy and beneficial in the long run is perfectly appropriate.

Greg G May 19, 2012 at 4:52 pm

Willetts, I do not dispute that there were many miscreants outside the financial industry. Your original reference to carpenters did not contain the information that you were referring to a carpenter who defaulted on his mortgage. I’ll bet most carpenter’s didn’t default on their mortgages.

My “McMansion” is the same house I bought in 1978 and fully paid off in 1998.

I’m sure I don’t understand yet which analogies are permissible.

The Original D May 19, 2012 at 6:11 pm

Yes, there is blame to go around, but surely you don’t think the dumbass who got in over his head with a mortgage has the exact same liability as the guy who sold a thousand dumbasses mortgages and took a commission?

Norman Pfyster May 19, 2012 at 6:41 pm

The idea that some could be liable for lending someone money when requested is rather odd. After all, the lender has already performed its side of the bargain…it gave the borrower the money. You can argue that the terms of the repayment need to be fair (thus laws against loan sharps and usury laws), but the party that is injured when a lender lends money to dumbasses is the lender.

I bought a house at the peak of the real estate market. I lost a bunch of money when I had to sell it for less than I purchased it. I never blamed the bank for lending me the money to buy the house in the first place.

The Original D May 19, 2012 at 8:02 pm

…the party that is injured when a lender lends money to dumbasses is the lender

Except that in the case of banks the losses extended to the taxpayer. And again, the guy who authorized the loans made his commission regardless. Principal-agent problem writ large. Angelo Mozilo still got rich even though he ran his company into the ground. Even after all the fines for insider trading and whatnot, Mozilo still took home hundreds of millions of dollars.

That’s why we have banking regulation.

Willitts May 19, 2012 at 10:12 pm

Greg, Norman, Original D:

When I find myself in total agreement with all of the responses, I realize that my further contribution is not necessary.

Greg, all analogies are suspect. I consider an analogy useful when their is no exact precedent. The risks of emerging physical technologies may be completely different from the risks from emerging financial technologies (life and limb versus financial), but the emotional reaction to the innovations are very similar.

msgkings May 21, 2012 at 4:51 pm

This is the best comments thread on MR in many weeks. And a special standing ovation to Willitts…

Mike in Qingdao May 19, 2012 at 12:24 pm

It seems to me that the finance industry mainly exists to exploit principal agent problems within institutional investors. By manufacturing the AAA imprimatur, Wall Street banks give the “I’ll be gone you’ll be gone” employees a fig leaf to hide behind in the unlikely event that any financial professional anywhere is ever accountable for their actions.

Patrick R. Sullivan May 19, 2012 at 1:07 pm

‘So far I find parts of this book brilliant and other parts dead wrong.’

That’s been my reaction to his numerous appearances on television too. He’s a really smart guy, but he isn’t as well informed as he should be to have written a book that claims to know so much economics.

CPV May 19, 2012 at 2:49 pm

My point isn’t that people without Wall Street experience are too critical. It’s that they have no idea how the game is actually played and frequently miss the point. A good place to start is to look at exactly how money is being made, from which counterparties, and what the real source of that money is – ie who really pays. Follow the money. Endless intellectualizing about risk transfer is not going to be illuminating.

duncan May 19, 2012 at 11:44 pm

This qoute makes a big assumption that “risk” is a definable and consistent. Is is variance, fat tails, value at risk, max possibile loss. At the very best risk is some probabiltiy or outcomes. It is nebulous and can’t be traded and shifted around like pork bellies.

The Keystone Garter May 20, 2012 at 7:17 pm

Ugh, repetitive motion mind injuries happening to me.

Banks provide jobs with loans to companies. These loans also enable banks to exist as workers and employers use financial services. If the banks are taking risks that either cause employers/workers not to use financial services, they will kill themselves. Putting people in personal financial debt by selling them too expensive homes, started the bank’s suicide. It is pretty simple to match financial services to consumer incomes. If bank don’t or likely won’t act to make this match, regulation is in order.

The Keystone Garter May 20, 2012 at 7:21 pm

Limiting all finance industry compensation to $1M/yr would solve this. You lose really good ROIs but you also get middle/poor represented as banking employees, and you lose the leverage piled on leverage gobbledy-goop. Tangible non-WMD goods R+D and maybe software R+D should be rewarded in America, at present finance industry compensation rates.

The Keystone Garter May 20, 2012 at 8:03 pm

To be more specific, right now the goal of the finance industry is to maximize immediate sales. It should be, if you want quality-of-life, to sell the optimal amount of financial services to worker clients that gets them some ratio of maximized aggregate income over the mortgage lifetime, and also preference to stable income stream. For employers, maximize sales over the lifetime of the capital (say, copper doorknobs) that is being sought.

Recessions happen every 8 or 9 nine years. So your get 3 of them over a 25 year repayment schedule. That means 3/5 of 5 yr mortgages would reset at a higher interest rate. That means you either sell cheaper homes than owner can presently afford, or you make them increase savings rate.

Banking is easy. Deprogramming is hard.

The Keystone Garter May 20, 2012 at 10:20 pm

What happens is finance funds Senators, Congressman, and Presidents, to give bailouts as an election condition and you get fewer imports and government services (IDK what those are in USA) when the bailouts happen. Still, decent chance of mortgage reseting higher.
If you index bank compensation to American longevity gains, and to non-WMD R+D, that probably covers about 2/3s of what Q-of-L is. All of a sudden you’d get banks fighting the NRA, fighting coal companies, fighting health insurers, fighting for education funding and universal healthcare or a swiss model or something….
A recession kills you if you are a bank, unless your nation bails you out of any crime. Then you want a recession. You want enough leverage interactions of enough different types, that it gives even the best of us a repetitive motion mind injury.

The Keystone Garter May 20, 2012 at 10:27 pm

I saw the episode where the investment banker funded the bioterrorist and Columbian drug kingpin, then framed his honest partner. He slept with his boss’s at-risk teenage niece and turned into a fruit to close a deal. That guy blew up a USA Army Base in his youth. He’s nailing the most beautiful blonde cop as a reward.
In Canada we were warned about ABCP.

Brian Gaerity May 21, 2012 at 10:23 am

Just want to say thanks to Norman Pfyster and Willitts for their extraordinary comments and explanations, in particular your deconstruction of risk management. You both should teach. Lord knows we all need a better understanding of finance, if for no other reason than to ensure our elected officials are endorsing sound policies. My limited understanding of finance and the crisis aligns exactly with yours. (Although I strongly object to Willitts’ use of “slut” to describe a woman with an STD, or even to one who has one-night stands. It’s a meaningless pejorative, equivalent to using “evil” to describe bankers who take risks and lose.)

I’ve never bought into the “evil Wall Street” or “Las Vegas” metaphors — it’s one of only a few criticisms I have of Obama (yeah, I’m a Democrat). I thought the “Salem witch trial” the Congressional Democrats held for AIG executives was just insane. Even really smart Democrats seem to fundamentally misunderstand finance. It is one of the party’s biggest weaknesses.

One question: Back in 2008 when the crisis broke (i.e., when the “run on the bank” hit), I think I remember that trading stopped on CDOs because no one could figure what the right market price was for them. If there truly was no opacity in these derivatives (i.e., traders understood the risk and how that risk was calculated), why was there so much confusion about pricing?

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