Wednesday, January 27, 2010

Who is To Blame?

Although it’s fun to vilify bankers, the truth is that there are many people whose interactions helped contribute to the financial crisis. People want to treat finance like physics, but it’s much more like biology. As Richard Bookstaber points out in his excellent A Demon of Our Own Design, the financial system is similar to a complex ecosystem—a minor event in one part of the world can eventually move through the system and lead to a major blow-up in another.

Unfortunately, many of the people within the system have incentives that are not aligned with the economy’s greater good. In a vacuum, many of these actors may believe there is nothing wrong with acting in their own self-interest. But when these actions are combined, the result can be disastrous.

These actors include:

Investment Banks: Salesmen have an incentive to sell products to clients (even if inappropriate for that client), traders have incentives to take risks, investment bankers have incentives to create bigger and bigger deals, etc. Not spending too much time on it because you’ve heard this all before.

Institutional Investors: Often, they are judged by relative, rather than absolute, performance. Even if a fund manager believes buying a CDO, for instance, is a bad idea in the long-term, he might need to buy them now or risk being outperformed by competitors (which would lead to funds flowing out of his funds and into the better performing ones). And even if the CDOs eventually do blow up, he can simply point to these other funds to show he shouldn’t be blamed—“no one else saw it coming, either”. As long as he does no worse than his competitors, he’s not in bad shape. This “Keeping Up With The Joneses” mentality can increase demand for products (whether CDOs or tech IPOs) from investment banks, whether or not the investments are sound.

Monoline Insurers and AIG
: They were paid for taking on risk—not surprisingly, they took on a lot of it. They’re willingness to insure many of the structured finance products allowed many of the deals to be workable (on paper, at least) for the banks. No doubt this helped drive the issuance of these products.

Rating Agencies: They are paid by the issuers of the securities, so they have an incentive to give better ratings (even if they claim they aren’t influenced by it). You’ve heard of the we’d- rate-these-if-they-were-structured-by-cows fiasco. But they also have an incentive not to look too foolish. Once they began actually downgrading the structured finance instruments and the insurers, it led to a downward spiral across the financial system.

Mortgage Originators: They were paid for making mortgages and, thanks to securitization, did not need to worry about the risks. Not surprisingly, they sold as many mortgages as they could, some resorting to boiler-room tactics including misrepresentation and fraud. They clearly did not have the best interests of the client in mind.

Regulatory Agencies: Some of them are funded by the people they regulate, so they have incentives to race-to-the-bottom when it comes to regulations. They also might have incentives to govern by rules rather than standards—easier to administrate, but also creating a demand regulatory arbitrage (triple-A requirements led to demand for the insurers). A cynic might also suggest that the regulators themselves have incentives not to question the people the regulate too much for fear of losing future employment opportunities when they move to the private sector.

Politicians: Obviously, “increasing homeownership” is a pretty good platform for both parties. Unfortunately, it leads to the creation of policies that allow many of these other actors to do bad things.

Homeowners: If they weren’t willing to trust financial professionals and take out mortgages, the investment banks couldn’t have created quite as many products (although, of course, many of the more complicated products were synthetic and, therefore, did not require actual mortgages).

A simple list that can go on and on.

The bigger point of this is that reforming the financial system requires more than just taking on banks on a few issues--it will require an extraordinary overhaul.

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