It ain't me babe...
I am struck by how Wall Street has gotten away with magician's misdirection in bellying up to the bar to take its share of the 'credit' for the ongoing financial disaster. IF you are a banker it is the unexpected performance of the cash flows in mortgage securities. IF you are a securitizer it is the credit enhancements that did not work. If you are a credit assessor it's that these assessments were misunderstood from the beginning. You know that AAA does not equal AAA. In credit rating not only does transitivity not hold but neither does reflexive identity. To hear firms speak of it, they were just doing their jobs. No one was untoward. There was no mischief. It was unexpected. And so on... It was an act of God- although whose god we may never find out...
Moral Hazard Meets Hippocratic Oath
It has been pointed out to me that if you go to a Doctor and ask for heroin or he/she will not prescribe it. Sure they could make a lot of money writing such prescriptions for addicts. Or they could invent some reason why an applicant 'needs' it. But in the 'famous' word s of Richard Nixon...'it would be wrong.' Some stop there some go on to do it anyway. . But doctors are a special breed; they have taken an oath to do no harm.
Maybe bankers need an oath other than a hypocritical one?
Don't Fence me in...
In the past bankers were the gate-keepers for prudence. Knowing they were at risk on a loan they set clear and restrictive standards for lending. This in turn corralled the prices of the assets they lent against (houses, for example).
It will long remain a point of contention as to why banks were willing to step out from behind their shields of proof of income, their ratio of income to payments, their down payment rules and so on to take nothing but the house as collateral- something they always had anyway. Perhaps the years of a rising equity market and a market that so quickly recovered from its demise (in 1987 anyway) gave a false sense of risk and exposure. One analyst/journalist (James K Glassman) had before the Tech Bubble came opined that the Dow could soar to over 36,000 as he applied the 'P/E' ratio for bonds to stocks as he argued market stability had reached a new plateau and all old metrics for valuation would ratchet upward as a result. This sort of thinking has been there for some time and was not eradicated by the Tech wipe out.
Getting beyond this one question remains and that is WHAT NOW?
WHERE TO NOW ST PETER?
I keep folding back time to go over 'old ground' to re-explore what happened because until we know the cause we cannot propose a good solution. Markets and market players are in denial in no small part because they fear liability claims against them.
Whatever the reason denial is not helpful. I offer these observations:
1.Do-gooding is dangerous. Once rules were broken to let economically disadvantaged to 'borrow more than 100% of their home's value' in a single mortgage, the flood gate was opened. If the disadvantaged could do it or have down payments waved and income tests set aside then aren't we all 'disadvantaged' with respect to wanting to buy a home we can't afford? That was one slippery slope.
2. Policy makers must do their jobs. The SEC embarked on something called self regulation. We can call it the fox guards the hen house. Oh, but these were reformed foxes. They were vegetarian foxes. They were ethically strong. They promised to use new sophisticated technology to...yeah right. Foxes don't guard the hen house period. And as a corollary regulators must regulate.
3. Regulators too must use judgment and prudence. It goes without saying that at the Fed Greenspan's constant testimonials to de-regulate every, and any, industry contributed to all this. His own very flawed analysis that in the US nationwide house prices had not fallen was historically correct but economically flawed. I wrote several research pieces showing that real prices had fallen. While nominal prices did not fall in the severe recessions of 1973-75 and 1981-82 (or more broadly 1980-82) that was because inflation was so high in those episodes. One we reduced inflation to a 2% range the risk to nominal house prices increased sharply but the Chairman did not see it that way - or did not WANT TO SEE IT that way. Was this simply bad economics on his part or a 'damn the torpedoes full speed ahead' tact toward what he believed - misusing the 'facts' to achieve his desired objective? We will never know and Greenspan will never admit failure. So check his speeches and think for yourself on that one.
4. Assessment of technology must be thorough. In an advanced economy such as ours consider this a broad warning about which technologies seem appropriate. Technology- new investment methods, rocket science in economics, call it what you will - it failed badly: Markets 'Ten' quants 'Zero' and this is AFTER LTCM, some lesson we learned from that one, eh? One thing we NOW HAVE learned is that statistical stress tests do not replicate real life situations very well. But didn't we know that already? Don't economic (econometric) models fail to track most of what happens in recession unless you go back and refit it with hindsight? As a very oversimplified example, I refer you to the ADP survey that was such a stellar performer until recession struck. Even in the mild portion of the recession ADP failed to work. In the severe phase its results were laughably bad. Then ADP/Macroeconomic Advisors went back to work to 'fix' it. The first estimate out of the revamped framework overshot the true job losses by a mile instead of undershooting. This is typical of modeling 'X' in recession. It is not really a failing of ADP/MA as it is simply an economist's reality. So why think stress tests on market valuation will work? I love technology and am not being a Luddite here, but do be careful how you employ technology and how soon you come to depend on a new approach that has not been tested in even one real world cycle.
5. Creeping dysfunction is a nefarious risk. Standing the test of time does not apply until you have a business cycle or two under your belt... Credit rating agencies have been there for some time. Markets eventually came to lean on them too hard and failed to understand that raters worked for issuers not buyers, just as real estate agents worked for sellers, not buyers. Rating agencies said their ratings were no substitute for investor due diligence but in fact that substitution became practice and ratings were used that way-and the agencies knew it. The market wanted a way to homogenize disparate paper to facilitate trading. What is worse is that agencies began to rate very different financial structures using the same nomenclature as for corporate ratings. Asset backed paper rated AAA was in fact in no way comparable to a corporate bond rated AAA but that 'fact' slipped by the market. The credit agencies were happy to post their disclaimers and to continue to collect their fees. They even rated and collected fees on munis (Municipal bonds) where defaults were rare. It was fine until things began to unravel. But then you could have guessed that. Who goes bust in good times? In retrospect we can say issuers got what they paid for: advertising that promoted their issues very successfully. At least on TV we are TOLD the difference between a commercial and an INFOMERCIAL. Not so in securities markets. The lesson again? Buyer beware. Distrust PAID third parties, unless YOU are paying them.
6. Leverage: Beauty and the beast. There is no need for a full discussion of leverage here. I'm simply making these points with some examples to flesh out the point. But when it comes to leverage what was the flaw? Was it excessive because rocket science failed to grasp how correlated risks were? Was the misjudgment in ratings or in credit enhancements a failure of institutions? Part of it was just that there was too much leverage. Why firms thought they could have so much more leverage with impunity still is not perfectly clear. This is where you see the perfect storm coming together.
7. Greed IS good but it failed in its mission-Why? In the Movie 'Wall Street' (that was nearly shot partly in my corner office) Gordon Gecko claimed that greed is good. Adam Smith had argued the same centuries earlier. Smith however showed that good things come when people are driven by self-interest or greed. Alan Greenspan does admit to being flummoxed on this point. He says he could not imagine firms would make such a mistake about their own self interests. Whatever you think about Greed and its role in this episode remember that these financial firms drank their own Kool Aid. They held this flawed paper on their own books. It has come back to haunt them. So it was not simply them gouging YOU to make money for THEMSELVES; it was something else... Greed failed more than greed itself was a problem - or is that not true? Why did firms so fail to get the risk and payoff right? Again we have to look above to the patterns and interlocking nature of mistakes that were made. Maybe managers and professionals were truly blinded by greed? Or simply motivated by it. Was there so much money to be made for EMPLOYEES that they were too willing to sell down the river of risk SHAREHOLDERS and BONDHOLDERS and GENERAL CREDITORS and their firms? Maybe some CLAW BACK provisions pertaining to employee compensation (bonuses in particular), as in the case of fraud, could stop such behavior?
8. Be careful what you wish for - People are drawn to Wall Street to make BIG MONEY. And that they do. But is The Street's payoff scheme an attractive nuisance? It does seem that Wall Street's asymmetrical payout scheme is at least partly to blame: I make Big Money I get a piece; I make a big loss and Oops it hits the firm's capital. As evidence of compensation dysfunction. Merrill's John Thain wanted a $10Million bonus for running his firm so badly he had to jump into the arms of BofA. John Mack of Morgan Stanley said it would look bad for Wall Street execs to get a bonus this year (2008) so they should not ask for one. But he misses the point too. It would be bad because they did not earn it. Moreover they should offer back to their respective firms the monies they were paid over the past two years for creating the mess than came home to roost this past year. But NO CEO is offering that, are they? Now that's leadership.
Has Policy Now Run Amok?
Firms may have been emboldened - or employees - to take more risk, thinking that FAILURE was NOT AN OPTION. By this I do not mean Hubris but the notion that they worked for firms that were too-big to fail. If that sort of belief is a root CAUSE of the problem then all these combinations that are making firms even bigger are a dysfunctional response to a pressing problem. At the very least firms must be able to fail so firms and employees will see risk and act as if risk is present. Claw back provisions on bonuses would make firms (employees and CEOs) more careful to see that their deals made money the right way instead of on a statute of limitation of one year subject only to board oversight instead of to legal redress. To facilitate the ability of all firms to fail, all derivative deals probably need to be washed though an exchange. Banks may have to have their options to do business limited. Structures like SIVS make no regulatory sense. If you can't do it on the balance sheet you can't do it all. Regulators need a framework and a mission. they also need some backbone and leadership that does not undermine the mission.
The failure of management theory-
For a long time, as an economist, I have been disdainful of the all the business school gurus and their various theories of management (okay, maybe a bit jealous of the limelight, too). That so many theories exist is a testament to how little we know about management or what a demand there is to obscure what management is and what it does. The objective for firms is to oversee and control managers so that they have the best interests of the corporation at heart. But who can oversee the one who oversees? Few corporate boards really control their CEO, usually it is the other way around. Plus it is complicated. You hire a CEO to lead so when should you stop them? Some firms try to get at fairness and independence by having a compensation committee to decide CEO pay. That committee may be different from the board but to whom does it report and who staffs it? Right! Management theories eventually come around to one thing: getting compensation right. Stock options were once thought to be the key but the CEO has a much different time horizon than the firm. Managing in up and down cycles is different and stock options may not fairly reflect effort or results in uncertain times. So where do we go?
A New Future Course of Action
I think the only effective oversight on a CEO will have to come from judicial oversight and clawback provisions for excessive bonuses. Such second guessing would kick in when it becomes clear a bonus was given for an activity that was not valuable to the firm. On this notion bonuses on Wall Street paid over the past several years could be 'clawed back' by shareholders who realized that the deals firms made were destructive and money-losing. Before you ponder what a hammer blow that would be to employees in this recession, ponder how different the outcome of the past several years might have been had this 'law' been in effect and had Wall Street been aware of such a provision. The idea is not to clamp a penalty on past activity but to impose a rule to affect behavior in the future. Clearly firms cannot police themselves. Boards simply are not independent except in extreme times - and not always then. Shareholders are powerless, scattered and without information. The only option for redress it to take the oversight out of the firm. It is not my intent to have THE COURTS oversee each CEO bonus but for each bonus to be subject to oversight and to the potential for rescission if it is paid by a too-pliant board for conduct that was actually detrimental to the firm. I think this could be a very promising avenue for oversight, especially since firms and their boards have failed so completely and management theories have given us nothing that is useful. It might also be a way to endogenize the asymmetry of risk on Wall Street by making traders know that their statute of limitations on a trade is not just this calendar year and to make employees know that risk matters, it does not simply revert to 'the firm' and get borne by its shareholders.