David R. Henderson  

Frequently Insightful but Often Misleading

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That's the title of my review of Jonathan Kay's book Other People's Money. It appears in the latest issue of Regulation.

Here's my introductory paragraph:

I can't give a AAA rating to John Kay's new book on finance; it's closer to a BBB+. Other People's Money is full of insights and, unfortunately, is sometimes misleading in important ways. His big-picture arguments are basically correct: that the financial sectors in the United States and the United Kingdom are overly complex and out of control; that this helped cause the 2007-2008 financial crisis; and that much of the dysfunction can be traced to regulation. Unfortunately, he misunderstands key events in U.S. economic history, and that detracts from his analysis. And some of his proposed reforms are too vague to be useful; they sound more like wishes than reforms.

Here's my comment on one of the book's strengths:
One of his most important insights is that much of the complexity of financial instruments is due to government regulation. He lays out, for example, how the Basel Accords, which most of the world's major wealthy countries pledged to follow, led to some mischievous, but totally predictable, "regulatory arbitrage." Kay writes, "The basic rule on capital requirements is that a bank must have equity capital--the money that can be lost before a business is forced into insolvency--equal to 8 percent of its assets." Forget for a minute that, as Kay points out, 8 percent seems awfully low; the situation gets worse, and the reason has to do with the risk-weighting of assets. Mortgages carried a risk weighting of 50 percent, meaning that the capital requirement on such mortgages was 4 percent (8 percent × 50 percent) of the mortgage principle. But--this is my example, not Kay's--mortgage-backed securities (MBS) carried a risk weighting as low as 20 percent.

Can you see where this is going? Kay does, but an example would have been helpful. Here is mine: Imagine that a bank has 10 high-quality mortgages on its books for $100,000 each, for a total of $1 million. On those mortgages, it must hold capital of $40,000. The bank manager would like to relax that constraint, so what does he do? He packages the mortgages into an MBS, which requires that the bank hold only $16,000 (8 percent × 20 percent × $1 million) in capital on that security. The risk hasn't changed, but the capital requirement has fallen by 60 percent.


And my comment on one of the book's weaknesses:
Kay also misleads readers about two relatively recent financial-industry heavyweights, Michael Milken and Frank Quattrone. He points out correctly that Milken helped invent "junk bonds." But Kay's tone is one of disdain and he ends his short section on junk bonds with the sentence, "Milken went to prison." Most readers will probably conclude that Milken should have gone to prison. However, though he did break several laws, those breaches appear to have profited him very little and cost others very little. In 1991, federal Judge Kimba Wood, who had earlier sentenced Milken to a stiff prison sentence, told his parole board that the total loss from his crimes was $318,000. In the 2011 book Three Felonies a Day, one of his defense lawyers, Harvey Silverglate, wrote, "Milken's biggest problem was that some of his most ingenious but entirely lawful maneuvers were viewed, by those who initially did not understand them, as felonious precisely because they were novel--and often extremely profitable." Although Silverglate clearly was an interested party, that statement fits the facts that I have been able to ascertain over the years. Milken was unfortunate enough to have been targeted by a politically ambitious U.S. attorney named Rudy Giuliani, who wielded the Racketeer Influenced and Corrupt Organizations Act to intimidate Milken.

Similarly, Kay writes that Frank Quattrone of Credit Suisse "expected favors from friends and clients in return for allocations of hot stocks." But Kay gives no citation for this claim. I think there's a good reason for this: a lack of evidence. For what really happened in the Quattrone case, see my "Hurray for Frank Quattrone: Rotten Tomatoes for the Media" (TCS Daily, August 28, 2006), and the even more extensive article, "The Case for Frank Quattrone," by Roger Donway (Atlas Society, July 1, 2004).


And finally:
And I can't let pass his comment about "well-educated young white men baying for money and praying for liquidity." Did he really need to mention the race, age, and gender of market participants? if they were old black women, would their actions be less deserving of criticism?


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COMMENTS (7 to date)
ThaomasH writes:

Pretty much my same grade, but on different grounds. Yes the problem is that (and even post Dodd-Frank remains) that higher leverage creates negative externalities. But the main reason for this is that when firms have to be bailed out, the shareholders and executives who created the externalities did not lose everything.

The second problem (I'm channeling Scott Sumner here) is that he implicitly assigns too much of the cost of the Recession to the financial crisis that precipitated it. The real cost was created by the reluctance of the Fed to take stronger action to maintain NGDP.

michael pettengill writes:

Ok, if regulation is the problem, how exactly would eliminating regulations on banks lead to banks holding 20% or 50% capital when investors want high returns ant that occurs with the highest possible leverage, of say 1% or 0.1% capital?

Why do regulations drive bankers, business people, shareholders to become grossly immoral and dishonest?

Jim McGinness writes:

I think I learned from Russ Roberts that one of the things regulation does is permit actors to substitute "what is allowed" for "what is prudent".

Investors with no expectations of bailouts are the ones who would keep immorality and dishonesty in check.

Tim Worstall writes:

I'm not sure that this is quite right:

"Mortgages carried a risk weighting of 50 percent, meaning that the capital requirement on such mortgages was 4 percent (8 percent × 50 percent) of the mortgage principle. But--this is my example, not Kay's--mortgage-backed securities (MBS) carried a risk weighting as low as 20 percent.
Can you see where this is going? Kay does, but an example would have been helpful. Here is mine: Imagine that a bank has 10 high-quality mortgages on its books for $100,000 each, for a total of $1 million. On those mortgages, it must hold capital of $40,000. The bank manager would like to relax that constraint, so what does he do? He packages the mortgages into an MBS, which requires that the bank hold only $16,000 (8 percent × 20 percent × $1 million) in capital on that security. The risk hasn't changed, but the capital requirement has fallen by 60 percent."

My understanding (which may well be wrong) is that the 20% weighting is to govt guaranteed MBS. Or at least quasi-govt guaranteed. So, Fannie and Freddie.

You can't get from here to there by creating your own MBS out of your own mortgages. But you can by selling the mortgages to a GSE and then buying the GSE paper.

If I've understood this properly that is of course a subsidy to the GSEs.

Brent Buckner writes:

You wrote: "Similarly, Kay writes that Frank Quattrone of Credit Suisse "expected favors from friends and clients in return for allocations of hot stocks." But Kay gives no citation for this claim. I think there's a good reason for this: a lack of evidence."

OTOH, absence of evidence is not evidence of absence. After all, Quattrone was clearly sensitive about written records (as you wrote in your linked article: "Three minutes later, Quattrone replied, 'You shouldn't make jokes like that on email!'").

NASD dropped its charges of spinning, but there was some evidence (e.g. see page 292 of _The Prince of Silicon Valley_ ).

David R. Henderson writes:

@Tim Worstall,
Thanks, Tim. I’ll look into it.
@Brent Buckner,
I’ll check your reference. You’re right that absence of evidence is not evidence of absence. But it IS absence of evidence. I think that when people claim that other people committed crimes, they should have some evidence.

Brent Buckner writes:

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