One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on "too much risk" in recent years. I think it is equally accurate to suggest that the financial system took on too little risk.
Consider the risks that were not taken during the recent credit and "investment" boom. While hundreds of billions of dollars were poured into new suburbs, very little capital was devoted to the alternative energy sector that is suddenly all the rage. Despite a "global savings glut" and record-breaking levels of "investment" in the United States between 2005 and 2007, capital was withdrawn from a variety of industries deemed "uncompetitive" in large part due to obviously unsustainable capital flows. Very few brave capitalists took the risk of mothballing rather than dismantling factories and maintaining critical human capital through the temporary downspike. Under the two to five year time horizon of our most far-sighted managers, whatever is temporarily unprofitable must be permanently destroyed. To gamble on recovery is far too great a risk.
I don't pretend to know where all that capital, that incredible swell of human energy and physical resources, ought to have gone. But it doesn't take an Einstein to know that it probably should not have gone into building Foxboro Court. Sure, hindsight is 20/20. But lack of foresight really wasn't the problem here. In 2005, how many macroeconomists or big-picture thinkers were arguing that the US economy lacked suburban housing stock of sufficient size and luxury? We gave the building boom the benefit of the doubt because it was a "market outcome". But the shape of that outcome was more matter of institutional idiosyncrasies than textbook theories of optimal choice. It resulted as much from people shirking risk as it did from people taking big bets.
The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up "super-senior AAA" tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed 'em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was "safe", so who cared what it was funding?
Finance is not a closed system, a zoology of exotic contracts and rocket scientist equations. The job of a financial system is to make real-world decisions, "What should we do?" A good investment is a simple answer to that question, with clear consequences for getting it right or wrong. Mom and Pop can have FDIC insured bank accounts, and imagine that there is such thing as a "risk-free return". But that's a lie, a sugarcoated subsidy. Foregone consumption does not automatically convert itself into future abundance. People have to make smart decisions about what to do with today's capital. If they don't, no amount of regulation or insurance will prevent all those savings accounts from going worthless. When huge institutions treat the financial system like a bank, depositing trillions in generic "safe" instruments and expecting wealth to somehow appear, they are delegating the economic substance of aggregate investment to middlemen in it for the fees, and politicians in it for whatever politicians are in it for. And we are surprised when that doesn't work out?
Of course we should regulate and manage the risks that were the proximate cause of the credit crisis. Anything too big to fail should be no more leveraged than a teddy bear, and fragile, poorly designed markets should be fixed. But that won't be enough. We've trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I've nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.
Investors' childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.
|Steve Randy Waldman — Thursday August 7, 2008 at 1:49am||permalink|
So I would separate the idea of risk taking as between these two planes of the integrated system. Your view that there was not enough risk taking translates, I think, to the idea that there was not enough visionary thinking in the real investment side of the economy. This could include both private and public enterprise. I wouldn't debate that part of it except to say the counterfactual would seem to involve at lot more central planning in the economy. Otherwise, how can we say that business was responding to anything other than the invisible hand that was dealt to it?
The financial system in such a world view is quite a separate issue for debate. One of the things that the financial system does is link savings with investment at the macroeconomic level. But this is not the only aspect of its activity. It may not even be the largest aspect. It is involved in several other macro categories of financial activity.
First is that the financial system connects many economic units with positive saving with those that have negative saving, neither of which has a direct connection to macroeconomic investment. For example, banks offering home equity loans, which borrowers use for consumption purposes, fund them with household unit savings in the form of bank deposits. But neither side of this linkage is necessarily connected to the level of macroeconomic investment. The two sides are brought together as a clearinghouse for the expenditure of current income on consumption of goods and services – not for its net saving and investment. Similarly for the famous mortgage equity withdrawal tsunami, much of which was used for personal consumption expenditures. One might push this analysis to the limit by suggesting that all finance is “inside money”, without any direct real economic effect, and that the true economic transaction is the linking of real investment with ultimate household equity (true saving), regardless of the nature of financial intermediation, but that's going a bit far with the idea. Nevertheless, the complexity and circuitousness of the financial system reinforces the idea of its separateness from the nature of the real investment it finances. For example, the new house builder and buyer together drive supply and demand for real economic preferences. Finance is the enabler of such a transaction but not the real asset allocator. Teaser rates enabled by Fed policy, and CDOs that manipulated paltry mortgage cash flows are quite distinct from the motivation behind and the result of the granite countertops they financed. Who would question these real preferences other than central planners?
Second is that the financial system has a great involvement in the trading of financial assets, which has nothing to do with the level of macroeconomic investment. For example, the super-senior CDOs that you refer to I believe are mostly synthetic. As such, they are a bet on the cash flow behaviour of a similar mortgage based financing cash instrument. But like all derivatives, they are a bet involving asset and liability counterparties at the level of the financial system, and again have nothing directly to do with underlying macroeconomic investment. Of course, there are a zillion examples of such derivative bets that are disconnected from real economic investment flows.
There was a great deal of risk taking in the financial system defined in this way. Most of the ensuing risk malfunction can be attributed prosaically to a failure of imagination in the sense of an overreliance on statistically based risk management systems (i.e. “value at risk” systems), and a corresponding underestimate of capital adequacy. But this failure followed from risk taking that is in a separate category from the heroic visionary risk taking that one might hope for in the real economy.
A couple of other points:
I do think one can go a bit far with this idea that leverage is inherently evil. If you really believe that too big to fail institutions should not be leveraged, then you also believe that commercial banks should not be allowed to take deposits. Deposits are liabilities, and constitute leverage to the position of bank equity holders just as much as other forms of debt. Deposits are the dominant source of commercial bank leverage. And of course there's almost nothing in the way of money supply remaining if banks can't take deposits. (Is this what Austrians want?)
Finally, the global savings glut is a croc. This is the “inside” financial system working overtime and globally. China has tons of US assets because it has pegged its currency for trade reasons, and US consumers have responded to such a manipulated pricing basis with a rampage of buying. Apart from those dollars it sells for other currencies, China has no choice but to cycle its surplus back into dollar financial assets. To the degree that China has bought treasuries, its connection with underlying real US investment is very tenuous. And to the degree that it bought agencies, its connection might be just as much with those US consumers who extracted MEW funds through mortgages for the purpose of buying Chinese products, as it is with the amount of US GDP that was actually attributable to excess new housing investment. To the degree that China has done other “riskier” stuff with its money (e.g. Blackstone et al), the relative amount is trivial, and even then is somewhat disconnected from real underlying US investment.
Thus, the scope of the financial system is in fact larger than the constituent issue of directing saving into investments in the macroeconomic sense of these terms. As such, and with all its failures, the financial system has taken all sorts of risk that doesn't directly connect with underlying economic investment, and which may have a quite different risk taking problem of its own, quite separate from the heroic failure of real investment risk taking that you have described.