The worm in the bud

I finally read Gillian Tett’s Fools Gold

, an account of the development of the derivatives industry centered on credit default swaps (CDS) and collateralised deposit obligation (CDOs) that collapsed so spectacularly last year. The discussion is excellent, but still, I think, too charitable to these instruments and their creators. Tett’s main source is the group at JP Morgan who pioneered many of these derivatives and, largely, got out before the crash. Their line, unsurprisingly, is that the problem was not with the concept as they developed, but its abuse by latecomers.

But a close reading of Tett’s account yields a different story. These innovations were defective from day one.

The crucial thing that made all these deals work was the so-called ‘super-senior’ tranche of debt that was supposed to be almost completely immune to failure (until, of course, it failed). This stuff was rated better than AAA, with the result that lots of banks were willing to carry it on their own books, using Enron-like special investment vehicles to skirt the Basel 2 requirements for capital adequacy. The alternative was to find a supposedly risk-free backer, such as an insurance company (AIG) or that contradiction in terms, a “monoline” municipal bond insurer willing to diversify into insuring exotic derivatives (Ambac and MBIA). The JP Morgan crew were never comfortable carrying huge volumes of debt, even allegedly riskless debt on their own books, and that’s why they ultimately left the field to others. But according to Tett, the very first deal that was done involved transferring the super-senior debt to none other than AIG, whose threatened collapse forced the Fed into the trillion dollar bailout of 2008. So, the worm was in the bud – there never was a sound basis for the whole idea.

Another important implication is that, thanks to the massive size and complexity of modern financial markets, fundamentally defective innovations need not be weeded out quickly, and can grow to astronomical size before they are. Bernie Madoff’s Ponzi scheme is a straightforward illustration of this. When it was exposed, quite a few commentators suggested that no one could run a Ponzi on this scale for nearly 20 years, as Madoff did. The alternative explanation, which was shown to be baseless, was that Madoff must have initially run a speculative strategy, turning to a Ponzi only when that ran into difficulties.

This is one instance of a more general point emerging from discussion of the financial crisis. As Felix Salmon observes, the extraordinary profitability of investment bank can most plausibly be explained by the hypothesis that risk is being shifted, without compensation, to someone else. Salmon focuses on the case of ignorant buyers, sold products they don’t understand. But, as Arnold Kling observes, an equally important source of investment banking profits is regulatory arbitrage at the expense of governments, and, ultimately, the public at large.

There are two main ways these problems can be resolved. To protect both ignorant buyers and the public, it would be necessary to regulate investment banks in the same way as other banks, and much more tightly than either was regulated pre-crisis. In particular, the idea of letting Goldman Sachs get the protection of a commercial banking license while operating as an investment bank is an obvious example of the kind of regulatory arbitrage that needs to be stopped. Properly done, regulation of this kind would kill off investment banking of the kind with which we are familiar.

The alternative is to assume that the buyers of investment bank products can look after themselves, and focus on protecting citizens from being made to repeat the bailout disasters of last year. The only way to do this is to reinstitute a much tougher version of Glass-Steagall, raising high barriers to all kinds of transactions (ownership, financing, joint venture) between investment banks and the core financial system guaranteed by government. Something of this kind will have to be done with respect to hedge funds and similar outfits if we are not to have a repeat of LTCM somewhere before long.

62 thoughts on “The worm in the bud

  1. There is an interesting book out at the moment and I cant recall the author because I am holidays and so is my mind but he was a trader at Lehman and he essentially blames the crisis on the removal of glass steagall and the other act that was changed in the US earlier this decade…
    It is telling because it comes from someone who worked within the finance industry in Lehman’s US for many years as a successful trader. Well worth a read. I will get the title later but the CEO Dick Fuld of 26 years and his lieutenant comes out looking not too healthy.
    In other words irrational deregulatiuon caused irrational exuberance. One interesting quote was from a senior (very senior exec) who said “you cant model human behaviour with mathematics”. Maybe he knew something so many economists dont. The VAR model failed because it had no history in its models. Thats whats wrong with modern economics as well. (by modern I mean the past thirty years of the profession’s rapture with elegant mathematical models with increasingly little reference to real world historical data. What is that but economic history???? It doesnt even exist as a subject in most universities. The profession is almost as detached from reality as happened at Lehmans (also reliant on mathematical models ie VAR for its real estate CDO operations which ultimately along with Fuld’s poor management appear to have caused the collapse).

  2. @Michael of Summer Hill
    Michael, thanks; I can`t say I have much familiarity with (much less envy of) Australia`s prudential regulation, but the “path to destruction” to which you refer wasn`t at all libertarian, was it?

    Maybe Australian regulators are more godlike, but elsewhere we have a continuing pattern of prudential regulation making everyone act imprudently. We might have a little more caution where more people, banks and firms have to shoulder more of the burden of risks that are realized, instead of presuming that government and taxpayers have their back. In other words, a healthier system is one where their is more freedom to fail, and more caveat emptor in place of caveat taxpayer.

  3. TT, I doubt that you are going to persuade people to go back to a situation where they could be wiped out by bank failures, as in the days before deposit insurance/lender of last resort facilities, and I think people are right in their preference.

    So, you need to make sure that regulated institutions don’t take too many risks, while not precluding risk-taking altogether. The obvious solution is narrow banking, with a sharp separation between regulated+guaranteed and non-regulated institutions (for which no bailout should be considered), as argued in the post.

  4. My reading of the following from Wayne Swan today is that he is looking at WIDE banking:

    “To further encourage private investment in RMBS and complement independent issuances, I have asked the Treasury and AOFM to consult with industry on the merits and commercial feasibility of delivering part of the support through a fee-based liquidity facility rather than direct investments by the AOFM.”

    In other words prearranged socialisation of losses for holders (some foreign some local) of domestically originated RMBS.

  5. TokyoTom, Libertarians would be better off pursuing more Goo Goo legislation closing loopholes and making governments more accountable rather pursing something which is unreal. And as for prudential regulation what can I say but once bitten twice shy.

  6. @jquiggin
    John, who`s trying “to persuade people to go back to a situation where they could be wiped out by bank failures”? I`m just pointing out that the core of the problem is moral hazard created mainly by deposit insurance and subsequent absence of market discipline, with opacity and risk spreading systemically (and globally) as a result of inadequate regulation.

    At least in the US, the requirement that bank investments be “investment grade”, but without pressure from depositors to make sure that ratings were actually meaningful, as opposed to a sugar coating paid for by the asset seller, is a good example of the resulting rot.

    Even just a little more market discipline would be helpful. A good start would be to revise deposit insurance schemes by limiting the “insurance” to a percentage of the deposit over a particular floor (such as, say 80-90% of amounts over $10,000); this would immediately generate depositor pressure on banks to make more meaningful (and transparent) analyses of investments.

  7. TokyoTom, the majority of Australians still truly believe in an egalitarian society, and even though our legislators do get things wrong our system works well.

  8. @Ernestine Gross
    Just to come back to Ernestine’s comment on shadow banking. In this account of an Lehman traders version of the collapse of Lehman I have been reading – the author refers to shadow banks as those without any deposits or funds of their own to lend from. In other words they borrowed from other banks to perform lending services and as you can imagine, their numbers multiplied rapidly in the US real estate / credit boom.

  9. Andrew Reynolds, governments are not perfect but at least we still have universal health care, aged pensions, etc. As for more power, well I’m all for Father Brennan’s recommendation of a charter of rights modelled along the Victorian and the ACT where each piece of legislation accompanied by a ‘statement of compatibility’ with human rights obligations. In otherwords public officials must repect your human rights above anything else.

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