Arnold Kling  

Felix Salmon vs. Olivier Blanchard

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Salmon writes,

At heart, it all comes down to information: loans are stronger and more desirable than bonds, because a bank intends to hold its loan to maturity and does a lot of underwriting, shoring it up with covenants. Bonds, by contrast, are often held only briefly, and are often bought by investors who do precious little fundamental analysis; what's more, they simply don't have the kind of granular information that bank lenders have. And securitizations are even worse than bonds -- no one really knows what's in them, and they're ultimately based more on models than on shoe-leather underwriting. So it's entirely predictable that the boom in mortgage securitization was bad for the overall quality of the debt. And attempts to show otherwise are ultimately doomed.

This would be news to Olivier Blanchard. I saw him this morning, and I asked him why the IMF wants to see securitization revived. He said "It's ec 10. Diversification and risk spreading area a good idea." Feeling Blanchard's contempt was nostalgic for me--it had been 30 years since we'd last been in the same room.

My view of securitization is that it is a 7-layer cake of moral hazard. The investment bankers get to eat the icing, and taxpayers get to clean up the mess.

Speaking of moral hazard, Mike Konczal proudly posted this in two places:

I understand the moral hazard argument, and though it obviously applies to government-sponsored entities like Fannie Mae and Freddie Mac, I think it needs to be proven rather than assumed that it applies to the banking sector.

If there were no such thing as moral hazard in the banking sector, then we would not need to charge premiums for deposit insurance or regulate banks in any way. Just trust them to behave prudently. I mean, if you tell me that I have to prove that there is moral hazard in the banking sector, that's strange. It's as obvious as gravity, the way I see it.

In fact, Russ Roberts will tell you that, because of too-big-to-fail, all sorts of financial firms feel like they're playing poker with house money (taxpayers are the house in this case). See moral hazard and capital structure, where I try to put a finance-theory perspective on Roberts' argument.

UPDATE: The Wall Street Journal writes,

"There is no question that, unless we enact meaningful reforms, the fact that the federal government intervened this past year will have made the problem worse," he [Deputy Treasury Secretary Neal Wolin] told a group of bankers in a speech. "We take this moral hazard challenge very seriously."

Comments and Sharing

COMMENTS (6 to date)
ed writes:

Had Blanchard actually taken Ec 10?

Standard risk diversification stories apply to individuals, not to firms. Firms are generally assumed to be risk neutral in basic Ec-10 style models.

q writes:

if securitization were revived, it would be at a much smaller scale forever because buyers understand the dangers much more. say that securitization came back in its previous form but at 25% of its previous level. say that cap requirements rules were changed to increase reserve levels against CDO senior tranches. and say that the rating agencies revamped their methodologies to give customers not just a letter rating but a closer view of what is inside the cake? would there still be a business there? would it distort markets and take down banking systems?

Todd writes:

The way I see it, the reason we need regulation of the banking sector is because we have a fiat currency ruled over by a central bank. If we allowed free-banking and competing currencies, the market would sort it out just fine without government oversight or intervention. When I say no regulation, I mean no industry specific banking laws, just continued enforcement of contracts.

wm13 writes:

I don't have any statistics, but I work in financial services, and the banks I know have a lot more bad loans than bad securities. Nor is it the case that the government bails out holders of bad securities more quickly than it bails out holders of bad loans. So I don't quite take Mr. Kling's point.

Robert Bell writes:

"It's ec 10. Diversification and risk spreading area a good idea."

So is "ceteris paribus", and as you point out, all other things are *not* equal, in particular, due diligence.

George writes:

In the spirit of the frequent "standing on one foot" entries here, I humbly suggest this bumper-sticker slogan:

Securitization wasn't risk diversification — it was risk obfuscation.

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