Arnold Kling  

Mark Thoma on the Risk Premium

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He writes,


Tyler Cowen focuses on the misallocation of risk due to government induced moral hazard. My own view is that misallocation of risk did play a role, but I think risk misallocation due to market failures, i.e. the failure of regulation, was more important in generating the crisis than moral hazard brought about by implicit or explicit government guarantees. I also think the misperception of risk was important, perhaps even more important than the misallocation of risk (though these are sometimes hard to separate)

I tend to agree with Mark, at least as far as the mortgage/housing crisis is concerned. I see a multiplicative effect of misallocation and misperception of risk. The primary misallocation was due to institutional factors, especially bank capital regulations, that raised the demand for AAA and AA securities. The primary misperception was the view taken by rating agencies, and probably by the key sellers of credit default swaps, that house prices could never fall nationwide. These misperceptions allowed the creation of artificially highly-rated securities to meet the artificially high demand.

A deep, Minsky-esque question is whether misperception of risk is inherently cyclical. It could be that, at certain points in history, an epidemic of bad judgment concerning risk is pretty much inevitable. When the epidemic occurs, it carries with it government regulators as well as private investors.


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COMMENTS (7 to date)
Tyler Cowen writes:

I do agree with Arnold and Mark that private sector error is causally more important. Still, we had one moment -- the LTCM bail-out -- where we might have short-circuited all those errors and we failed to do so. There have been plenty of pieces on bad private risk assesssment and not so many fleshing which versions of the moral hazard make sense (most of them don't).

Greg Ransom writes:

It seems grossly perverse to characterize this as simply a misperception of risk -- unless you wish go humpty-dumpty on us.

>>The primary misperception was the view taken by rating agencies, and probably by the key sellers of credit default swaps, that house prices could never fall nationwide.

Greg Ransom writes:

Is there any way to mark a principled distinction between cyclical Hayekian misperceptions of investment opportunity across time (mediated by banks, credit, and time-taking investment ) and cyclical "Minskian" misperceptions of risk?

Um. No.

>>A deep, Minsky-esque question is whether misperception of risk is inherently cyclical. It could be that, at certain points in history, an epidemic of bad judgment concerning risk is pretty much inevitable.

Tom West writes:

It seems grossly perverse to characterize this as simply a misperception of risk -- unless you wish go humpty-dumpty on us.

Greg, can you elaborate? Are you saying that everyone was aware of the risk but didn't care?

Is there any way to mark a principled distinction between...

Of course there wouldn't be any way to mark a difference. This crisis would simply be one example of a larger tendency in humanity. To answer the question Arnold poses requires a broad examination of both financial and non-financial events across history.

To me, such a hypothesis seems highly likely.

fundamentalist writes:

"A deep, Minsky-esque question is whether misperception of risk is inherently cyclical."

Hayek thought so. But he also asked why would otherwise intelligent men regularly make the same error. His answer was that monetary policy clouded their vision.

Mike Rulle writes:

One can imagine that investment banks and rating agencies did not engage in high risk activity because they thought they would ultimately be bailed out if they failed. I also agree that regulation failed because of inability to understand how similar risks had different rules applied to them (for example, CDS versus the underlying instrument).

Also, the now obvious absurdity of relying on "terminal value" to assess risk has been ruthlessly exposed. I recall working on M&A assignments as a young associate on Wall Street. We would spend days and weeks getting the details of the cash flows and balance sheets correct to determine value. Then we would randomly assign some multiple to the company at the end of the analysis period 5 or 10 years hence.

This "terminal value" determined 80-90% of the present value--all the detailed analysis being shown as almost immaterial. The rating agencies and CDO producers also did detailed cash flow analysis---but at the "end of the day" they relied on "terminal values" to justify their ratings. They thought they were safe because home prices had never declined.

Still, government driven Moral Hazard played an enormous role. Who in their right mind would have bought a Fannie or Freddie bond, were it not for the assumed Treasury Guarantee the markets have always believed in? It was impossible to even come close to understanding their financial statements. This in turn let those GSE's engage in the most reckless of leveraged activities. Additionally, they had enormous free reign to bypass the income statement with those ridiculous "hedge accounting" rules. Whatever impact the GSE's had in causing this crisis would have been non-existent had their been no implicit guarantee on their debt. Debt buyers did not care what the GSEs did. This is almost a text book definition of Moral Hazard.

aaron writes:

I think you both confuse risk and uncertainty. People believed that because we could measure risk, uncertainty went away.

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