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Executive Compensation
April 3, 2012 4:32 AM   Subscribe

The Incentive Bubble (ungated pdf) - "The fraying of the compact of American capitalism by rising income inequality and repeated governance crises is disturbing. But misallocations of financial, real, and human capital arising from the financial-incentive bubble are much more worrisome to those concerned with the competitiveness of the American economy."
An economy can be only as strong as the allocation mechanisms that ensure that capital of all types moves toward its highest social use. When risk is repeatedly mispriced because investors enjoy skewed incentive schemes, financial capital is being misallocated. When managers undertake unwise investments or mergers in order to meet expectations that will trigger large compensation packages, real capital is being misallocated. And when relative compensation is as distorted as it has been by the financial-incentive bubble over the past several decades, one can only assume that human capital is being misallocated, to a disturbing degree. Awakening our monitors to their responsibilities and to the flaws of market-based compensation provides the best hope for correcting these misallocations and strengthening the U.S. economy for the challenges of this century.
Satyajit Das: Pravda The Economist's Take on Financial Innovation - "There is no acknowledgement that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries. There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions... The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits."

Wall Street's Broken Windows - "James Q. Wilson was a political scientist who often studied the government response to blue collar crime. The public knows him best for his theory called 'broken windows...' Wilson took social norms, community, and ethics seriously. He argued that as community broke down fewer honest citizens were active in monitoring and policing behavior. The breakdown in community was criminogenic – it led to widespread serious blue collar crime. He urged us to take even minor blue collar crimes and breaches of civility seriously and to demand that they be contained through social pressure and policing... Similarly, corruption that is excused and tolerated by elites is unlikely to remain at the level of 'a few deals.' Corruption is likely to spread in incidence and severity precisely because it undermines community and the rule of law and it is likely to grow more pervasive and harmful the more we tolerate it."
posted by kliuless (54 comments total) 18 users marked this as a favorite

 
This bit:
The skills of managers and investors are among the most precious capabilities in our market economy. Accordingly, they should be richly rewarded. But they are extremely rare, and assessing them is a complex, multifaceted process requiring judgment.
Reminded me of:
Throughout history necromancers, witch-doctors, alchemists and ju-ju men have extracted high incomes. They’ve done so because their patrons have believed their job to be very difficult, demanding supreme skills. But in truth, the jobs of foretelling the future, controlling the weather and turning base metals into gold haven’t been difficult ones. They’ve been impossible.
posted by TheophileEscargot at 5:32 AM on April 3, 2012 [19 favorites]


Interesting topic on the mispricing of risk caused by poorly structured compensation, and the how that relates to the dangers of financial innovation, with a nice follow up on how the change in comp has had a negative increase on ethics in the finance world.

first comment : Rich people are witchdoctors

You guys are the best.
posted by JPD at 5:54 AM on April 3, 2012 [7 favorites]


The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits."

So I sorta disagree with this statement. Sorta. When most of the "innovations" of the last 40 years are examined (whole loan securitization, interest and currency swaps and the world they birthed, portfolio 'insurance', the math behind CDO's, credit default swaps, etc) the original buyers knew what they were buying. Most of the time the first examples of these products were created as bespoke one-offs for someone. Because they were bespoke the margins were high, but that was fine because it filled a niche that didn't exist, and the people buying them went into it with eyes wide open, they knew the embedded commissions were high, but they were willing to pay that price. Hell on some of these the clients almost built the pricing model. Where Das is right is that once the banks had these things created, and realized how profitable they were, they sold the shit out of them to people who didn't understand what they were buying, what the risks were, and how much money the banks were making off of them. And the banks kept making more of them until either spreads shrunk and they became less profitable, or a product pushed beyond the envelope of what it was designed to be (CDOs) imploded.

The problem isn't "innovation" per se.
posted by JPD at 6:04 AM on April 3, 2012 [4 favorites]


There are some really odd claims in the Naked Capitalism post (although that's a given from that site). First, this objection to ETFs:

There is no discussion of a key underlying issue – the idea of diversification. The Economist argues that “the dotcom bust had underscored the importance of diversification”.

Diversification to reduce risk is not without problems. As equity indexes are weighted typically by market capitalisation, as an individual share price rises it becomes a larger part of the index and therefore the ETF. During manic market phases, such as the dot com and now the AGF (Apple Google Facebook) boom, ETF investors may inadvertently find them heavily exposed to such stocks.

In asset classes such as debt, the idea of indexation is more problematic. As the indexes are weighted by the amount of bonds on issue, as an issuer borrows more it becomes a larger part of the ETF, irrespective of its ability to make repayments. As Worldcom and more recently European sovereign debt shows, the results are not pretty.


Well, yes, in general when an asset's value rises, it becomes a more important part of your investment portfolio, unless you do some rebalancing, or are invested in an asset that rebalances itself, such as a time-target fund. But this has nothing to do with financial innovation--the effect is just the same if you bought stocks directly, or indeed, if you invested in a house and house price subsequently rose. It's weird to attribute this problem to financial innovation, when in fact financial innovation is a possible solution to a problem that already existed. Furthermore:

Liquidity and lower transaction costs only benefits an investor when they trade. High liquidity and tight bid-offer spreads are only available, as all practitioners know, when it is not needed, becoming the first casualties of market downturns and volatility.

That's just plain ridiculous. Look at the bid-ask spread of any stock, right now. If there stock has any significant market cap at all, it's virtually guaranteed that the spread is pennies, or fractions of a penny. This is absolutely a new thing, and it's definitely good for the investor! How in the world does Das think it was better in the old days to pay at least 12 cents, and often significantly more, to trade? Sure, there might be stability risks such as the flash crash (which should not have hurt you if you were not actively trading), but to argue that tight bid-offer spreads are only available when not needed is just contrary to reality.
posted by dsfan at 6:08 AM on April 3, 2012 [2 favorites]


dsfan - I think that last point is one of the traditional talking points for the anti-HFT brigade that they've basically run the traditional market-makers out of business (which is true) and that unlike market-makers who would attempt to provide liquidity at moments of stress, the quasi-HFT market makers of today leave the market when the models breakdown. Actually I think its a pretty correct statement, although I think they overstate how often it occurs.
posted by JPD at 6:24 AM on April 3, 2012 [1 favorite]


dsfan - I think that last point is one of the traditional talking points for the anti-HFT brigade that they've basically run the traditional market-makers out of business (which is true) and that unlike market-makers who would attempt to provide liquidity at moments of stress, the quasi-HFT market makers of today leave the market when the models breakdown. Actually I think its a pretty correct statement, although I think they overstate how often it occurs.

It is the traditional statement they make, although I agree it's overblown. But his claim, as I read it, is stronger than that: "tight bid-offer spreads are only available, as all practitioners know, when it is not needed." It's available right now! If I wanted to trade a share of stock, I can definitely get it at a better price than I would have under the traditional market maker scheme. And this is probably true over 99% of the time, the only question is how many .9s I can add on. Maybe I'm being ungenerous, but Das seems to be saying that the tighter spreads cited by Vanguard of all people don't really "benefit all investors." I find that an unusual claim, given that I would benefit if I stepped out and traded a share right now. He seems (to me) to be only looking at the dark side, and refusing to even acknowledge the significant benefits that seem to be present, both in bull and bear markets (the price decline in 2008-2009 was fairly orderly, as it happens), with more frequent trading.

By the way, his simultaneous argument that "financial products need to be opaque and priced inefficiently to produce excessive profits" and objection to frequent trading in markets such as interest rate swaps is difficult for me to understand. You know what's a good way to make financial products less opaque and more efficiently priced? Trading them!
posted by dsfan at 6:38 AM on April 3, 2012


first comment : Rich people are witchdoctors

You guys are the best.


Well, to be fair to witch doctors, witch doctors only scam you for the money you're willing to give them. Wall Street financiers will create insane amounts of risk, and then threaten Congress with civil war until the Treasury hands over trillions of dollars — no strings attached — to save them from the horrors of having an actual job. The net effect of this is basically stealing the wealth of the middle class by saddling them with the debt created by their failed financial system, and then refusing to pay more taxes to help with the deficit that can be directly traced back to their stupidity.

As a kicker, they'll supply millions of dollars for propaganda campaigns to dupe the middle class into voting against their own interests. You can talk about "negative increase in ethics," but if you were being honest, you would say "completely predictable actions of powerful, selfish, greedy assholes."

If the top 1% were raptured into the heavens one day, nothing about my daily life would change. And if the money they were sitting on and doing fuck-all with was recycled back into the economy, it would get a hell of a lot better.
posted by deanklear at 6:44 AM on April 3, 2012 [10 favorites]


deanklear I think you might have missed the point. Its a derail.

dsfan - agreed, question of how you read what he's saying, but generally agree with what you say. Your last point is true and pretty amusing.
posted by JPD at 6:51 AM on April 3, 2012 [1 favorite]


You know what's a good way to make financial products less opaque and more efficiently priced? Trading them!

Ugh. I renew my call for everyone in finance to take just one Systems & Signals course. Higher frequency polling does not guarantee more accuracy. Negative feedbacks (in this case trading costs) are absolutely critical to maintain stability.
posted by Popular Ethics at 6:52 AM on April 3, 2012 [2 favorites]


Higher frequency polling does not guarantee more accuracy.

true. I don't think that's what people who call for products to be commoditized and traded on an exchange are calling for though.
posted by JPD at 6:56 AM on April 3, 2012


"Rich people were witchdoctors"? How did you even get that from his comment?
posted by sutt at 7:01 AM on April 3, 2012


deanklear I think you might have missed the point. Its a derail.

It's possible, but I think it's important to remember the purpose of financial innovation is to make rich people richer. To say that their track record is poor when it comes to ethics would be both an understatement and a complement.

There's a reason Madoff appeared legitimate for so long, but unfortunately for him his "financial innovation" was comprehensible. If he had been dealing in the ponzi schemes of CDOs instead, or front-running the whole market like Goldman Sachs does, he'd still be popping up at dinner parties and smiling in the latest issue of Forbes.
posted by deanklear at 7:03 AM on April 3, 2012 [2 favorites]


Higher frequency polling does not guarantee more accuracy.

The empirical evidence on the effect of frequent trading on volatility is decidedly mixed, although my read is that probably more studies than not conclude that trading slightly dampens volatility (for an intelligent but somewhat contrary view from Dean Baker, see here). But, as a nonfinancial business, you are probably going to get much tighter pricing on standard and frequently-traded products such as interest rate and currency swaps than in something more exotic. This isn't coincidental.
posted by dsfan at 7:09 AM on April 3, 2012


it's important to remember the purpose of financial innovation is to make rich people richer

nobody has to buy or sell any of this ...

Do you have a mortgage? Is it opaque to you? Solutions:

a) educate yourself (may be expensive in time or you may only think you know enough)

b) PAY an expert (who is not otherwise compensated) to advise you

or is that too expensive?

c) get advice from and "expert" on comission ... (oops)

Are garage mechanics evil because they know more about cars than you do? What if garage mechanics earned commison?
posted by fistynuts at 7:37 AM on April 3, 2012


fistynuts: People do fear being cheated by garage mechanics.
posted by jb at 8:12 AM on April 3, 2012


Exactly. So either employ an expert, or educate yourself. This applies as much to the individual as the Governent.

Instead we have everybody in the world believing they are experts on finance.

Why is that?

Would you employ your Senator/Representative/MP/TD to fix your car?
posted by fistynuts at 9:04 AM on April 3, 2012


Yeah, but you also have to regulate the experts. Cheating's cheating.
posted by Trochanter at 9:16 AM on April 3, 2012 [1 favorite]


Plus the back and forth of people between the regulatory agencies and the regulated industry is a problem waiting to happen. Talk about perverse incentives.
posted by Trochanter at 9:18 AM on April 3, 2012 [2 favorites]


If it were possible for everyone to protect themselves from predatory commercial practices (whether committed by auto mechanics or bankers), we would never have developed contract laws and the various enforcement mechanisms that gave rise to the modern state.

If caveat emptor were a workable alternative system, it would have taken hold successfully by now. The fact that even in the many years since latin became a dead language, we still haven't managed to obviate the need for the state enforcement of rules of fair play in our markets by embracing the system of caveat emptor should probably persuade any but the most hardheaded doctrinaires that it's an unworkable alternative system.

We need to do a better job of accepting and living pragmatically within the world we've got, rather than positing the possibility of idealized fantasy worlds or blaming the victims of charlatans and frauds. No one is too clever to be taken in by a sufficiently sophisticated con. No one.
posted by saulgoodman at 9:39 AM on April 3, 2012


This isn't an either or situation. There needs to be better regulation, but that regulation can't be done in such a way that is strips too much risk out of industry, in fact it should encourage more risk taken by smaller players.
posted by JPD at 9:47 AM on April 3, 2012


Exactly. So either employ an expert, or educate yourself. This applies as much to the individual as the Governent.

Isn't the whole point that you can't know if an expert you employ is ripping you off without educating yourself first? Which obviates the need for the expert (unless you just don't have the time to do the work yourself, in which case it's hard to see justifying the massive salaries those experts get now, since they'd be relegated to the role of errand boys in that case)?

Doesn't matter, though, because there are a lot of experts making decisions for us that we don't even have the option of approving or rejecting. The experts that manage the investments made with the funds we deposit in our bank accounts, for example, or those who buy and sell our mortgages or "borrow" our stocks to let other investors make short sales on margin, pension and other institutional fund managers, etc.

The consumer markets--where consumers actually have direct influence and decision-making power--are only a tiny part of the modern economy as a whole. I think the economy as a whole has gotten so specialized, compartmentalized and byzantine that consumer market choices hardly have any real economic power anymore expect in the most extreme cases or around the edges.
posted by saulgoodman at 10:13 AM on April 3, 2012


Yeah there needs to be a very big difference between how you regulate consumer facing products and institutional products.

Doesn't matter, though, because there are a lot of experts making decisions for us that we don't even have the option of approving or rejecting. The experts that manage the investments made with the funds we deposit in our bank accounts, for example, or those who buy and sell our mortgages or "borrow" our stocks to let other investors make short sales on margin, pension and other institutional fund managers, etc.

huh? yes you do. You don't think the people who manage your investments have your interests at hand? who are you invested with? fire them. You realize that if you own index funds stock lending basically pays for the costs of managing your money?And what's with the anti-short selling thing?

The consumer markets--where consumers actually have direct influence and decision-making power--are only a tiny part of the modern economy as a whole.

not true. The entire financial crisis was basically because the consumer market kept consuming products that banks shouldn't have been permitted to offer them.
posted by JPD at 10:20 AM on April 3, 2012


This isn't an either or situation. There needs to be better regulation, but that regulation can't be done in such a way that is strips too much risk out of industry

Agreed. It'd be nice though, if both law and regulation could conspire to make it harder for bad faith actors, frauds and irresponsible risk takers to hide from the consequences of their behaviors behind corporate law and regulations that go too far in the direction of limiting personal liability and the deliberately convoluted pro forma paper trails these laws produce.

Where's all the concern from Wall Street about the "moral hazard" that limiting personal liability under corporate law creates? No, it's only moral hazard when poor/middle class consumers are held personally to account for their economic behaviors. The rest is just necessary evil.

huh? yes you do. You don't think the people who manage your investments have your interests at hand? who are you invested with? fire them. You realize that if you own index funds stock lending basically pays for the costs of managing your money?And what's with the anti-short selling thing?

As far as I know, I can't tell my bank how to invest my deposit funds. And it's not an anti-short selling thing, exactly, but most ordinary investors have no idea that their stocks can be lent out without their knowledge for use in short selling--whether those practices are sound or beneficial or not, to me there's an implicit, unexamined property rights issue there. But I won't push the point. It's just peculiar to me that a share of stock I nominally own through, say, Ameritrade can be lent out to someone else who wants to do a short sale without my having any right of refusal (or at least, if I do, it's not a very well communicated right, at least by online brokerages). Some brokerages retain the right to lend out stocks held in cash accounts, you know. And they aren't always very explicit about it. That's my beef.

The entire financial crisis was basically because the consumer market kept consuming products that banks shouldn't have been permitted to offer them.


I don't share this view. I still blame the investment markets that created the demand for all those mortgage-backed CDOs. The consumer end of the deal was one of the last floats in the parade.
posted by saulgoodman at 10:37 AM on April 3, 2012


I can't tell my bank how to invest my deposit funds. No but commercial banks can only invest deposits in a very small subset of assets that are pretty highly regulated. You could also choose to invest with a credit union that only sells loans to local businesses and residents.

Yes stock lending is rather opaque. I just don't think it causes a loss of value for the long shareholder.

I still blame the investment markets that created the demand for all those mortgage-backed CDOs. What was inside those CDOs? In case its not clear - I'm not blaming the consumer here. I'm blaming the mortgage companies and the regulators for not protecting consumers from themselves, but consumers did actively choose to purchase homes using the most "affordable products" available. Feedback loop for sure and hard to say which came first, but consumers played a role.
posted by JPD at 11:01 AM on April 3, 2012


I'm blaming the mortgage companies and the regulators for not protecting consumers from themselves, but consumers did actively choose to purchase homes using the most "affordable products" available.

But in the states where this was most true, long before the consumers started queuing up for these easy loans, officials were busily reworking regulations to make it even easier and to dismantle regulatory protections against fraud. In Florida, they took away licensing requirements and let just about anybody become a loan originator, and unsurprisingly, that led to massive rates of mortgage fraud (and BTW, don't Florida, Nevada, Arizona and California, alone account for most of the troubled mortgages in question? All states that had extraordinarily high rates of mortgage fraud in the wake of de-regulatory jags? And didn't the SEC lodge a formal complaint against Goldman Sachs for designing complex securities that had the effect of dramatically magnifying the effects of the housing crisis?)
posted by saulgoodman at 11:33 AM on April 3, 2012


It was not consumers that caused this crisis. It was the combination of deliberately lax state regulatory systems meant to open the flood gates to create new raw material for investment instrument creation (CDOs) and the way these complex instruments were structured to pay off big for the investment houses if they failed that caused the crisis.
posted by saulgoodman at 11:36 AM on April 3, 2012


I think ETFs are a good idea, and probably a good example of "Financial innovation". They allow regular investors to diversify very easily across either a broad or narrow class of stocks.

If you're investing for fun, they are more fun. One benefit is that you can invest in commodities easily, without worrying about futures contracts or whatever. So you can invest in gold or commodities or entire industries, and you're less exposed exposed to risks like fraudulent CEOs or mistakes by one company, and because you can trade them in real time you so you can change your mind whenever you want.

At the same time, though some ETFs may just be sucking money out of people, like the leveraged, short indexes would probably just completely screw any 'normal' investors who tried to invest in them.
"Rich people were witchdoctors"? How did you even get that from his comment?
Particularly the comment wasn't even about "rich people" but specific types of investment bankers. The implication in interpreting it that way is that all rich people are rich because they were able to extract money from the stock market, which would mean they produced no real value, only siphoned off the 'flux' as money moved around. Surely there are some rich people left who actually produced something, rather then simply inheriting some money or going to Harvard and making friends with the right people to get an investment banking job.
but consumers did actively choose to purchase homes using the most "affordable products" available.
The problem is you can't blame regular people for thinking that affordable and "affordable" aren't actually the same thing.
huh? yes you do. You don't think the people who manage your investments have your interests at hand? who are you invested with? fire them. You realize that if you own index funds stock lending basically pays for the costs of managing your money?And what's with the anti-short selling thing?
Most employees have 401(k) type retirement accounts, and don't really have that much control over who manages the money or what they are invested in. In some cases you have a fixed-benefit pension fund that you have no control over whatsoever, but it's not supposed to matter because you get paid either way.

I think the lack of true 'democratic' control is part of the problem with corporate governance. People are invested, but they aren't 'direct' shareholders, rather then own mutual funds and those mutual funds get to vote and hold board seats.

And of course the people on those board seats are all members of the 1% club. So you have a situation where corporations use lobbying dollars to benefit the executives, board members, and major investors (i.e. the mutual funds) rather then the people who actually hold a significant portion of the stock. It's highly problematic.
posted by delmoi at 12:26 PM on April 3, 2012



I don't think the financial innovation process is entirely deliberate as the author says; honest miscalculation was a big part of it. Companies like Lehman Brothers, Bear Stearns, AIG, etc., wouldn't have purposely put themselves out of business and damaged the entire industry. Alan Greenspan wouldn't have promoted the subprime industry if he really understood what was happening. Seems to me CDO's were so easy to sell that they fed, even created, the subprime loan industry, creating a real-estate bubble. Many misjudged the effectiveness of diversification by region and loan quality, and didn't believe real estate prices would go down significantly as a whole the way they did. When some did see what was happening they did their best to take advantage of it. I thought was pretty on the mark.
posted by Golden Eternity at 12:39 PM on April 3, 2012


The problem isn't "innovation" per se.

That's a straw man, as your lead-in quote clearly shows:
"...much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency."
posted by Mental Wimp at 12:40 PM on April 3, 2012


Oops. Meant to say I thought Margin Call was pretty on the mark.
posted by Golden Eternity at 12:41 PM on April 3, 2012


But in the states where this was most true, long before the consumers started queuing up for these easy loans, officials were busily reworking regulations to make it even easier and to dismantle regulatory protections against fraud.

yes this is true. I'm not denying that. I already said "regulators didn't protect consumers and banks preyed on them" I'm saying consumers weren't capable of figuring out what bad deals these sorts of loans were so they shouldn't have been offered. That doesn't mean consumers didn't still choose to buy them. They still said "well sure this house is 7x my annual income, but this new kind of loan my bank is offering me means its only 25% of my monthly take-home. Lets do it" The banks and regulators were clearly the most culpable, but if the consumer didn't take out the loan then it never would have happened. Those loans are what were put into the CDO's. They literally don't exist if people stop paying too much for houses. You can't totally write off the role of the consumer. The regulators should never have allowed the consumers to make those choices.
posted by JPD at 1:10 PM on April 3, 2012


The entire financial crisis was basically because the consumer market kept consuming products that banks shouldn't have been permitted to offer them.

How is this not the same thing as harmful innovation, but with the actors behind it politely whited-out?

At any rate, this is second-order consumption that was enabled only by availability of "innovative" finance on the corporate/institutional elite level. The liar loans, etc, would not have been available if all the risk wasn't capable of being securitized and passed on down the line to be divvied up, and ultimately dumped on other consumers through instruments such as retirement funds managed not by those consumers themselves (who were often unable to choose alternatives) but by rather participating members of the same financial services elites.

You dig Latin? Like the sound of "caveat emptor?" How about the sound of "quantum meruit?"

disclaimer: posting this while distracted in class. Sorry if I lost the plot....
posted by snuffleupagus at 1:19 PM on April 3, 2012


Cui bono?
posted by Mental Wimp at 1:26 PM on April 3, 2012


And didn't the SEC lodge a formal complaint against Goldman Sachs for designing complex securities that had the effect of dramatically magnifying the effects of the housing crisis?

Yeah, but you also have to regulate the experts. Cheating's cheating.

I still blame the investment markets that created the demand for all those mortgage-backed CDOs.

If it were possible for everyone to protect themselves from predatory commercial practices (whether committed by auto mechanics or bankers), we would never have developed contract laws and the various enforcement mechanisms that gave rise to the modern state.

If caveat emptor were a workable alternative system, it would have taken hold successfully by now.


It was so called 'experts' who bought those CDO's, under contract (who were considered 'market professionals' to the point that only 'caveat emptor' applies).

Rather than actually doing the due diligence that a prudent investor would do when buying a bunch of opaque stuff, the lowly paid (only 4 x national average) investment managers turned to the lowly paid (only 4 x national average) analysts at the ratings agencies, and as they said it was safe, they bought it.

Undoubtedly the guys at Goldman were paid more than any individual buyer, but less that the sum of all of the buyers. At least the guys at Goldman were actually doing the job they were paid to do.

There is only one significant piece of advice anyone, be they consumer, government or market professional needs to know, and that is

NEVER buy anything you don't understand, if it sounds too good to be true, it's because you don't understand it yet.
posted by fistynuts at 1:27 PM on April 3, 2012


oh and:

that had the effect of dramatically magnifying the effects of the housing crisis?

For those foolish enough to buy those securities, not the housing crisis as a whole...

That is the proven effect of leverage, for better or worse, magnified profits, magnified losses.
posted by fistynuts at 1:41 PM on April 3, 2012


How is this not the same thing as harmful innovation, but with the actors behind it politely whited-out?

Because there is actually a very small set of the population those loans are appropriate for. Stated-income loans existed for years before the crisis. There was not a single popular form of loan that postdated the creation of CDOs. Neg-Am, Exploding ARMs, all of them been around for years before the crisis.
posted by JPD at 1:48 PM on April 3, 2012


magnified losses
which were shifted to home-buyers and taxpayers.
posted by snuffleupagus at 1:49 PM on April 3, 2012


fistynuts,

I think you are ignoring the central problem: those with the most resources, including time, are always winners, but in more complex environments they are often the only winners. If we live in an information based economy (which we do) then there have to be rules to try and vet information, because there are too many specializations to reasonably expect everyone to be an expert on everything.

You say "educate yourself" as if someone who has kids and a 50-60 hour workweek has time to do anything at all besides what their job entails, and what their families need. But let's say that they do. Let's say they can afford stocks, and invest in safe mutual funds at the advice of their financial advisor. Let's say their mutual fund hires a huge firm like Goldman Sachs to give them investment advice, and let's say that Goldman Sachs tells them that CDOs are a fabulous idea, even when Goldman is betting all of their money on the collapse of the entire CDO market. So, even if someone followed your advice, they still would have lost due to massive information asymmetry, not due to shortsightedness as consumers.

The libertarian idea of people bearing full responsibility for every decision means that the economy can only be as complicated as an average individual can wholly understand. If you do want to keep the modern creature comforts of civilized life, you have to install some reasonable safety nets and policing authority, or else the boom and bust cycle will grind civilization back and progress will virtually stop. Excepting advances in computer technology, that's what's happening to the United States. Life expectancy is going down. Infant mortality is on par with developing nations. All of this complexity is starting to defeat itself, because the business community has stopped creating institutions that give a damn about ethics, or even punishing the truly unethical, which I'd count as the vast majority of Fortune 100 companies.

Additionally, since we've decided that everything is only worth money, the institutional failures that usually affected things that didn't really matter — retail sales, stock prices, etc — are now affecting institutions that do matter like health care, education, and our justice system.

The lesson from the Great Depression was that banking and insurance and stocks were very important parts of the economy; so important that they shouldn't be entirely entrusted to any sort of private power. Only a few years after those firewalls were destroyed, the whole system predictably collapsed, while in nations like Canada that still enforced rules, the banking system was barely affected. You are welcome to toss out the red herrings of consumer choice and education, but honestly, that's just victim blaming. Our economic system is suffering from systemic, foundational failures, and until those are addressed, not much is going to change.
posted by deanklear at 1:53 PM on April 3, 2012 [4 favorites]


There was not a single popular form of loan that postdated the creation of CDOs. Neg-Am, Exploding ARMs, all of them been around for years before the crisis.

There absolutely was a standard mortgage, and we all know well what it looked like. Fixed rate, 15 or 30 years. 20% down (or more.) The incentives to sell riskier loans and bigger houses to consumers came when banks no longer needed to carry them on their own balance sheets.

In short, tell me why the Giant Pool of Money was wrong?
posted by snuffleupagus at 1:54 PM on April 3, 2012


And, perhaps more to JPDs point, it isn't necessary for particular financial instruments to have been created after CDOs for their (mis)use to have been innovated. Innovation =/= Invention.
posted by snuffleupagus at 2:00 PM on April 3, 2012


There absolutely was a standard mortgage, and we all know well what it looked like. Fixed rate, 15 or 30 years. 20% down (or more.) The incentives to sell riskier loans and bigger houses to consumers came when banks no longer needed to carry them on their own balance sheets.

30-year fixed rate mortgages with early prepayment options are only "standard" in the sense that they were strongly encouraged/subsidized by the government. It's an inherently unstable product--an enormously long-duration asset funded by very short-term liabilities, i.e., demand deposits--that barely exists elsewhere in the world (I believe it's basically the US and Denmark, if I recall correctly). I don't think a strong argument exists that keeping these assets on the banking sector's balance sheets promotes a stable financial sector.
posted by dsfan at 2:32 PM on April 3, 2012


which were shifted to home-buyers and taxpayers.

home buyers: no. taxpayers:yes, but subprime was just the straw, over-leverage was the culprit.

Let's say they can afford stocks, and invest in safe mutual funds... Let's say their mutual fund hires a huge firm like Goldman Sachs to give them investment advice...when Goldman is betting all of their money on the collapse of the entire CDO market

Can you see what is wrong there? Who pays the second hand car salesman to tell them which car to buy?

And yes, the lobbied for regulation changes were a disaster, btu isn't every piece of big business based lobbying?

I agree with you , the skilled outperform in a complex environment - but the issue is the pay based model, because unless you are willing to pay the gamekeeper what he can earn as a poacher, how do you expect to stop the poacher?

Hiring experts on comission does not work, you have to hire them on fixed fee. Pretty much every other higly skilled profession recognises this, except for finance.

You are welcome to toss out the red herrings of consumer choice and education

I'm not talking about consumer level education(which is pretty much covered completely in the Grantham letter in the OP), what I'm talking about applies just as much 'market professionals' - the people running the mutual fund, who are paid to evaluate investments for their clients.

None of them understood what they were buying and still buy lots of stuff without understanding it, or even having read the contract. Do you believe there is any business that would not take advantage of customer who thinks that way?

All the consumer needed to know about the subprime crisis was "Can I afford this mortgage?".
posted by fistynuts at 2:42 PM on April 3, 2012


Steve Waldman made an interesting series of blog posts on the topic of opacity, regulation, and incentives in finance: 1, 2, 3.
posted by samw at 2:43 PM on April 3, 2012


shifted to home-buyers and taxpayers

Banks Take More Hits on Bad Loans
Fannie and Freddie asked banks to buy back $33 billion of loans last year. That is up 10% from 2010, according to federal securities filings the companies have made this month. The banks don't typically pay the full amount but during the second half of 2011, the companies collected $11.1 billion from banks, compared with $6.9 billion in the first half of the year... Fannie and Freddie... can force banks to repurchase loans found to contain faulty appraisals and other defects... Not all repurchase demands result in a buyback. Fannie and Freddie have withdrawn about one-third of all demands, after banks produced appropriate records or successfully appealed to the companies.
viz. "Federal entities account for a growing share of foreclosed property holdings," foreclosures & possible GSE principal reductions...

also btw: "Recently, mortgage rates have backed up, just as we are approaching the summer selling season. If the Fed wants to support asset prices, then clearly, if the data weaken over the next couple of months, it would make sense for them to move on MBS instead of Treasuries as it would shift portfolio and lending preferences to MBS and the mortgage market."

US Made Profit on Mortgage Debt: "In the latest sign of the government's gradual retreat from financial-crisis-related programs, the Treasury Department is expected to announce Monday that taxpayers reaped a $25 billion profit on mortgage bonds purchased at the height of the meltdown... The government last week sold the last of the bonds, winding down Treasury's ownership of debt backed by the federally backed mortgage investors Fannie Mae and Freddie Mac. Treasury spent $225 billion on purchases over 16 months before it began selling the securities last year."

Now you see the headline fiscal deficit, now you don't:
So, in case you missed it, the IMF released an excellent, pithy staff note on 'Accounting Devices and Fiscal Illusions' this week – all about book-cooking of sovereign debt stats.

It touches on almost any accounting trick you can think of, where the effect is that 'this year's reported deficit is reduced, but only at the expense of future deficits,' as the IMF note says. 'The result is that the reported deficit loses some of its accuracy as a fiscal indicator,' it drily adds.

Anyway, the paper covers 'hidden borrowing', such as Greece's now-infamous swaps; 'disinvestment', such as Greece's now-infamous off-balance sheet revenue securitisation vehicles; and 'disappearing government', such as Greece's now-infamous state transport companies, which have since re-appeared on the orders of Eurostat.

Not all Greece, though. Under 'disappearing government' (or disappearing banking crisis liabilities, more like) the paper also name-checks state-owned UK lenders, the Irish bad bank, and the big daddy of them all, 'The United States does not recognize as its own the assets and liabilities of Fannie Mae and Freddie Mac.' It also includes things which we suspect might be the fiscal-illusory wave of the future, such as sovereign lease finance...
consumer facing products and institutional products

cf. institutional money and shadow banking:
What the trends of the last few years show is that the minuscule yield certain investors would get by putting cash in money market funds, was deemed less valuable than the government guarantee that backs non-interest bearing accounts.

Absolute safety over meagre yield.

And the investors who made the switch from MMFs to these insured accounts are, we suspect, similar to those who represent the constant demand for safe assets that Gary Gorton's recent preliminary paper described.

In other words, these are investors looking for short-term savings vehicles only if those vehicles are either buying safe assets directly or lending against safe assets as collateral. This is money that would rather be in the shadow banking system.
bernanke sez: "[R]ather than being some ad hoc and unprecedented set of actions... the Fed's response was very much in keeping with the historic role of central banks, which is to provide lender of last resort facilities in order to calm a panic. And what was different about this crisis was that the institutional structure was different. It wasn't banks and depositors. It was broker-dealers and repo markets. It was money market funds and commercial paper but the basic idea providing short-term liquidity in order to stem a panic was very much what [Walter] Bagehot envisioned when he wrote Lombard Street in 1873..."

but note: "[F]rom the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. Importantly, this combined fiscal and monetary leverage produced outsized returns that exceeded the ability of real economies to create wealth."

and with that in mind...
How American Corporations Transformed from Producers to Predators: Corporations are not working for the 99 percent. But this wasn't always the case. In a special five-part series, William Lazonick, professor at UMass, president of the Academic-Industry Research Network, and a leading expert on the business corporation, along with journalist Ken Jacobson and AlterNet's Lynn Parramore, will examine the foundations, history and purpose of the corporation to answer this vital question: How can the public take control of the business corporation and make it work for the real economy?

Taxing The Economy To Save It: I am inclined to conjecture that over the last 30 years, reductions in top marginal tax rates may have provided a huge incentive to expand the financial services industry. The increasing importance of finance also seems to have been a significant factor in the increasing inequality in income distribution observed over the same period. But the net gain to society from an expanding financial sector has been minimal, resources devoted to finance being resources denied to activities that produce positive net returns to society. So if my conjecture is right — and I am not at all confident that it is, but if it is – then raising marginal tax rates could actually increase economic growth by inducing the financial sector and its evil twin the gaming sector — to release resources now being employed without generating any net social benefit.
posted by kliuless at 3:21 PM on April 3, 2012


Do you believe there is any business that would not take advantage of customer who thinks that way?

That is frankly ridiculous. Why would I expect businesses to cheat their customers? If Goldman Sachs was instead selling a robot butler, which was programmed to steal all of the cash and valuables from a customer's house and deliver it to Goldman's safety deposit box after casing the place for 90 days, you'd think that is a fair business model that should remain illegal?

The net effect of their products were exactly that: financial time bombs that hurt their clients and benefited Goldman Sachs. Why would you defend that behavior as ethical? Or have we finally decided to turn America into the thunder dome?

All the consumer needed to know about the subprime crisis was "Can I afford this mortgage?"

Many of them could, until the the largest recession in 70 years reduced incomes across the board. And most of the ones who couldn't were preyed upon by banks to earn commissions and then sell off the loans to get repackaged and incorrectly marked as AAA.

It seems like you'll do anything but blame the criminals who engaged in this unethical behavior. Why is that?
posted by deanklear at 3:49 PM on April 3, 2012 [1 favorite]


All the consumer needed to know about the subprime crisis was "Can I afford this mortgage?"
And so was unleashed the horde of storefront mortgage brokers, barely more financially literate than their marks fiduciaries clients, but nevertheless all too happy to explain to them exactly why they could (as per the script in the binder provided by their boss.)

This was temporarily a hot "career choice" when my original entering cohort graduated from college. A bunch of them tried to convince me to buy a house—any house, more or less—on spec via a balloon variable rate liar loan, as a better alternative to renting an apartment. And I was (then) a drop out with a part time job.

These guys thought they were doing me a favor, and that they had careers ahead of them based on the sacrosanct and inviolable principle that real property "only rises in value." The (many) borrowers they landed were even less able to see through the bullshit.
posted by snuffleupagus at 4:21 PM on April 3, 2012


Because there is actually a very small set of the population those loans are appropriate for. Stated-income loans existed for years before the crisis. There was not a single popular form of loan that postdated the creation of CDOs. Neg-Am, Exploding ARMs, all of them been around for years before the crisis.

I agree with JPD that the primary cause of the increase in subprime lending seems to have been due to the creation and massive explosion in the CDO market. I don't necessarily think the best solution would have been to regulate the mortgage market with a consumer protection agency or something similar. It would be better to apply regulation to the CDO market itself--perhaps with government verification of the risk/rating of these securities and regulation of capital reserve requirements for bond insurers, etc., that deal with CDO's or other unregulated securities. All told it seems we could be in much worse shape than we are.
posted by Golden Eternity at 7:01 PM on April 3, 2012


That is frankly ridiculous. Why would I expect businesses to cheat their customers?

Robot butlers? Every business 'cheats' their customers, thats what profit is.

How about second hand car salesmen? Would they sell you the lemon for the same price as the non lemon if you can't tell the difference?


financial time bombs that hurt their clients and benefited Goldman Sachs.

So why did the 'clients' (that word doesn't mean what you think it means) buy it?

Why would you defend that behavior as ethical?
the criminals who engaged in this unethical behavior

Not ethical =/= illegal. There are no big businesses that are ethical, beyond a veneer, even LiveStrong is on shaky ethical ground.

There is a reason they were called 'liar loans', and it wasn't the banks that were lying, so if you want to go down the route of criminalising unethical behavior, I think we're going to need bigger jails.
posted by fistynuts at 1:11 AM on April 4, 2012


Robot butlers? Every business 'cheats' their customers, thats what profit is.

No, profit is the difference between income and expenses. There are many companies that offer products that work as advertised and serve useful purposes.

How about second hand car salesmen? Would they sell you the lemon for the same price as the non lemon if you can't tell the difference?

And there are in fact lemon laws that are supposed to protect consumers in many states. Again I'll ask the question, why do you support unethical behavior like that?

So why did the 'clients' (that word doesn't mean what you think it means) buy it?

Because the experts they relied on told them to. You said that one option was to pay an expert, and many paid financial advisers believed that mortgage backed securities were a safe investment because they were rated AAA by every major credit rating agency. Saying the equivalent of "tough shit" may make you feel smart and important, but it's not an actual solution to the very real problem of markets being distorted by information asymmetry.

Not ethical =/= illegal. There are no big businesses that are ethical, beyond a veneer, even LiveStrong is on shaky ethical ground.

Well, let's just let them take advantage of the poor, the elderly, and people who are dumb enough to trust financial advice from every major financial news outlet, financial advisor, and official statements from the banks themselves. That seems like the best solution, right?

There is a reason they were called 'liar loans', and it wasn't the banks that were lying, so if you want to go down the route of criminalising unethical behavior, I think we're going to need bigger jails.

Alright. Now you're just lying.
So why did lending standards decline? At least one study has suggested that the decline in standards was driven by a shift of mortgage securitization from a tightly controlled duopoly to a competitive market in which mortgage originators held the most sway. [1] The worst mortgage vintage years coincided with the periods during which Government Sponsored Enterprises were at their weakest, and mortgage originators and private label securitizers were at their strongest...

The Financial Crisis Inquiry Commission reported in January 2011 that: "...mortgage fraud...flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports—reports of possible financial crimes filed by depository banks and their affiliates—related to mortgage fraud grew 20-fold between 1996 and 2005 and then more than doubled again between 2005 and 2009. One study places the losses resulting from fraud on mortgage loans made between 2005 and 2007 at $112 billion. Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities."
WikiPedia
'The Offering Documents for the Certificates at issue, which were relied upon by Plaintiffs, represented, among other things, that (i) the loans packaged into the Certificates were underwritten pursuant to the Countrywide Defendants’ specific loan origination guidelines; (ii) Countrywide Home (defined below) evaluated the prospective borrowers’ credit standing and repayment ability prior to approving any loan; (iii) when the Countrywide Defendants’ made an exception to the stated underwriting guidelines, they did so on “a case-by-case basis” and only if “compensating factors” justifying the exception were present; (iv) almost every mortgaged property received an independent appraisal which conformed to acceptable standards and formed the basis of its loan-to-value (“LTV”) ratio, an important metric to MBS investors; (v) the loans selected for securitization were chosen “in a manner [not] intended to affect the interests of the certificateholders adversely”; (vi) the “AAA” or other investment-grade ratings assigned to the Certificates were accurate reflections of the Certificates’ credit quality; and (vii) the Certificates’ issuing trusts possessed good title to the underlying mortgage loans. Each of these material representations was false when made, and Defendants knew or recklessly disregarded the falsity of these representations. Plaintiffs relied on the misrepresentations and suffered losses as a result.'
That last quote is from the lawsuit filed by insurance companies against Bank of America for mortgage fraud. Right now Bank of America is trying to get away with just 8.5 billion in settlement, but it will probably go federal and the settlement should be much higher.

You either haven't read much at all about the subprime crisis, or you are willfully ignoring the evidence to fit your ideology. Either way, you're wrong.
posted by deanklear at 4:52 AM on April 4, 2012


You either haven't read much at all about the subprime crisis, or you are willfully ignoring the evidence to fit your ideology. Either way, you're wrong.

It's the modern disease...
posted by Mental Wimp at 12:24 PM on April 4, 2012


why do you support unethical behavior like that?

It’s certainly frowned upon, but then what isn’t these days?
How am I supporting it? By arguing that scapegoating is pointless? By observing that it occurs frequently?

Your idealogy seems to be that one specific group of actors are wholly responsible for the entire house price crash, too big to fail- banking crisis, ratings agency mortgage fraud, global recession etc and that every other actor in the sorry mess is a wide eyed innocent.

Mine isn't.

Saying the equivalent of "tough shit" may make you feel smart and important
Now you're just lying.

I'm not running for office, I thought we were having an open discussion, if you want to troll then I'm not that interested really

samw: The Steve Waldman links are great, hadn't seen those
posted by fistynuts at 2:16 PM on April 4, 2012


It’s certainly frowned upon, but then what isn’t these days?
How am I supporting it? By arguing that scapegoating is pointless? By observing that it occurs frequently?


This is the part I don't understand. If someone was going around robbing houses, I imagine you'd be demanding that the police do something about the robbers. Why don't you want to punish defrauders for stealing people's money?

Your idealogy seems to be that one specific group of actors are wholly responsible for the entire house price crash, too big to fail- banking crisis, ratings agency mortgage fraud, global recession etc and that every other actor in the sorry mess is a wide eyed innocent.

Mine isn't.


I base that opinion on facts. For instance, many people said that removing Glass-Steagall would lead to insane amounts of leveraged risk creating another bubble, and then it happened. In 2004 the FBI warned that mortgage industry fraud was at "epidemic" levels. Many economists, like Dean Baker, stated that the real estate asset bubble was happening, and his predictions also held true. Most of the people who predicted the asset bubble believe that all of the evidence points to deregulation and dangerous banking practices combined with predatory lending and fraudulent claims by top banks as the major ingredients into the housing asset bubble and global financial meltdown.

So why should I believe your position is serious when you only put forward assertions? Why weren't there warnings from the FBI about "epic" fraud perpetrated by individuals trying to rip off banks? And even if I give you that point for the sake of argument, why aren't you blaming the banks for being stupid enough to give out loans without documentation?
posted by deanklear at 5:41 PM on April 4, 2012


Yes, let's pretend in our fairy world that there is a bright white line between unethical and illegal, especially in banking transactions.

I used to live in this world where "illegal" was anything that a prosecutor could get a conviction for in the face of whatever legal defense the accused could put up. Anything else is merely unethical. However, if one never actually tries to make the case, then it's hard to say what is legal and what is merely unethical. Certainly the activities engaged in by the banks, both investment and otherwise, could arguably be illegal. It would be nice to see some effort put into making the case, since the marginal behavior was so clearly destructive of so much of society.
posted by Mental Wimp at 6:42 AM on April 5, 2012


Your idealogy seems to be that one specific group of actors are wholly responsible for the entire house price crash, too big to fail- banking crisis, ratings agency mortgage fraud, global recession etc and that every other actor in the sorry mess is a wide eyed innocent.

Mine isn't.
Just look at the way she was dressed!!!!
posted by delmoi at 6:11 PM on April 6, 2012


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