Arnold Kling  

Simon Johnson on Geithner and Summers

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One-Party State Watch... Audience Questions, 2...

He is not happy with the "foundation" for regulatory reform proposed by the current and former Treasury Secretaries.


Their view: Regulation is overly focused on safety and soundness of individual banks. Reality: There was a complete failure of safety and soundness supervision. This must be fundamental to any financial system - without this, you'll get mush every time.

I agree that Geithner and Summers get the diagnosis wrong, as do many others. The problem was not a gap in regulatory coverage. The problem was that Freddie Mac, Fannie Mae, and regulated banks held too little capital, using tactics that were approved by regulators, with Congress putting pressure on regulators to go easy. Geithner and Summers make the financial meltdown sound mysterious and complex. In fact, given the regulatory capital arbitrage that drained capital from the system, the meltdown was pretty straightforward.

In football terms, the problem was not a gap in the defensive coverage. The problem is that the defense got run over. Geithner and Summers want to change the defensive formation, but Johnson and I are concerned that the players still can't tackle.

Johnson and I both approve of the attempt to make it easier to deal with under-capitalized firms without having to bail them out. That is the one proposal that is aligned with my view that it is better to try to make the financial system easy to fix than attempt to make it impossible to break.

Another key element in the easy-to-fix approach is to break up financial institutions that are too large and too complex. The economic benefits of financial behemoths are unclear. The social costs when they fail are now obvious. Even with smaller institutions, though, the possibility of highly correlated failures is one to lose sleep over. In that regard, a structure of institutions and regulators that is messy and has many overlaps may turn out to be more robust than one with a neat, clean organization chart.

Johnson raises the issue of bank executive compensation and incentives for risk-taking. I do not go along with him in suggesting that government change the compensation structure at banks. I don't think that government should have to create incentives for executives to care about long-term franchise health. But if you made me the regulatory czar and told me that this was my responsibility, then I would still leave compensation structure alone. Instead, I would threaten any CEO of a failed bank with castration.


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COMMENTS (8 to date)
DWAnderson writes:

And to think some people dislike torture...

Milton Recht writes:

It is a risk preference problem and it is not a capital or leverage problem. As anyone familiar with financial theory knows, leverage can be place anywhere in the investment chain to create a higher risk level. Higher leverage is just a way to increase risk and the potential return.

So, if capital is increased at the bank level (lower leverage and lower risk), banks will either invest in riskier products or make safer investment products riskier by incorporating leverage into the product directly or implicitly, such as through embedded options, etc.

Using residential mortgages as an example, their risk is increased by going from 80 percent loan to value to 100 percent loan to value. Additional risk is created by lending to lower credit worthy borrowers.

When the mortgages are packaged as investment products, borrowed funds can be used to increase the value of mortgages in the product so that the total mortgage value exceeds the equity investment in the product, which increases their riskiness. The investors in these leveraged products can borrow funds themselves to increase their equity investment in the leverage products, further increasing the risk to the investors.

The investor's risk preference ultimately determines the amount of risk in the invested products. There are too many ways to increase risk. Regulations and regulatory supervision will not stop excessive risk from occurring if that is what the bank or any other investor desires.

It is a rehash of the old Modigliani-Miller problem about the optimal capital structure. A bank with low leverage can invest in riskier products to achieve the same total institutional risk that higher leverage would achieve. Despite the regulators' attempt to prevent increased risk, an institution with a higher risk tolerance will find ways to invest in products that match its risk profile. The risk to the institution will not be lower with higher capital amounts.

I agree with your statement that the "problem was not a gap in regulatory structure." What would cause financial institutions to take on so much risk that the continued existence of the entire institution was in jeopardy?

Moral hazard and incentive compensation themselves cannot explain the institutional behavior. Participants, many of whom had restricted company stock, risked too much of their own personal wealth, careers and reputations for the bonus compensation structure to be the answer. Furthermore, many of the investors, including the investment and commercial banks, are too sophisticated not to have understood the risk, despite the credit rating agencies' stamp of approval and their post mortem statements.

While there are many "expert" answers proffered, none offer an adequate explanation of why institutions took on so much risk. Many sophisticated investors and financial institutions either misread the risk in the market or intended to take on excessive risk. Both are troubling and not easily fixed.

Arnold Kling writes:

Milton,
Good points. It is worth thinking about this in Modigliani-Miller terms, in the sense that many forms of leverage are substitutes for one another.

On the other hand, Modigliani-Miller assumes transparency (seeing through the corporate veil), which is not a good way to describe the recent situation. However, if anything, issues with transparency would seem to make the problem even harder to solve.

Michael E. Marotta writes:

I found the article on the Treasury website
here . This seems more like chat around the watercooler, scuttlebut.

Over the last two generations, our universities, icing the cake of the public schools, created business managers with looter mentalities. They believe that government regulations keep robber barons like themselves from stealing it all before anyone else can. Adam Smith and Benjamin Franklin would not recognize them as capitalists, and neither would Ayn Rand, of course. I just read _The Man Who Found the Money_ about John Stewart Kennedy, the banker for J. J. Hill and many other railroads. We lost contact with that brand of capitalism. The current "crisis" is, indeed, a moral failure. Crisis is in quotes because continuous waves of such events are no longer special, but the predictable outcome of interventionist ideology -- beginning at the personal level with financiers who feel that they need external, social contraints or else they would not know right from wrong.

http://www.washtenawjustice.com

Bayard writes:

No doubt, the regulation could stay as it is, but the regulators need to be beefed up, and irresponsible players taken down by regulators. Also, if banks have difficulties or look like they will fail, don't bail them out. Let them go. Even the ones deemed too big to fail. A short term intense pain is better than endless mailaise. We are never going to recover to true prosperity, because at the time of failure there were too many other problems looming, energy costs and oil shortage/overpricing, global warming, health care costs, etc. Now we have too much to deal with and have devoted the resources to deal with them to the bailout/stimulus. If Paulson had only devoted the $350 billion to containing mortgage foreclosures, most of the "toxic" assets would have abated into manageablility. Now, it's too late.

Regulations may need to be enhanced, but only to the extent of a new Glass-Steagle. If we can keep the commercial banks from being paired with big investment houses, we can keep the money safe.

Walt French writes:

@Milton, good points, but allow a little room for Akerlof next to M&M: M&M equivalence only obtains when there are complete, information-rich markets for capital.

Pointedly, regulatory required reserves, guarantees, FDIC insurance, Greenspan Puts, etc., are NOT made by profit-maximizing entities who demand higher expected returns for higher risks; they are made to implement policy, typically expecting LOWER direct returns in the risky climate in which they are made. FDIC and Basle type standards to protect against bank failures price risk about the same, AFAICT, but only systemic risks -- identical exposures, or correlated risks -- threaten the economy to the extent that our current crisis does.

Government oversight is far from the only incomplete market... huger information asymmetries also result from FASB's scandalous accommodation of banks' desires to hide billions in SIVs and other off-balance-sheet liabilities; the impossibly dense offering memoranda for auction-rate notes; the excessive (!) reliance on mark-to-market pricing during the "everybody else is doing it" phase of issuing CDOs; the undisclosed magnitude of CDS "insurance contracts" without a dime of backing; ... these all violate traditional best practices AND torpedo M&M's premises.

A key tenet of the original SEC legislation was to provide accurate, high-quality, relevant and meaningful information to all investors (especially, to small investors). The utter failures listed above explain a huge share of our current crisis. (Diamond & Dybvig, widened just enough to cover traditional and shadow banks' *current* funding sources, explain much of the rest.)

fundamentalist writes:

We should keep in mind that what in hind sight appears to have been risky was not viewed as risky at the time. I disagree that people knew they were taking huge risks in the past. That simply is not true. Very few people thought they were taking on risky investments or that they had a higher tolerance for risk. Those investments appear risky now simply because the real estate market collapsed. Few people thought that the real estate market would collapse on a nation scale. It had never happened before, so why would they expect it to happen now? Real estate collapses were always a regional affair.

At the same time, you have every mainstream economist in the nation, including Nobel Prize winners, reassuring the nation that the Fed never causes any harm. The Fed can flood the nation with paper dollars and nothing bad will happen. As a result, a few people, but very few, saw the housing market as a bubble, but mainstream economists saw it just a higher level of equilibrium.

Milton Recht writes:

@Walt, Investment banks were both originators and buyers of packaged mortgages. They held either their own mortgage originations or those of other investment banks. In either case, these investors had first hand market knowledge and that would preclude an Akerlof situation. Additionally, there was a lot of external, readily available information including which markets were hot and where mortgage originations were occurring.

Both sellers and buyers of mortgages had either complete knowledge or similar incomplete knowledge of the products. Neither was at an informational disadvantage to the other.

Government guarantees (i.e., puts, FDIC insurance, reserves, etc.) apply more to commercial banks than investment banks and do not adequately explain Bear Stearns, Lehman, Morgan Stanley, Goldman, etc.

While NRSRO ratings reduced capital requirements, and increased returns to the investment banks, lowering capital does not increase the actual return of the product and it risk reward profile. In addition, ratings do not explain the excessive investment concentration in mortgage products and the lack of diversification.

The excessive investment concentration in mortgage investment products shows a tolerance for increased risk in itself without consideration of the risk of the products. Institutional investors (except those whose investment aims are concentration and lack of diversification) know better than to put too much money into a single investment area. The change in mortgage risk, after investment, does not explain this behavior.

Furthermore, in the institutional sales markets, as opposed to the retail sales market, reputational risk is a real concern and damage to it is a real cost that would be considered. It is unclear why institutional salespeople and the firms would knowingly jeopardize their reputations. Anyone who has worked on Wall St. knows institutional investors do not easily forget. Firms not only sold products that blew up, they held on to these products themselves.

There were liquidity and funding crises at these banks due to the term mismatch between funding and investments, but these firms' treasurers know beforehand of the mismatch and attempt to prevent these types of crises from ever occurring. It is their normal operating procedure and great pains are taken to avoid a funding crisis.

In addition, firms packaged and invested in mortgage products after property values had reached their peaks and had started to decline. Why continue to invest and increase funding risks?

So far, the available explanations lead one to believe that these firms were either institutionally suicidal or absurdly stupid. Neither explanation really seems plausible.

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