[NOTE: I was drafting this post when Henry Manne posted his open letter to Fama and French. I’m hesitant to post over Henry’s important letter, particularly since TOTM was down yesterday and lots of folks may not have seen the letter. I’m doing so only because this post is a good follow-up to Henry’s points about trading and market efficiency. If you haven’t read Henry’s letter, please do so forthwith!]
Let’s get one thing straight: At the end of the day, our recent financial woes were primarily caused by the mispricing of assets. A housing bubble (or, more accurately, a number of local housing bubbles) emerged as home prices grew much faster than home values. People were buying homes that they knew were on the pricey side because they figured they could always sell them to a “greater fool” who’d pay even more. Lenders financed these transactions because they knew they could sell their mortgages to federally-backed greater fools, Fannie Mae and Freddie Mac. Eventually, though, it became apparent that prices were out of line with values, the stream of greater fools dried up, and lots of folks found themselves in the unfortunate position of owing more on their homes than the homes are worth. Homeowners began defaulting on their mortgages, many of which had been sold off and packaged into securities that were purchased by financial institutions. Those defaults caused the mortgage-backed securities to fall in value, reducing the capital of the financial institutions that held them and causing insurers of those securities (e.g., sellers of credit default swaps) to have to pay large claims. It’s a somewhat complicated story, but at the end of the day there’s a clear culprit: real estate (and real estate-related) bubbles.
To prevent future economic harm from similar bubbles, both the House and Senate financial reform bills would create a systemic risk regulator whose responsibility would be to identify system-wide financial risk and limit the activities of systemically important financial firms. The most basic charge of the systemic risk regulator would be to spot incipient bubbles, for, as Clifford Asness has explained, “It is precisely the danger of bubbles and their popping that historically has caused ‘systemic risk’ to be unveiled.” Absent widespread mispricing (overvaluation) of an asset or asset class, systemwide financial risk seems fairly unlikely. Thus, the number one task of the systemic risk regulator will be to ferret out bubbles.
How exactly this Oracle will do its job is a bit fuzzy. It will face at least three major difficulties.
First, bubbles are notoriously difficult to identify before they pop. How does one distinguish between price increases occasioned by expectations of rising earnings and those resting on a belief that greater fools exist? As Asness observed, even the highly competent Maestro Greenspan couldn’t do it:
We actually had a de facto systemic risk regulator for the last 20 years or so. His name was Alan Greenspan. In the face of both the tech bubble and the recent real estate/credit bubble there were multiple calls for him to slow things down before the ultimate crashes. “Please raise interest rates.” “Please raise margin requirements” (tech bubble). “Please jawbone the markets” (he infamously tried that once in 1996, but he let rising stock prices and some good productivity data convince him he was wrong). … The point is we had someone on the job, someone with tremendous talent and credibility, someone actively trying to assess whether each of these orgies was in fact a true bubble — and he could not make that call until it was too late. … Would a Risk Czar [or council of systemic risk regulators] have worked better? Is he [are they] going to be smarter than Greenspan and know when things are bubbles and when they are not? Will he [they] know when actions might be precipitous and choke off economic growth (still the best anti-poverty program ever devised)? Is anyone that good? No one in the history of government or industry has been.
Second, as Tyler Cowen has explained, a systemic risk regulator will face intractable difficulties in reducing risks without spooking markets in a way that stifles beneficial economic activity:
The more formal the institution, the greater its power to spook markets and become a source of systemic risk itself. Let’s say that an SRC [systemic risk council] were summoned into being and one day the Council warned that systemic risk was unacceptably high. Economic activity would plummet and freeze up immediately and furthermore a liability issue could arise for any manager who did not shut down lots of plans. The practical reality is that the Council would have to be very, very cautious in its statements and actions. It’s a bit like how the security alert these days is always on “Orange.” High enough to indicate some kind of warning and to protect the regulators from a charge of complacency, but not so high as to terrify everyone or indeed inform anyone.
Third, the very existence of a systemic risk regulator may enhance moral hazard and thereby increase asset mispricing. With a systemic risk regulator on the job, investors may be less worried about overpaying for assets. After all, the systemic risk regulator should have prevented any bubble pricing; why worry that you’re buying something grossly overvalued? If investors adopt this mindset, bubbles may become more common.
Despite the difficulties of identifying incipient bubbles, stopping them without curtailing beneficial economic activities, and avoiding moral hazard, the proposal for a systemic risk regulator has broad, bipartisan support. Apparently, that’s because preventing the systemic risk associated with asset bubbles is just so important.
It is therefore more than a little ironic that the supporters of government efforts to ferret out and prevent asset bubbles are vociferously attacking the sorts of private transactions that tend to constrain asset overvaluation. I’m speaking, of course, of the sort of “speculative” derivatives trading in which John Paulson engaged, the sort of “bets” Goldman Sachs facilitated when it set up synthetic collateralized debt obligations on which its sophisticated clients could stake a position.
Members of the political class have attacked these sorts of business practices on grounds that they don’t produce anything and are really just “gambling.” For example:
Senator Chris Dodd:
[T]here’s something terribly wrong about a system in a country of ours where you make billions of dollars by making nothing or producing nothing, but merely taking advantage of an economic situation.
[NOTE: Sen. Dodd was summarizing a New York Times op-ed in which columnist Frank Rich complained about “capitalism’s worst ‘innovation’ in our own Gilded Age: the advent of exotic, speculative ‘investments’ that have no redeeming social value and are instead concocted to facilitate gambling for its own sake.” Mr. Rich concluded that “something is fundamentally amiss in a financial culture that thrives on ‘products’ that create nothing and produce nothing except new ways to make bigger bets and stack the deck in favor of the house.” Sen. Dodd said Mr. Rich “has it exactly right.”]
Senator Richard Shelby:
First of all, from my perspective and, and the perspective of a lot of people in America, we’ve got to end once and for all the casino atmosphere of Wall Street where they’re gambling, basically, on synthetic ideas and so forth.
Senator Claire McCaskill:
It’s not investment in a business that has a good idea. It’s not assisting local governments in building infrastructure. It’s gambling, pure and simple raw gambling. They’re called synthetic because there’s nothing there but the gamble, the bet. You are the bookie, you are the house.
Senator Carl Levin:
As far as I’m concerned, we ought to eliminate the damn synthetics. To me, they don’t serve any real purpose at all. They’re just betting on something where they don’t have a stake, they’re not hedging legitimate risk. … I’d get rid of them, and there will be an effort to get rid of them, and I will vote for it.
The critics of investors who go short (i.e., bet that an asset’s price will decline) and of the firms that create the investment vehicles by which they may do so are mistaken when they say these investments produce nothing of value. Most obviously, many investors who take short positions are simply trying to hedge other long bets. Their short positions therefore produce valuable risk reduction that enhances liquidity. But even the derivatives traders who aren’t hedging their own bets — even those who are merely “speculating” or, to use the favored term of derision, “gambling” — are producing something that’s absolutely essential to economic growth: information. When an investor buys a put (an option to sell), short sells a stock, or purchases a credit default swap on a debt security, he’s sending a powerful signal: “I believe this asset is overvalued, and I’m willing to bet my own money on that belief.”
That signal is particularly valuable, given that many of the most influential voices speaking on the fundamental value of investment assets are biased toward optimism. When it comes to equities, corporate managers can hardly be expected to reveal that their own companies are overvalued, and the recommendations of professional stock analysts are notoriously biased toward optimism, as I explained in this article. Indeed, in the run-up to the bursting of the tech stock bubble, a time of extreme equity overvaluation, analysts’ buy recommendations outnumbered sell recommendations by a factor of 100 to 1. As of October 26, 2001 — after Enron’s CFO had been forced to resign, the SEC had initiated an investigation into the firm’s accounting, and the Wall Street Journal had published a series of articles on the company’s earnings management problems — fifteen of seventeen top Wall Street analysts maintained buy recommendations on the company. This makes sense given that most analysts are employed by investment banks that earn the lion’s share of their profits doing deals for corporations that do not respond favorably to adverse analyst recommendations.
A similar conflict of interest neuters the oligopoly of agencies charged with evaluating debt securities. As the New York Times observed this past Sunday, the ratings of those firms, which are hired by the companies whose debt they rate and are legislatively protected from competition that could generate more accurate ratings, have proven to be remarkably unsound. Ninety-one percent of the triple A-rated securities backed by subprime mortgages issued in 2007 have been downgraded to junk status, along with 93 percent of those issued in 2006. (More data here — be sure to check out the chart.) Again, there’s a fundamental conflict of interest. As the Times explained:
The banks pay the raters and have an enormous incentive to shop around for ratings. E-mail made public in April indicates that raters give in to the temptation to manage their ratings in order to acquire more business. A 2004 e-mail message from one Standard & Poor’s employee to another referred to a meeting to “discuss adjusting criteria for rating C.D.O.’s of real estate assets this week because of the ongoing threat of losing deals.” A 2007 e-mail message from a Moody’s employee to a Chase banker suggested a colleague was “looking into some adjustments to his methodology that should be a benefit to you folks.”
Our political leaders are wrong, then, when they berate those who “bet against the market.” Rather than “producing nothing,” those investors (and the market makers who facilitate their adverse bets) create something that we desperately need: valuable information that will correct asset prices and ensure that investors don’t lose their shirts in the long run.
Nonetheless, Congress’s adverse reaction to the shorts and their facilitators is unsurprising. As James Surowiecki observes in his fascinating book, The Wisdom of Crowds, politicians have long sought to demonize short-sellers and their kin. Following the Great Depression, short-selling was denounced on the Senate floor as one of the “great commercial evils of the day” and “a major cause of prolonging the depression.” It was, for some time, banned outright in England and New York state. It incurred the ire of J. Edgar Hoover, who vowed to investigate whether short-sellers were conspiring to hold down stock prices. In 1995, the Malaysian finance minister went so far as to propose that short-sellers be caned for their anti-social behavior! State treasurers haven’t gone quite that far, but they have recently come out, guns blazing, against financial institutions that would dare question their creditworthiness by selling credit default swaps on their debt.
The reaction of these state officials makes sense. They want to borrow money cheaply, and rising prices for credit default swaps on their debt increases their borrowing costs. More generally, though, the political class always has an interest in rising asset prices, which translate into higher tax revenues. By contrast, short-sellers and their ilk tend to decrease the prices of overvalued assets. This harms politicians who have less money to play with, but it keeps investors from losing their shirts when bubbles inevitably pop.
So at the end of the day, we have two fundamentally different approaches to preventing asset bubbles and the harm they entail. The political class wants to entrust this task to a centralized body of experts — a systemic risk council. Market liberals would deputize scads of individual investors to perform this task by making bets against different types of assets, thereby signaling their private information suggesting overvaluation. If we take the market route, we’ll have to be willing to tolerate fat cats who prosper on others’ losses, but we won’t have to worry about (1) how our Platonic guardians will be able to distinguish bubbles from real value appreciation, (2) whether the systemic risk council can stem irrational exuberance without spooking markets, and (3) the degree to which a systemic risk regulator will create moral hazard.
I’d opt for markets, fat cats and all.