Bankers' Greed: Probably Not the Cause of the Crisis

Brian Doherty | September 21, 2009

From Jeffrey Friedman at Critical Review's very interesting "Causes of the Crisis" blog:

Many banks had invested heavily in triple-A rated tranches of subprime mortgage-backed securities, and when delinquencies and defaults on subprime mortgages began to spike, the price of these tranches began to fall, calling into question the solvency of banks that had invested in them....

How can the banks’ investments in subprime mortgage-backed securities be explained?...self-interest, i.e., "greed," is always the most popular explanation among economists—and the general public. So a new idea took root: Far from being irrational, bankers knew how risky these investments were, but made them anyway because they were paid big bonuses for short-term profits.

This “executive compensation” theory of the crisis is now the keystone of the conventional wisdom, having been embraced by President Obama, the leaders of France and Germany, and virtually the entire financial press. But if anyone has evidence for the executive-compensation thesis, they have yet to produce it. It’s a great theory. It “makes sense”—we all know how greedy bankers are! But is it true?

The evidence that has been produced suggests that it is false.

For one thing, bankers were often compensated in stock as well as with bonuses, and the value of this stock was wiped out because of the investments in question. Richard Fuld of Lehman Brothers lost $1 billion this way; Sanford Weill of Citigroup lost half that amount. A study by Rüdiger Fahlenbrach and René Stulz [3] showed that banks with CEOs who held a lot of stock in the bank did worse than banks with CEOs who held less stock, suggesting that the bankers were simply ignorant of the risks their institutions were taking....

Perhaps the most powerful evidence against the executive-compensation thesis, however, is that 81 percent of the mortgage-backed tranches purchased by banks were rated AAA[5], and thus produced lower returns than the double-A and lower-rated tranches of the same mortgage-backed securities that were available. Bankers who were indifferent to risk because they were seeking higher return, hence higher bonuses, should have bought the lower-rated tranches universally, but they did so only 19 percent of the time.

Mike Flynn from Reason Online back last October on the causes of the crisis.

Comments

moosecat|9.21.09 @ 3:42PM|#

come on you can't fool us. we all know the financial meltdown was due to FREE MARKET GREEEEEEEED!

:p

|9.21.09 @ 3:42PM|#

A good friend says it is like an anology of an all you can eat buffet - when someone eats too much and gets fat, who do you blame? The man who owns the buffet, or the people who can't control their eating?

In the case of the mortgage meltdown, the banks are like the buffet owners - and they are NOT to blame! The free market is an instrument of FREEDOM!

In other words, it should be clear to all with eyes that the meltdown was caused by people with poor education and no "money sense" who were easily duped by ACORN/Fannie May/Barny Frank/Obama. They are the criminals. But it is easier sometimes to use a simple anology to get the point across (the buffet one is my personal favorite).

"You can give a man a fish, but you'll only be turning him into a wealth draining succubus on the soul of the Free Market"
Milton Friedman

The Extispicator|9.21.09 @ 3:48PM|#

LOL ... as if "evidence" mattered. Truth is only what the dominant narrative says it is. The narrative has been written; give up already!

Those greedy bankers gave the poor old widow $250,000 so they could take her $150,000 house. What they lost on each deal, they tried to make up for in volume.

|9.21.09 @ 3:58PM|#

It occurs to me that many people who were blaming the lenders solely for the housing bubble and its collapse were talking about how banks "wanted to own lots of homes." I knew that was false at the time, but I'd say it's been proven false by the fact that lenders are avoiding foreclosure like the Swine Flu.

|9.21.09 @ 4:01PM|#

Bankers destroyed the economy because they're racist. There, I said it. I win.

Old Bull Lee|9.21.09 @ 4:03PM|#

I work at a financial institution - trust me, we DO NOT want to foreclose on anything. It always comes out a loss in the end.

|9.21.09 @ 4:03PM|#

Those greedy bankers gave the poor old widow $250,000 so they could take her $150,000 house. What they lost on each deal, they tried to make up for in volume.

Hey, it worked for DEC.

MNG|9.21.09 @ 4:16PM|#

But why assume the behavior had to be rational? People were making money off this as far as I can tell, and lots of people risked a lot hoping it would keep on that way though in hindsight or yes even at the time they should have seen how crazy risky that was in the long term. But that's not remarkable. People do that kind of thing in Vegas everyday..

|9.21.09 @ 4:17PM|#

But why assume the behavior had to be rational?

If you miss out on the profitable part of Krugman's housing bubble while your competitors don't, you risk falling behind.

Hoping for Logic|9.21.09 @ 4:20PM|#

I work at a financial institution - trust me, we DO NOT want to foreclose on anything.

This racism just sickens me.

trollumination|9.21.09 @ 4:22PM|#

So basically this had nothing to do with bankers trying to get free money out of the market because everybody else was doing it too and they wanted to get paid, but it was all caused by those evil evil liberals wanting mortgages for lazy blacks and mexicans, and the even more evil 'accounting standards' which collapsed this totally awesome totally not a pyramid scheme economic shitball that otherwise would have unwound uneventfully and in a totally free market way, right?

Slurp it up, boys. Slurp it up.

For all your talk of Libertarianism you display a really remarkable obtuseness to supply and demand and actual production of real goods and services. What is wrong with you Reason guys, anyway?

|9.21.09 @ 4:29PM|#

Drink!

|9.21.09 @ 4:34PM|#

But I won the thread when I said "racism" before anyone else. Waaaaaaaaahhhhhhh!!!!

Old Bull Lee|9.21.09 @ 4:44PM|#

At least we have trolls from both ends of the spectrum today. Parent Rights/Marine Patriot and trollumination should just get a room already.

Mango Punch|9.21.09 @ 5:07PM|#

"81 percent of the mortgage-backed tranches purchased by banks were rated AAA[5], and thus produced lower returns than the double-A and lower-rated tranches of the same mortgage-backed securities that were available"

Tier 1 regulatory capital! What bank would want that? It's so not in right now.

When you think Risk is spread, who wants low yielding assets --> Low Tranches are Securitized!!


Greed was a part of it...But, idiocy is what drove equity-stake-holding-CEO's banks under...

Fluffy|9.21.09 @ 5:12PM|#

So basically this had nothing to do with bankers trying to get free money out of the market because everybody else was doing it too and they wanted to get paid, but it was all caused by those evil evil liberals wanting mortgages for lazy blacks and mexicans, and the even more evil 'accounting standards' which collapsed this totally awesome totally not a pyramid scheme economic shitball that otherwise would have unwound uneventfully and in a totally free market way, right?

Slurp it up, boys. Slurp it up.

For all your talk of Libertarianism you display a really remarkable obtuseness to supply and demand and actual production of real goods and services. What is wrong with you Reason guys, anyway?

Um, no.

The element of the narrative that is always omitted here is that while these mortgages were actually being originated and these securities were being created, foreclosure rates and default rates went down. Every year. By record amounts.

Every time someone thought up a new exotic instrument, the data got better.

This part of the story has to be left out, because if it's included the culprit becomes the Federal Reserve, for creating bubble market conditions under which irrational investments looked not only rational and safe, but more rational and more safe than traditional bank assets had looked in the past.

The "bankers are evil and greedy" narrative relies on the assumption, never stated, that the bankers should have ignored their own data - even though the Federal Reserve didn't. The Federal Reserve looked at the macro data and said, "Woo hoo! It's not a bubble, it's a new paradigm!" and every DC policymaker said the same fucking thing. If the Federal Reserve can duck the responsibility for identifying the bubble, then the evil greedy bankers who bought MBS when the data told them to can duck it, too.

DC policymakers don't want to accept that when they try to manipulate the business cycle, they will warp decisionmaking in the market as a whole. But that's MacroEconomics 101. You can't open an Economics textbook without being pummelled by the truism that holding your foot down on the accelerator if you're the state will change market outcomes by changing what individual economic actors will perceive as rational. But not according to the political class, because that would require the political class to admit it was wrong, and stop trying to pass blame out to private actors.

Mango Punch|9.21.09 @ 5:25PM|#

"This part of the story has to be left out, because if it's included the culprit becomes the Federal Reserve, for creating bubble market conditions..."

While yes this is true, I think some people put too much emphasis on it. Bubbles happen. period. They happen with or without government intervention. Yes in this instance government involvement exhaserbated the problem, but that doesn't mean the bubble wouldn't have occured or gotten as big as it did.

A better take away is that the government failed to prevent the bubble, this is a strong line of reasoning towards regulation not working. The government creating a bubble isn't as strong because bubbles happen anyway, and can be just as big or bigger.

Neu Mejican|9.21.09 @ 5:38PM|#

Let's start here...

http://www.edge.org/3rd_culture/taleb08/taleb08_index.html

Bankers' lack of understanding of statistics: may be the cause of the crisis.

Fluffy, you should read this if you haven't...

Also...
http://www.youtube.com/watch?v=ujTANpSXIvY
http://www.youtube.com/watch?v=6X7pNFbGjz0

classwarrior|9.21.09 @ 5:42PM|#

Here's another view, courtesy of Kevin Drum (Mother Jones):

Oh come on. Before 2001, banks were required to meet full capital requirements for all asset-back securities on their books. But in January 2002 that changed: AAA-rated securities, because they were so safe, were allowed to be backed by only 20% of the usual capital. That meant banks had every incentive to manufacture and keep on their books as much AAA debt as possible. It allowed them to increase their leverage fivefold.

Later, of course, regulators went further and allowed banks to use their own internal models for risk adjustment, which gave them even more incentive to play games with risk weighting. As a result, they sliced and diced their securities into a little bit of lower-rated stuff and a whole lot of super-senior tranches, which their models said were so safe they required barely any capital at all to back them. Leverage went through the roof.

Banks didn't hold lots of AAA-rated securities because bankers were playing it safe. They held lots of AAA because it allowed them to game their capital requirements and pile ever more risk on their books. It's evidence of exactly the opposite of what Friedman suggests.

|9.21.09 @ 5:52PM|#

Was executive compensation the cause of this crises, no. Did our current compensation structures make it worse, yes. And not just exectuvive compensation, but all the way down the line. If you reward people for selling crappy mortgages, guess what they do, sell crappy mortgages. And if you allow off balance sheet financing, and people to remove the risk from what they sell, that makes it worse.


Really, the solutions are simple, even if no one likes the answers.

1. Reform compenstation to make it more focused on long term profits, and not just at the top.

2. Higher capital requirments, most likely with some type of method that requires the bank to lean into the bubble phase.

3. Stop off balance sheet financing (ie securization). Make the banks keep all loans on their books. They can issue new bonds or take more deposits if they want to issue new loans.

4. Get the Government to stop promoting housing, and the Fed to stop promoting a consumer economy, and let interest rates go back to a more reasonable level.

5. No more to big to fail, split up Fannie, and Freddie, and probably BofA, and Citi as well. If your company failing can cause the collapse of the economy, you are to big.


See Easy,
And just like that by properly alinging risks and rewards, most of the regulators jobs will be done for them, and there will be much smaller chance of shit like this happening.

Final note, the GSE's had over 600 regulators watching over them, yet they are in some of the biggest trouble. Regulation by itself is not the answer. You have to properly align incentivies, or people will behave badly. That's what makes capitalism work (or not).

Mango Punch|9.21.09 @ 6:02PM|#

Kroneborge:

"3. Stop off balance sheet financing (ie securization). Make the banks keep all loans on their books. They can issue new bonds or take more deposits if they want to issue new loans"

Wow, do you hate free economic growth?

Securitizations, even if over done, have created insane amounts of wealth creation and not just on paper. It is absurd how much more liquid financing is especially to middle market companies because of securitizations...

I suppose the next logical step though is to eliminate the limited liability of stocks, because everyone knows that management not owning their company in full, miss-aligns their risk reward trade off (and yes people used to make this argument)...

|9.21.09 @ 6:30PM|#

I disagree, what type of real wealth has been generated by securitzation?

We already have stocks, for people that want a riskier/ownership interest in a company, and we already have bonds for those that want a steady stream of revenue, but are more risk adverse.

I content that "most" of this financial inovation, is generating very little value, and creating a lot of systematic risk.

To much credit, might appear to be a good thing at first, economies can seem to grow faster etc, but it's like a line of coke, the high wears off quick, and you are left fiending, and broke.

MattXIV|9.21.09 @ 6:34PM|#

Re Drum's remarks:

The first paragraph makes sense but the second paragraph doesn't. If the regulation explicitly only allowed reduced requirements for AAA, then it make sense to slice the debt up into AAA and junk tranches, but if the new regulations allowed a sliding scale across all the ratings, the bias towards AAA should have been reversed by it - you barely have to keep any capital for AAA tranches but that would be offset by the higher requirements associated with the junk tranches unless the lower than AAA but still investment grade tranches were treated the same as junk.

On to the broader point:

The AAA ratings were a problem because the underlying debt wasn't really AAA material. So how did they slice up lower grade debt to get AAA ratings? Seniority - specifically since seniority gives the creditor first short the value from the assets securing the debt, if you only put in debt that is senior enough that liquidation of the asset would return the principle, the bond will be very highly rated. This means that the amount of security provided by seniority is proportional to the value of the asset backing of the debt. But the underlying asset was experiencing a bubble, which means it was unrealistic to use the current market value, which is generally the best way to value an asset, since the other methods are subjective and thus subject to bias (which is why mark-to-market is generally a good way of looking at things). Of course, a bubble not only means the asset is above it's equlibrium price, it means that the equilibrium price is unknown - to assign a value to the asset properly, just knowing there is a bubble isn't enough. So, it was essentially impossible to come up with an accurate rating for the debt in the first place, and the methods that might have produced more accurate results were (rightly!) considered suspect because the overwhelming majority of the time they're inferior to using the market value of the asset.

trollumination|9.21.09 @ 6:36PM|#

Bull, you really think there is a spectrum with 2 ends and the truth lies somewhere in the middle? Do you really think that? Everybody says it but nobody thinks about it. Nobody is thinking at all.

Why am I mad at the Right? For mistaking a pyramid scheme for investment, or disingenuously PRETENDING to think it was investment while pocketing cash the whole time. Truth is, nothing is produced in these damned bubbles. $X goes in. It gets written down on paper as being worth $10*X or $100*X. The Wall Street fuckers take bonuses that total approximately $X, and they don't forget to tip their bartenders either, and $X seems small next to $10X or $100X, and the shit comes crashing down and the fuckers say "We only got a few percent" but the truth is that few percent was all the REAL money in the scheme, the rest was paper and it was fake. And I don't wanna read about how if the regulators had allowed phony reserves it coulda ended better. No, it couldn't. Reason's staff have been behaving like complete tools in all economic matters.

Why am I mad at the Left? For thinking that giving a working man easy access to credit is doing him a favor. No, giving him a RAISE would be a favor. But that would require he be employed in something productive, and isn't that just so icky and old-fashioned?

Why do I feel the Libertarians have completely forgotten their principles here? Because so many, such as the Reason staff, defend every stupid pyramid scheme and fakery that there is and swear allegiance in an almost religious way to a 'market' that produces nothing real and perniciously misallocates resources away from production of actual goods and services in a systematic manner.

Who am I not mad at? Well, I suppose I can't blame the Left-anarchists, and I really DO appreciate a decent Taibbi rant now and then. But it's not like that particular quadrant has any influence, goals, or ambitions of any sort, so it's not like they win a prize or anything.

Here's what I want to know. If Libertarians are such economic whizzes, please explain. Anyone? Anyone? How is it that the Fed makes money fucking FREE to any well-connected bankster, to invest in absolutely anything that could turn even the slightest edge of profit. And do they invest in anything productive? No! They put every fucking dime of it into consumer credit! Why is that? The whole reason to pay these assholes is that they 'allocate resources' but they don't, they refuse to do any such thing, they print up money and loan it to Billy Bob to buy Chinese made singing fucking fish, so what IS Wall Street doing? And why do Libertarians fucking cheer them on the whole time?

twodays|9.21.09 @ 8:18PM|#

So basically the article says that the bank executives were just stupid?
and now as a reward for this stupidity they get massive government subsidies?

|9.21.09 @ 8:39PM|#

The more I think about it, the more i am led back to two factors:

1. The flawed risk models used by the ratings agencies.
Without this, not only would the MBSes not have been overrated, but the pricing on all the derivatives that depended on there would have been much different. Including the CDOs and CDSes sold by AIG.

2. The fed-induced housing bubble, that caused the national housing market to become correlated, and screw up the risk models above.
Not only is the bubble bad for it's own reasons, but causing all housing markets to boom simultaneously made it impossible to average out risk by assembling baskets of mortgages from across the country. That led to the vast underestimation of risk in the models used by the ratings agencies.

|9.21.09 @ 8:42PM|#

But why assume the behavior had to be rational? People were making money off this as far as I can tell, and lots of people risked a lot hoping it would keep on that way though in hindsight or yes even at the time they should have seen how crazy risky that was in the long term. But that's not remarkable. People do that kind of thing in Vegas everyday..

I think what a lot of people don't get is that nobody thought it was risky. Mortgage backed securities were widely thought to be nearly as safe as treasury bonds. They jumped on them because they were believed to be very safe, and yet provided unusually high returns.
Not because they got all irrational and crazy and risk-loving.

hmm|9.21.09 @ 9:22PM|#

I wonder how things would have turned out for the GD or the current mess if the bankers were forced to hold a week long Rockefeller Morgan, Rothschild, Cartelyou style marathon ass saving bailout meeting like the did in 1907.

Of course these are the same tards that turned the power over to the Fed, or if your tinfoil hat is on the ones that took power with the fed.

Either way it would be nice to see someone other than government trying to solve the problems.

The evil banker, evil broker, evil Wall Street, evil corporations, evil everything theory gets old. There were assholes and evil fucking narrow minded egotistical short term profit seekers, but they were the few. The many are the tards that missed the bubble and the ones that regulated us into it.

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hmm|9.21.09 @ 9:28PM|#

How is it that the Fed makes money fucking FREE to any well-connected bankster, to invest in absolutely anything that could turn even the slightest edge of profit.

Do you realize money has been virtually free to you as well and still is incredibly cheap? The difference being you, or joe schmuck, leveraged a house and the guys on Wall Street leveraged securities.

The fucking add guy is stalking me again.

Neu Mejican|9.22.09 @ 1:20AM|#

Hazel,

The flawed risk models

Like I said, read this.

http://www.edge.org/3rd_culture/taleb08/taleb08_index.html

|9.22.09 @ 2:31PM|#

Neu, yeah, I was going to comment on it. It looks like a cool paper. I just haven't had time to really read it.