Arnold Kling  

Narratives of Knowledge and Arrogance

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Megan McArdle has written about the evil man theory (also here). The key to a narrative of evil is that someone knew.

Early in the crisis, we were hearing that banks knew that the loans they were making were headed toward foreclosure. That was what the bank executives wanted--to take people's houses. That narrative is no longer operative.

Now, a popular narrative seems to be that executives knew that they were accumulating toxic assets, but they could hide the truth from shareholders and meanwhile loot their companies with bonuses and golden parachutes. Or that they knew that a government bailout was in the offing, a proposition that I discussed yesterday.

Finally, there is the notion that officials knew that credit default swaps belonged on an organized exchange, but chose instead to let the four-year-olds play with fireworks. If you believe that counterparty risk was the main problem with CDS, then maybe that's right.

I actually think that there were much larger risks at work in the whole concept of CDS. To have a viable market with an organized exchange, you need natural sellers as well as natural buyers. For example, with oil futures, natural buyers are airlines seeking to hedge the cost of flights that have already been sold. The natural sellers are producers seeking to hedge commitments to incur cost to deliver oil.

With CDS, the natural buyers of protection against a bond default by XYZ corporation are the owners of bonds issued by XYZ. And the natural sellers of protection are...who, exactly?

Instead, you have unnatural sellers, whose only mechanism to back their bets is to go out and short the bonds of XYZ as the probability of default starts to increase. That strategy blows up in the aggregate.

To me, that suggests that an organized exchange in CDS would not solve the problem. The exchange itself probably would blow up due to widespread "fails." Or else, if its rules were strict enough, the exchange would force an even faster blow-up of the companies on which CDS were traded, as the sellers of CDS rush to short the securities of those companies.

My narrative is focused on arrogance, not knowledge. I don't tell a story of villains who took advantage of what they knew. I tell a story of executives who thought they knew more than they really did.

The kicker in my narrative of arrogance is that I believe that people in Washington are even more arrogant than people on Wall Street (actually, a lot of them are the same people, working in different offices). If the issue is evil, then transferring power to Washington might help alleviate the problem. But if the issue is arrogance, then transferring power to Washington might serve to exacerbate the problem.

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COMMENTS (18 to date)
Less Antman writes:

So the only natural sellers of life insurance are those who want me dead? The only natural sellers of home insurance are pyromaniacs and Luddites? I think you've just theorized the entire insurance industry out of existence.

The reason exchange-traded credit default swaps would have helped is that the risks could have been diversified: lots of investors offering small amounts of protection instead of AIG offering $100 gazillion would have made the promises more viable to keep. Yes, there might have been some counterparty failures, maybe quite a few, but it is hard to imagine it would even remotely approach what we now have. At worst, it would have given insurers a place to offload some of the risk they faced, reducing their losses (and the subsequent bailouts).

I'm not the natural seller of soft drinks, but having Coca-Cola as a small part of a diversified investment portfolio makes me a safe one.

shayne writes:

Thank you, Arnold.

Something I've noticed recently - principally on business news, such as CNBC - is an extraordinary lack of recognition that any sort of economy exists outside of the Wall Street financial sector. Only rarely do any of the 'experts' and 'talking-heads' even vaguely refer to what they call the 'real' economy. I can understand the Wall Street perspective and projections - they see their little world collapsing and assume/claim the rest of the economy must be in similar condition. In short, the Wall Street folks believe they are the economy - all of it.

Arnold Kling writes:

Less Antman,
Insurance is the right analogy here. Insurance is a very difficult industry to sustain. Insurance companies are supposed to hold lots of capital and lots of reserves. They are supposed to be tightly regulated (there were dozens of regulators on site at AIG, not that they were able to spot problems in time.)

That is a very different model from the Chicago commodities markets. We don't observe property and casualty insurance contracts traded on the Merc, and I think that's for a good reason.

jck writes:

"And the natural sellers of protection are...who, exactly?"
ever heard of bond buyers?
when you buy a bond, you are selling protection.

jb writes:

The thing about AIG and the housing bust was that it was pretty obvious that there was going to be a problem. Even to me - and I'm a layperson who barely pays attention to credit markets at all - my ongoing assumption was:

"When the ARM rates adjust up, a bunch of people are going to go broke. Thank god I did not buy an ARM mortgage."

I looked at the market, and scratched my head, and wondered what the bankers knew about home loans and foreclosures that I didn't. Because it certainly seemed like there were going to be a lot of foreclosures in the near future, and yet the banks seemed to be more aggressive than ever at loaning people money.

But honestly, AIG should have known, should have anticipated, and should have raised their insurance rates aggressively as the incidence of foreclosure started to tick upwards. If they had raised their rates, it would have made the whole traunch thing less attractive.

This is hindsight, of course, for me. To an actuary, this seems like something they should have predicted, and to the boss of an actuary, this seems like something they should have acted on.

Instead of nationalizing the banks, it seems like the government should have just taken over AIG and payed out the foreclosure insurance claims at 70 cents on the dollar or somesuch. But then, I'm just a layperson, so I don't pretend to speak authoratatively about this.

Frejus writes:

Kling and McArdle beat a largely well-worn drum. History is replete with fingerpointing. It's human nature. The new language--suits and geeks--tells us little that is not already known. Also, when arrogance or evil makes a mess, the police eventually move in. Those police might also be arrogant or evil, but that's also a historical given.

This entire financial crisis is, in a way, a traditional race to the bottom. People fooling themselves, for greed or ideological reasons, into thinking that short-term profits would escape from the gravitational pull of long-term fundamentals. E.g. Mr Kling argued that housing prices might be reasonable again and again. Glassman argued about DOW 36,000 ten or so years ago. Fundamentals have intervened have since intervened.

OneEyedMan writes:

"To me, that suggests that an organized exchange in CDS would not solve the problem. The exchange itself probably would blow up due to widespread "fails." Or else, if its rules were strict enough, the exchange would force an even faster blow-up of the companies on which CDS were traded, as the sellers of CDS rush to short the securities of those companies."

Well, the futures exchanges I've worked with have limits on the number of total outstanding contracts one firm can hold in order to manage their credit risk to any one firm going belly up. This might have reduced the CDS concentration, making the leading financial firms hold less CDS exposure and making it profitable for many more firms to have a small amount of exposure. Not only only would this have reduced the likelihood of their failure, but a little bit of pain widely distributed would have had less of a systemic impact.

caveat bettor writes:

An exchange mechanism alone would be weak, but coupled with a clearinghouse requiring dynamic margin deposits and collateralization would reduce the fails risk, as has been true for most other listed derivatives exchanges.

paul writes:

This is why Fischer Black is the God of Finance

Hedging, Speculation, and Systemic Risk

Fischer Black
Sloan School of Management, MIT

this is why Fischer Black is the God of finance...


Investors like to speculate. Financial institutions accommodate them, often hedging to reduce the risk of insolvency. Neither investors nor financial institutions create systemic risk. Governments do that, by refusing to enforce contracts, and by guaranteeing private debt without charging market rates for the insurance they are providing. Then governments ask for tax money so they can regulate to reduce the systemic risk they themselves have caused.

winterspeak writes:

Arnold: I think your analysis of the CDS market is exactly right. The CDS market was essentially meant to be a private version of FDIC insurance that extended over the shadow financial system. Of course, private companies cannot be LLRs (since they cannot print money), and the situation that would required CDS would be a situation where the CDS could not be covered.

The shadow financial system, so long as it is susceptible to bank runs (which it is -- even if you don't agree that MT is the entire crux of the problem it is certainly an important part of the problem directly linked to CDS) needs an LLR. There is only one LLR in town. Moving CDSs to an exchange does not make it a LLR instrument.


Bill Woolsey writes:

Kling continues to insist that those selling default swaps must be planning to "hedge" the risk by shorting those same securities _after_ the risk rises. This involves planning to be first to find out that the securities are going to default, and then shorting them so that someone else (those buying the securuties) take the loss instead.

Why not instead have the plan of buying a default swap on the security so the loss is shifted off to the new seller?

What kind of "plan" is that?

The plan has to be to have enough wealth to take the loss. If there is no default, you make money. If there is a default, you lose money.

The natural "seller" of credit default swaps holds a portfolio of safe assets. By sellng the swap, they add risk and return.

Of course, investors in the securities buying the default swaps could instead hold lower risk securities. The sellers could directly hold the more risky securities.

Lord writes:

I don't buy either theory of evil or arrogance. Some were evil and more were arrogant, and the evil are always adept at taking advantage of the arrogant. It is quite clear from industry participants they did not care whether the loans were repaid; the property was their security. The arrogant thought prices would never fall. The evil kept reassuring them of this. The willful suspension of disbelief is still lying even if it is to oneself. Plausible denialability is more important than being correct. Failing in the conventional manner more important than succeeding unconventionally.

Steve Sailer writes:

Maybe the problem wasn't evil vs. arrogance, it was ignorance?

Let me remind everybody of the power of political correctness to make seemingly intelligent people ignorant.

For example, the LA Times today lists the number of foreclosures in Q3-2008 by zip codes across California. Beverly Hills had 7 foreclosures, while Compton, spiritual home of gangsta rap, had 252 foreclosures. In 2007, a 500 sq. ft. one-bedroom house in Compton sold for $340,000 or $680 per square foot. My guess would be that the mortgage on that was very close to the full $340,000.

Now, in a world without political correctness, emails would have gone flying among financial institutions asking, "How can anybody hope to find a Greater Fool willing to pay more than $680 per square foot for a 1939 house ... in Compton. Compton!!!! That's where the Crips are from and NWA. Straight Outta Compton!"

But, an email like that would get found by the plaintiff's attorneys during discovery in another redlining discrimination lawsuit and all sorts of bad things would ensue for the individual who wrote it and his firm.

So, best not to write anything down. And when you don't write things down, you aren't as smart. Best just to be ignorant.

bh writes:

Weren't the buyers investors who wanted to invest in corporate bonds. After all, receiving the insurance payments of CDS is equal to shorting a treasury and investing in the underlying corporate bond.

This does lead me to wonder why the buyers simply did not buy the underlying corporate bond. I guess the corporate bonds were too illiquid, while CDS is quite a liquid instrument.

Maybe it was the leverage from receiving the insurance payments? Maybe there is some tax story?

Of course, why didn't the corporations issue more bonds themselves to meet that demand?

I am puzzled myself.

Frejus writes:

Sailer wrote: "Compton, spiritual home of gangsta rap, had 252 foreclosures. "

And Torrance, home of the white middle class, has 608 foreclosures.

Since the numbers are not normalized for population nor number of homes in the area, they are all meaningless.

It's not about political correctness. It's about some guy on the internet selectively mining the data to support his racism.

Less Antman writes:


I think the regulatory hurdles to exchange trading are the main reason we don't have more futures contracts to supplement or replace direct insurance policies. Absent a much freer market than we have today, though, we can't test the thesis.

In principle, though, shared risk for profit as part of a diversified portfolio is sufficient motivation for being an individual insurer. In fact, the use of commodity futures has exploded over the last several years amongst investors diversifying an equity portfolio who have no personal interest in the price of the commodities they are trading.

Imelda writes:

Maybe they didn't have evil intentions.

Maybe they were just following orders. Or preferences.

Leonardo writes:

As one comment notes "The reason exchange-traded credit default swaps would have helped is that the risks could have been diversified..." Is this the same assumption behind securtization?

Rather than minimise risk, an exchange would have compounded it further. Just look at the currency markets as an example to see what happens when everyone tries to exit the same door.

Ultimately, the root problem to this debacle is that much of modern finance rests on erroneous theories and assumptions.

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