Arnold Kling  

Make it a Crime

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James Hamilton writes,


I believe there was an unfortunate interaction between financial innovations and lack of regulatory oversight, which allowed the construction of new financial instruments with essentially any risk-reward profile desired and the ability to leverage one's way into an arbitrarily large position in such an instrument. The underlying instrument of choice was a security with a high probability of doing slightly better than the market and a small probability of a big loss.

Hence, subprime loans. Hence, selling credit default swaps.

In my previous post, I mentioned Adam Michaelson's book on Countrywide. He also argues that the incentives were to push for short-term profits and to ignore long-term risks. He describes a meeting where the option-ARM (most people's candidate for Most Dangerous Mortgage Product Ever) was introduced. I'm not sure that Countrywide was the first to market with it--their version may have been a "me, too" offering. Jim Hamilton's question boils down to: what would have changed the incentives at that meeting?

As I have written before, I think that we ought to make it a crime to endanger a financial institution that has government backing. Countrywide owned a bank, which means it had government backing. If the executives running Countrywide had faced the threat of prison, my guess is that the tone of the meeting where folks were proposing the option-ARM would have been a teeny bit different. My guess is that Michaelson and other doubters of the proposal would have been listened to a lot more carefully and been given a lot more encouragement. The proponents of the idea would have had to justify to Angelo Mozilo why they should do something that could land him in prison.

Mozilo, with his swarthy looks, sharp suits, and proud demeanor, could play the part of a crime syndicate figure on a cop show. But as far as I know, he was not that sinister. In fact, he was a really good CEO, who, like many other good CEO's, decided to ignore the possibility that the housing bubble could pop. They needed different incentives.


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COMMENTS (10 to date)
OneEyedMan writes:

"As I have written before, I think that we ought to make it a crime to endanger a financial institution that has government backing."

What would this mean? Almost any financial investment could have some probability of causing the bankruptcy of a the firm holding it. Only the small subset of assets with limited downside would be otherwise. Any many of those assets with limited downside have unlimited upside, requiring someone else to take unlimited downside. Those products would be in serious jeopardy.

Even derivative structures with limited downside when hedged through sort of optimal replicating portfolio would be forbidden because tracking error could bring the firm down too.

Any real implementation of such a law would require malicious intent to deliberately collapse such a guaranteed firm or otherwise forbid nearly every financial derivative and short selling. Neither would stop this sort of problem. The former wouldn't because it is toothless, the later because derivatives behavior would be driven off shore.

I guess it is possible that non-bank financial companies could take over trading in many of these assets, but that's sort of like the mortgage origination and investment banks that brought on the current calamity.

Bill Conerly writes:

OneEyedMan has the right idea.

Take a garden variety business or consumer loan to an entity with a stellar history and prospects. That loan reduces the bank's liquidity, which puts the institution at risk. The loss of liquidity is a genuine business risk. Unless, of course, the loan is immediately callable, and the borrower is likely to be able to make a payment if the loan is called on very short notice. But how many loans fit such a profile?

Not only does the loan reduce liquidity, it poses some risk of default. Aside from treasuries, there is a positive probability of default. Even federal agency securities, such as Fannie and Freddie preferred stock, had a possibility of default.

Simply buying treasury bills would not protect a banker from prison, because the yield on treasuries would not cover overhead, even if the bank paid zero interest on deposits.

Perhaps Arnold is more clever than the rest of us. Maybe he's arguing for an end to federal guarantees on banks entirely. ?

Bill Woolsey writes:

Kling's proposal isn't that bankrupcty for an FDIC insured bank requires jail from some executive of other. It is rather that criminal penalities would be possible for reckless endangerment. The prosecutor would have to prove beyond a reasonable doubt that someone was guilty of that crime. He has emphasized situations where the crime involves some kind of financial innovation. So, pointing out that banks have been making commercial loans with funds from checkable deposits for centuries would be a defense.

In my previous readings of Kling's proposal, I thought that a key element was that the financial innovation involved an effort to evade safety and soundness regulations. Avoiding capital requirements has been a major issue in this crisis. However, consider bank employees that consprired with borrowers to create shell corporations to hide diversification issues.

Financial innovation played a role in overcoming interest rate floors. Now Accounts. More recently, financial innovation continues to overcome the restriction on interest rates on
demand deposits and reserve requirements on
all checkable deposits.

It has always bothered me a bit that these ruined the money supply figures, but also, it just seemed wrong. Why not get rid of these regulations rather than evade them to irrelevance?

Of course, capital requirements on banks with deposit insurance are essential to provide protection to taxpayers. Financial innovation to evade those regulations is ... well, criminal?

Is it true that the SIV's from Citibank always included a backup line of credit from Citibanks? If that is true, then the SIV was a sham to avoid capital requirements and maybe Rubin should be doing some jail time.

Daublin writes:

It's a good question, Arnold: what would change the incentives to actually worry about small risks of massive damage?

That sounds like a question that won't really be answerable, and suggesting jail time is practically an admission of it. Can you describe a more specific law than willful recklessness? As others have pointed out, almost any action carries risk. Worst, as Bill points out, the spotlight is going to be on innovators. In hindsight, anything that goes wrong is going to look like a terrible idea.

This just doesn't look workable. It looks worse to me than the periodic collapses we see now.

It seems like a better line of answer would be to make sure we are resilient when these collapses happen. For example, we wouldn't want the government to be so levearged that it can't help, the army so overextended that it can't do anything new, our allies so heavily called upon that they have nothing left when we have a true time of need.

floccina writes:

Short of making in a crime we could make management and investors liable for bank losses. I guess we shield people from liability because people are naturally risk averse and so we believe that more risk will bring about higher but less steady growth but perhaps we have gone too far in shielding people from risk.

A question for my fellow posters:

Does the FDIC, like a private insurance company, look to drop firms that take on too much risk, if not why not?

In the current crisis did the people at the FDIC not see the risk or were they legally unable to act?

One of the problems that I see here is that home owners, who vote in higher numbers than non home owners, liked the housing bubble and so it seems all government liked the bubble which leads one to say perhaps we must have such a problems periodically. Maybe would should embrace such events as educational. In this country of great abundance recessions seem not so painful. There is evidence that in recessions in rich countries the violent crime rate falls because people drink less, the death rate falls because people drink less, drive less and work less. Recessions teach people to save for the next recessions and teach people to do their due diligence before investing. Recessions teach people that they need family and friends from time to time so they should contribute.

The Sheep Nazi writes:

Unfinished sentences like "make it a crime" always get you in trouble. Try this instead: make it a crime, and put Eliot Spitzer in charge of prosecuting it. Because, you know, some Spitzer or other will contrive to get put in charge of prosecuting it. Very curious posting this is, in light of the sensible things Dr. Kling has said about Spitzerism before.

Dan Weber writes:

The more risk you eliminate from the economy, the bigger risks that people will take thinking that risk has been eliminated.

The safest thing is for people to not think that risk is gone. (Which leads to some weird contradictions if people think "this system is safe because we haven't gotten rid of the risk.")

chanceH writes:

Lets just go ahead and institute the death penalty for losing money in the stock market. That way prices will only go up! Boom! no more recessions ever!

Greg writes:

This sounds a lot like Sarbanes Oxley to me. That didn't work out so well, did it? Wouldn't something like required clawback provisions in management contracts be easier? They would certainly be more quantitatively verifiable than recklessness.

George writes:

Arnold,

I find your lack of lack of faith in the political-legal system disturbing.

(Yes, that's supposed to be two "lack of"s.)

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