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Is the American economy taking too much risk?
As usual James Surowiecki has an excellent piece. Excerpt:
Fund managers get bonuses at the end of each year, and they keep those performance fees even if the fund eventually goes south. So if a billion-dollar hedge fund rises twenty per cent in its first year and falls twenty per cent in its second, its investors will have lost money, while the fund’s manager might earn forty million dollars in performance fees. Hedge funds do have a rule that’s meant to deal with this problem: when a fund loses money, it yields no performance bonus until investors get back to even. The catch is that nothing prevents a hedge-fund manager from simply shutting down after a bad year and walking away with the fees he’s already accrued...Because fund managers reap large rewards on the upside without a correspondingly punitive downside, they have a much greater incentive to take big risks than ordinary investors do.
Managers, or for that matter ordinary investors, may not under normal conditions have enough incentives to take risk. Remember the Kenneth Arrow argument that not all private financial risks amount to equivalent social risks? Who cares if you lose money, provided that no real resources have been destroyed? Yet a risk that pays off, say with a new product, does not in general return the entire social value of that product to the entrepreneur.
With hedge funds, are we now above or below the optimal amount of risk? The answer of course is "we are taking the wrong kinds of risk." We are finding more and more ways to (implicitly) write naked puts in highly leveraged forms. Yes this has brought us new products but it all seems to be new mortgage products. Could those products possibly justify the financial carnage we have seen? That is the critical question but I suspect the answer is "no," that in this sphere we stepped beyond the bound of optimal risk-taking.
The junk bond revolution of the 1980s involved some "excess" risk-taking, but I believe those risks were more closely connected to the real economy, and more likely to bring real economy benefits, than the recent spate of mortgage-related risks.
Posted by Tyler Cowen on November 9, 2007 at 04:12 AM in Economics | Permalink
Comments
Okay, something puzzles me.
Last time I looked at a mutual fund, I looked at the cheapest set of fees, and worked out that if I invested $10,000, after the fees were accounted for the fund would have to make a return of 6.3% (nominal) in order to make as much money for me in the first year as if I'd just stashed the $10,000 under my mattress. Which means I would have lost about 2% to 3% of the value of my $10,000 in real terms by the end of the year.
6.3% was on the high end of their nominal rates of return over the last five years.
My calculation of course ignored the risks of my mattress being burgled. But it also ignored the risk of someone embezzling the fund.
Keeping the money in the bank was a far better deal.
Why does anyone invest in these funds?
Posted by: Tracy W at Nov 9, 2007 6:59:35 AM
An excellent explanation, Prof Cowen.
I will add that the junk bond revolution looks better as more and more years pass. Probably some kind of reversion to the mean. Even George W Bush will be recalled with nostalgia 15 years from now.
We have to give this present crisis a few years to play out before we can make any judgements.My
guess is that the CDO type strcutures are here to stay and are essentially 80's style mortgage
securitization on steroids. The benefit of all financial innovation is driven ultimately not by
how much yield it can generate but how effeciently it can allocate risk across the system. FOr
efficient ex-ante risk allocation people have to know what they are buying(ratings agencies
should have done a better job here). That tells me that most financial innvoation is not in
finance at all but elsewhere, like FICO scores, home appraisal, and various othre standardized
forms of snaphot risk measures which allow large scale financial transactions. It is possible to
over-trust these measures but the alternative is poorer risk allocation.
Posted by: sa at Nov 9, 2007 7:15:12 AM
Tracy W.,
You should revisit your calculations. Many funds have fees well under 1%, and index funds can be in the neighborhood of .25% or less.
Posted by: Bernard Yomtov at Nov 9, 2007 7:58:20 AM
Kind of a terrible article that makes it seem as if 100% of hedge funds (I will get to mutual funds in a moment) have lost money. Some have, but many have not. In fact many have done quite well. The same goes for mutual funds and traditional separate accounts, which have far more assets than hedge funds do. Plenty of funds have excellent 5 and 10 year records right now, many without taking any unusual risk.
Posted by: mcwop at Nov 9, 2007 8:01:22 AM
Tracy W - those were the cheapest funds you could find?
Your last point is a good one - nobody should ever invest in those funds. But my question to you is, have you ever looked at Vanguard?
Posted by: Independent George at Nov 9, 2007 9:33:09 AM
Oops, that link was supposed to take you to the fees page.
Posted by: Independent George at Nov 9, 2007 9:37:20 AM
If hedge fund activity does not, in the aggregate, produce anything of social value -- as you claim -- it would
have to at some point revert to below-normal returns. In fact, this is exactly what I believe, and the
only way to check it would be to look up average H/F returns. These statistics do not exist, but the
closest approximations (which you posted about a few months ago) say they do underperform, at least once
fees are taken into account.
So, H/Fs seem to be just a giant vehicle for giving away money to other people.
One more thing: Yet a risk that pays off, say with a new product, does not in general return the entire social value of that product to the entrepreneur.
Nor would we want that! That would mean innovation is no longer a social good!
Posted by: Person at Nov 9, 2007 9:57:42 AM
The S&L crisis was about deregulation where firms had incentives to take risk but still had government backing for failure. Of course S&L's took too many risks. That was then, what about now.
If hedge fund manager compensation is out of whack with long term performance, then consumers should be less willing to pay high fees. Unless the consumer has no interest in the long term performance and is only trying to consistently surf the next hot wave. Then you are paying a premium and taking a greater risk to beat the market over some relatively brief period. In the long run, with market improvements, the hedge fund's risk adjusted rate of return should equal the greater market rate of return.
Sub-prime loans have some problems. Mortgage failures and foreclosure have a negative externality on communities. If a home near you goes into foreclosure your home can drop 10%. The damage to a local community can be severe.
Next, the originator of the loans has incentives to hide the real risk of the loan. Much like the seller of a used car, the sub-prime mortgage originator has an incentive to get the deal done and worry about problems later. But the market assumes that the used car seller may be hiding defects and the market will adjust the price they are willing to pay downward. With the sub-prime loans, investors did not price in the risk they were taking. Why? Was it mass stupidity? Was it false signals from the rating agencies? Were so many people making money from the system that even those who knew they were playing a game of hot potato just thought it was worth the risk to them, even if bad for the broader market.
Posted by: DanC at Nov 9, 2007 10:00:07 AM
Tracy W, you need some help. I strongly second the Vanguard recommendation.
On risk: Tyler's clearly on the right track in terms of looking at various incentives. There seems to be considerable widespread carnage from the US mortgage boom of the past few years, and this carnage extends to a variety of surprising areas. Why, for example, are banks in the UK at serious risk from their investments in US mortgages?
Some questions that might be asked:
1. Do financial managers really have good models of risk? Or do they just think we do? (insert obligatory "Black Swan" reference here)
2. Is there some fundamentally bad assumption that was made here? For example, if the probability of failure of loan A is 5%, and loan B is 10%, the joint failure is .5% -- IF they are independent. But CDO's made up of mortgages aren't independent (surely I don't have to explain why here). Did they underestimate the covariance? That's what I mean by a fundamentally bad assumption.
3. Are these financial packages really offloading risk / spreading risk around / diversifying, or are they creating a large Rube Goldberg structure in which we aren't lowering risk by diversifying it, but creating so many connections that a "margin call" creates an overall risk of crashing.
4. Citi seems to be in trouble in commercial paper for lending out long term but borrowing short term. Isn't that a pretty basic error? Isn't that fundamentally what happened to many S&L's only a couple of decades ago?
5. Why do we allow companies to keep so much "off-book" that clearly creates obligations (Enron, Citi)? Is a large part of the problem one of transparency?
6. Do the rating agencies (Moody's, etc) really understand risk? Are there good statistics about how good they are?
I'm at risk of getting to the "foaming at the mouth" stage and don't want to hijack the discussion. I've provided a blog link above which is available to anyone who wants to flame me directly ;)
Posted by: ZBicyclist at Nov 9, 2007 10:07:20 AM
Maybe investors of hedge funds are writing naked puts by way of the managers' incentive pay, but this is common knowledge ex ante and investors should be pricing that into their decision.
Many other trading houses employ the same unbalanced method of bonus.
I think that they do create a positive externality of liquidity for the market. (Ameranth maybe went belly-up and cost investors a couple billion, but anyone who wanted to hedge natural gas for long-dated terms found a nice tight market to trade against with them.)
Posted by: Nate at Nov 9, 2007 10:15:27 AM
Hedge funds have always had asymetric risk reward profiles. The greater the leverage, the greater the return almost assured to the managers while risk increases exponentially to the investors.
Used to be there was a hurdle rate - say the risk free rate at worst, or some market index - that had to be met before the 20% of profit incentive kicked in. Fund managers found it was too hard to make enough profit so these have largely vanished. We are left with high water marks. But typically when a fund loses a lot of money it has to close. The "talent" is paid largely on the 20% and if it going to take 2-3 years to get back over the high water mark, they just depart for other firms. Solution is to close up and start again with a new fund. Survivorship bias in the stats of the hedge fund world is rampant.
Posted by: martin at Nov 9, 2007 11:20:05 AM
Regarding ZBicyclist's point 4 above: the financial services sector exists in order to borrower short and lend long. The (non-financial) business and household sector, in the aggregate, want to borrow long (home mortgages, corporate bonds) and lend short (checking accounts, CDs, etc.). It doesn't make sense to criticize the financial services sector, therefore, for the basic enterprise of borrowing short and lending long, although one can criticize a particular structure as being imprudent.
Posted by: y81 at Nov 9, 2007 11:24:04 AM
Running a HF can be incredibly profitable, and a down 20% year does significant damage to the value of that franchise. Brian Hunter may have come out ahead for his nat-gas shenanigans, but his boss who was running a $10B hedge fund that went away surely did not.
Posted by: fmb at Nov 9, 2007 11:24:50 AM
ZBicyclist:
1. From what I've seen the modelers do have pretty good models of risk, the problem is usually that senior management doesn't always understand (or pay attention to them). Not in every case, but in more than I'd care to count.
2. I'd say it's likely to be massive underestimation of the covariance of loans failing. Keep in mind that historically defaults were regional and mostly due to structural changes in the economy not the result of a tax break induced national housing price increase.
Also, the other big shift between previous credit crunches and this one is that accounting rules require much earlier reflection of likely losses (mark to market rather than provisioning). Almost no bank has had actual defaults that are even up to normal levels yet (only on certain vintages), but any fool can guess where the default line is headed so the prices move down pretty dramatically. This appears to lead to deeper (ideally shorter) credit busts, but you have to survive the depth first.
3. They did a good job of spreading risk around, but they also do a very good job of hiding who has it. So no one wants to make safe loans either. A credit crunch is a lot like a big festival that had lots of short relationships forming and ending, when suddenly an announcement was made (X people have AIDS) so the party stops but no one gets tested (there's no annonymous testing) so everyone is waiting for symptoms to start showing. New financial products make it easier to hide risky behavior.
4. It's a little different. The S&Ls got burned when rates moved (because they'd locked in their revenues but not their interest expenses) Citi's SIVs were hedged against that, but after the above scenario, they can't get commercial paper to replace the paper that is expiring. Because people believe there is a high enough chance of failure that they don't want to just earn 30 day, tight credit spread returns if there's any risk of default.
5. Because anything that you can keep off the book but earn any sort of spread on, greatly boosts management performance metrics. Take two computer companies, HP and Dell. Have one design and build some components in big factories, and the other assemple subsystems built by other (private or foreign) firms. Both sell a computer for a 10% mark up, but one has $20 Bn in assets and the other $5 (mostly cash). For the last decade investors decided the latter was "innovative" and rewarded management with double the valuation (for the same earnings), banks saw this discrepency and adjusted.
6. Probably, but they provide basically the service of being yes men to both sides. What caused a decent portion fo the problem was that there are lots of pension funds that had restrictions on nominal credit quality of assets they could own, but needed to earn returns of much lower quality assets, and there were lots of managers who becuase of the incentives above wanted to write puts/insurance on pretty much anything they could. Put those together and you have the incentives to create the CDO market we had.
I don't think securitization will be going away anytime soon, but it's likely that there will be substantial consolidation of the support tranche industry. It was the emergence of very diverse low quality/low capital insurers (hedge funds) that underpriced too much risk. This is why Buffett continues to state his dislike of derivatives while operating a company that does little more than write derivatives. Buffett really doesn't care for undercapitalized competition (they tend to depress margins).
Posted by: nelsonal at Nov 9, 2007 11:31:44 AM
Something that many people (and worried regulators) seem to overlook, or not realize, is that derivatives don't add any risk overall, and they don't decrease risk overall, they merely repackage it and disperse it from agents who presumably have too much risk towards agents who presumably have too little risk. In this model derivatives are unequivocally a good thing because they enable new wealth creation devices (e.g. new firms, or new "greenfield" investments by existing firms, or the ability of individuals to take on a higher paying job that is riskier thanks to insurance) by previously "underrisked" agents.
As a basic example of spreading around existing risk, imagine Andy, Bob, and Charlie. Andy is a recent GMU grad who also just inherited $1 million from a recently deceased grandparent. Bob is 50 and owns and runs his own business, Bob's Bakery, which is worth $1 million. Charlie is 65 and owns and runs his own business, Charlie's Cheese Shop, which is worth $1 million.
Andy has parked his new cash in 11 different FDIC insured banks until he can find something more sophisticated to do with it, and he has the brain and education to in fact do something more sophisticated. Bob is looking to either expand his business, or buy another business on top of his own. Charlie wants to retire and doesn't want the hassle nor the risk associated with owning a business.
Andy lends Bob $1 million to buy Charlie's Cheese Shop, which he then indeed buys and merges with Bob's Bakery. Charlie puts his $1 million into 11 FDIC banks ($100,000 is the insured limit per individual per bank), coincidentally the same 11 banks that Andy had his money in. No new wealth has been created (yet anyway) and no new risk (overall) has been created.
Worried minds though will say "wait a minute, there is $1 million in new debt, and without any new wealth creation going with that debt, how can you say there is no new risk? This is horrible, quick, somebody pass a law!" What these worried minds are missing is that the new debt creation does not in this instance mean new risk creation. What the above 3-way transaction accomplished was to take the risk away from Charlie, and redistribute it to Andy and Bob. Bob takes the first $1 million of risk of the new combined company, and Andy takes the second $1 million of risk. Before the 3-way transaction there was $2 million worth of risk amongst the three of them (assuming for convenience sake that the FDIC deposits are risk free, noting that there is no such thing as free risk....), and after the transaction there was $2 million worth of risk.
Hence in that example the worried minds are worrying for no reason whatsoever, and if they do in fact manage to pass their idiotic law society will definitely be worse off as a result.
Now for an example of added risk. Keep Andy and Bob with the same profiles pretransaction from above, and ignore Charlie. Andy lends Bob $1 million to expand Bob's Bakery, opening up a new location, thus leveraging (they both hope anyway) Bob's skill and Bob's Bakery reputation. Now there is a new $1 million of debt, but even now this $1 million of debt doesn't represent new risk. It is the creation of the second store which is new risk. The debt represents the dispersion of this risk, with Bob again taking on the first million of risk and Andy taking on the second million of risk.
The new risk is the newly created equity (which was then dispersed), yet somehow worried regulators don't freak out over the massive venture capital explosion that has taken place since the late 70's when the capital gains tax was dramatically slashed. Instead worried regulators freak out over the dispersion of the new risk that transfers the already existing risk from those with "too much risk" to those with "too little risk".
If Andy and Bob have both done their due diligence then society comes out ahead taking into account the risk/reward ratio, even if the company goes bust. This is because in the long run, spread across many such open eyed "risk taking wealth creators", there will indeed be a net new creation of risk.
In the case of the subprime mortgage morass, one of two things happened. First, not enough people did their due diligence and we have an example of mass hysteria. In the second possibility the new loans made sense on a risk/reward ratio basis, but this was the 1 time in 36 that the dice came up snake eyes and the risk didn't pay off.
I lean toward (heavily tilt is more accurate) the former explanation. In either case, the problem was not the derivatives (i.e. the dispersion of risk), but rather the problem was the failed investments underlying the derivatives. Derivatives are a bogeyman made up by people who aren't (or weren't) paying close enough attention. The real bogeymen are the long list of people who needed to go brain dead at the same time and thus turn wealth into dust in order for this to eventually become a "crisis". The concept of lending to worthy home buyers without perfect credit is a sound one that puts putative home buyers with too little risk into their own homes. What it needs to be a net "good thing" though is for both the home buyers and the mortgage buyers to make sure that the home buyer on a risk/reward basis can pay back his mortgage.
Posted by: happyjuggler0 at Nov 9, 2007 11:32:01 AM
Hedge funds have been a great addition to the universe of retail investment products precisely because they cater for a different investor risk profile than tradtional funds do.
They are designed such that the managers have incentives to take a lot of risk, in the hope of securing unusually high returns for the investors. Sometimes this works, to the satisfaction of both. Sometimes it doesn't to the dissatisfaction of both. Sometimes it works for a while and then stops working, to the satisfaction of the manager but not the investor.
A person who couldn't work that out in advance should not have invested in a hedge fund. Those who could should not complain if they lost their money.
Posted by: Mark at Nov 9, 2007 1:02:03 PM
I asked a friend who is in a position to know and she reported that some well-managed investment firms use better incentive structures than a simple 2-and-20 annual bonus.
Things like managers being partially invested in their instruments (via their bonus) and multi-year averaging of returns to vest their upside comissions. I'm sure there are plenty of other tools as well to encourage a longer view among the managers.
Perhaps we hear about the spectacular flameouts only because they occur in firms that don't take adequate management precautions about the asymmetric nature of upside/downside risk, thus incentivizing behavior that leads to spectacular flameouts.
I don't know what the "right" amount of risk is, but I don't think you can ignore the fact that there seem to be persistent money-makers who live entirely in high-risk areas. I suppose the market will tell us when the aggregate performance of all high-risk funds approximates the general market/GDP growth then we are at the "right" amount of risk.
Posted by: Paul J. Reber at Nov 9, 2007 1:40:49 PM
Kenneth Arrow argument that not all private financial risks amount to equivalent social risks? Who cares if you lose money, provided that no real resources have been destroyed?
These large performance fees account for a significant portion of the increase in income inequality in the US. Could it be that the reason wages are lagging GDP growth is that GDP includes these performance fees as services, when in fact they neither add or subtract real value to the economy. Financial services account for over 20% of GDP and has been one of the strongest growing sectors for years.
Posted by: joan at Nov 9, 2007 4:50:17 PM
Returning to Cowens point; hedge fund managers have turned Arrow upside down. The private gains to the hedge fund managers is greater then the social value of their actions. The negative externalities of these sub-prime loans (like the decline in the value of housing, the temporary downturn in the economy, etc.) will be greater then any value that society received form their creation.
Worse yet, hedge fund managers get a tax break to create the chaos. I trust the market to correct for the errors in judgement. I hope the Congress increase taxes, or do away with the tax breaks, that encourages activity with, in this case, negative benefits for society.
Posted by: DanC at Nov 9, 2007 8:52:13 PM
happyjuggler's neglects that misunderstanding and therefore mispricing a risk is in itself a risk, and how do you measure that? To the extent that derivatives are widely misunderstood (and therefore mispriced), they increase risk by distributing it unpredictably. There are plenty of real uncertainties in investing without manufacturing additional risk factors by making the game more complicated.
It's very easy (and profitable) to create risk where none existed before; we call that gambling. Other forms of creating risk may be less obvious.
Posted by: Brian Slesinsky at Nov 10, 2007 12:39:49 AM
Brian Slesinsky,
You take the majority point of view, that the problem with derivatives is that they are misunderstood yet used anyway. As a practical matter this is basically almost all an increase in agent risk, not societal risk.
The point I was trying to make is that the real societal risk involves the real asset underlying the securities (e.g. the home that was mortgaged, not the mortgage; the business that was expanded, not the loan or equity that was issued that financed that expansion).
If "everyone" is systemically mispricing a set of securities, the losses accrue to those who have overpriced the issues, but there are symmetrical gains (on a dollar weighted basis, but not likely on a person to person basis) for those on the underpriced side of the trade.
The societal risk to any form of security is not the security (e.g. "junk" debt or "derivative", insert your own bogeyman here ____) itself. The reason the subprime crisis is damaging is not that some institutions stand to lose a lot of money (and already have), nor is it that some mortgage lenders go out of business with their resulting job losses, nor is it that some people will have to move from houses they putatively owned and bakc into apartments like ~30% of the US population already does. The real problem is the massive misallocation of real assets (icluding both capital and labor, not to mention time) that resulted in net wealth destruction.
People gain and lose money in the stock market all the time but economists generally don't sweat it when a multitrillion dollar stock market loses a trillion dollars here or there. So why are people so bent out of shape by the subprime morass? It is because in the stock market the losses and gains represent a repricing of what "we" think those assets are worth, and not necessarily an actual destruction (overall) of assets underlying the stock market. But the subprime morass is troubling because the plummeting prices of securites there has been a result real wealth destruction, with the real wealth destruction being the actual societal problem.
So the question comes down to this: Is the problem that collateralized debt was too hard to understand that caused the problem, or is the problem that not enough people chose to do their due diligence (i.e. their critically necessary homework) on valueing the assets and liabilities underlying the securities in question, namely the home prices and the ability of the borrowers to repay. This as opposed to their being unable to understand which the relative upside and downside of any given tranche of the underlying pool of mortgages.
I come out strongly in favor of the underlying asset/liabiity problem of course, not how it was packaged. If anyone involved (borrowers, mortgage brokers, investment bank packagers of collateralizations, mortgage insurers, and the end buyers of these products such as hedge fund managers and pension plan managers) had done their homework properly as to the value of the underlying assets and liabilities, then it really doesn't matter one bit to society if they systemically misprice the complex final security products themselves. Such mispricing of sound underlying assets would simply mean that those on one side of the trade would make more money, while those on the other side of the trade would make less money, with zero change in actual societal wealth as a result of that mispricing.
In short, it is not the CDO's and CMO's that werre mispriced that is the problem. The problem is that people who had no business buying homes got mortgages, and the latter resulted in net wealth destruction.
Think of it this way. If I buy a lemon of a used car from a used car dealership, I lose a bunch of money but the dealership gains a lot of money. Sucks for me but not for society at large which shows no net gain or loss (excepting marginal efficiency). My problem was that I didn't check out the car carefully enough, not that I bought a used car. There is nothing wrong with buying a used car, and similarly there is nothing wrong with buying CDO's. Indeed, the marketplace for used cars is itself a healthy thing that enables a more efficient distribution of cars, pairing up appropriate car with appropriate car buyer to the net gain of society as a result.
Posted by: happyjuggler0 at Nov 10, 2007 11:17:16 AM
happyjuggler0 writes: "it is not the CDO's and CMO's that werre mispriced that is the problem. The problem is that people who had no business buying homes got mortgages, and the latter resulted in net wealth destruction."
This seems a curious argument.
Sure, people who had no business buying homes got mortgages. In addition, people got stupid mortgages. OK, not stupid, maybe inappropriately structured for their financial situation.
It didn't matter to the mortgage broker, so long as these loans were good enough to sell downstream.
In fact, so long as you can act as an intermediary and the mortgage is minimally good enough to ship the risk further downstream, why should you care? There's no virtue in making the product any better than it has to be in order to be sold. And there's no virtue in pricing the product a $a when $a+x can be obtained for it.
In terms who you are selling it to -- are they exercising diligence (and is there enough transparency to allow diligence)? Or are they also thinking that they can move it downstream if it has a good Moody's rating?
My overall point here is that instruments such as CDOs, marketed in the way that they are, seem to discourage diligence.
Sure, lots of people got lots of stupid mortgages. But they had a lot of help in finding people who'd be willing to consider their mortgage a worthy investment. And the current liquidity problems aren't a result of Joe, Jane and Bill getting stupid mortgages -- they are because [to oversimplify] the financial section enabled millions of Joes, Janes and Bills.
Posted by: ZBicyclist at Nov 10, 2007 3:17:41 PM
ZBicyclist,
I made two long posts in this thread so far, so I'll try to keep this one shorter.
In my list of people who had gone brain dead (I'll add unethical as an alternative to brain dead), namely borrowers, mortgage brokers, investment bank packagers of collateralizations, mortgage insurers, and the end buyers of these products such as hedge fund managers and pension plan managers, I definitely should have added ratings agencies, and perhaps home appraisers as well.
Lots of people blamed "junk" bonds for all kinds of crap that they had nothing to do with in the 80's, and while the secondary market for them got obliterated by stupid legislation in the late 80's, it came back when the bulk of these issues came out whole and paid off their creditors in full without defaults.
These instruments (so-called junk bonds, aka high yield bonds, aka low grade bonds) are today common and uncontroversial. In my opinion the same will eventually hold true for CDO's, including collateralized subprime mortgages. The key is that as always it is buyer beware, whether the security in question is stocks, plain vanilla bonds, futures, or something more exotic. They are all economically sound and useful tools designed to match buyer and seller of a risk/reward device to the benefit of both. It is completely up to both the buyer and seller to determine the soundness of both the underlying asset and the appropriateness and price of any asset they are buying.
Finally, I will concede that there is a strong dislocation effect that is going on as well as the societal wealth destruction involved in the issuance of the underlying mortgages.
This dislocation occurred because the bubble burst, and now people have overeacted in the other direction. As a result there is less matching of appropriate buyers and sellers going on (of both labor and products and services), and thus less productive economic activity. Third parties do indeed get hurt by bubbles when they inevitably burst.
I am merely trying to point out that the notion that derivatives are a bogeyman is false. The bogeyman is a lack of due diligence. The fact that some of these securities are new doesn't excuse people from doing their homework, just the opposite in fact, one needs to put in more effort to determine if it makes sense.
Posted by: happyjuggler0 at Nov 10, 2007 4:08:51 PM
I won't dispute your argument that derivatives aren't inherently bad, in theory. Maybe in a different market they'll be fine. But I don't like blaming people for "not doing their homework" (that is, not collecting relevant information and making prudent decisions) because it means that we stop thinking about the incentives that caused people to stop doing their homework.
I think of this in terms of information flow: risk is increased by the lack of relevant information about an investment. Apparently some banks stopped even collecting the relevant information ("stated income loans"). This is like a car dealer that doesn't want to know anything more than they have to about a car they're buying, so long as it's not visible when they sell it.
The market for abstractions of risk removes the banks' incentives to collect relevant information about risk, which means that loan officers no longer ask for it, which means that naive home buyers don't think about it as much. People stopped doing their homework because nobody demanded it of them. Apparently loan officers were doing some home buyers a service by making sure they had their finances in order. Innovation in financial markets made this no longer necessary (apparently) so it disappeared.
These changes were apparently widely known in the industry, but there was an industry-wide failure to think through what issues might arise and figure out what institutional reforms were needed due to this increase in easy credit and reduction in information-collecting, before things went south. Maybe this is because too many people are in a position where it doesn't pay to collect and disclose more information.
Posted by: Brian Slesinsky at Nov 10, 2007 5:57:44 PM
Brian Slesinksy,
there was an industry-wide failure to think through what issues might arise and figure out what institutional reforms were needed due to this increase in easy credit and reduction in information-collecting, before things went south. Maybe this is because too many people are in a position where it doesn't pay to collect and disclose more information [emphasis added]
I think you and ZB may be on to something important, namely the genesis of bubbles, or at least some of them. Not the full picture of course, if only it were that easy, but perhaps part of the DNA strand of such rare but recurrent creatures.
In any bubble one can think of there seem to be "enough" people who understand that there is a bubble. The problem seems to be that there is an asymmetrical incentive structure involved that stops those who are clueless from being informed by those in the know.
One gets rich in capitalism by being the rare supplier to a surfeit of buyers, or to be a rare (and correct) buyer from a surfeit of sellers. Giving away such information, if "they" would even listen and believe you, has no "positive internalities", only positive externalities. Indeed considering opportunity cost, giving away your asymetrical information has a terrible opportunity cost for you.
Posted by: happyjuggler0 at Nov 10, 2007 10:31:08 PM
