Credit Derivatives as Weapons of Economic Mass Destruction...
Poorly-understood and badly-modeled financial derivatives turned out to be weapons of economic mass destruction. Jacob Weisberg draws an analogy between all the people (like him) who believed that Saddam Hussein's weapons of mass destruction existed in Iraq before 2003 and all the people (like him) who believed that credit derivative weapons of economic mass destruction did not exist before 2007.
Weisberg writes:
Robert Rubin is the wrong guy to blame for the financial crisis: The assumption that the rating agencies knew their business, a key enabler of the subprime meltdown, is analogous to the view before the Iraq war that Saddam Hussein had WMD. There are a lot of people now who scoff about what an obvious fallacy that was and not many who can point to doubts expressed at the time...
Well, in addition to Robert Shiller and Dean Baker, three people who can point to doubts expressed at the time come to mind: Raghuram Rajan, Alan Greenspan, and me.
What are we, chopped liver?
The best is Raghuram Rajan, August 27, 2005:
http://www.kansascityfed.org/publicat/sympos/2005/pdf/rajan2005.pdf: My main concern has to do with incentives. Any form of intermediation introduces a layer of management between the investor and the investment. A key question is how aligned are the incentives of managers with investors, and what distortions are created by misalignment? I will argue in this paper that the changes in the financial sector have altered managerial incentives, which in turn have altered the nature of risks undertaken by the system, with some potential for distortions....
The knowledge that managers are being evaluated against others can induce superior performance, but also a variety of perverse behavior. One is the incentive to take risk that is concealed from investors— since risk and return are related, the manager then looks as if he outperforms peers given the risk he takes. Typically, the kinds of risks that can be concealed most easily, given the requirement of periodic reporting, are risks that generate severe adverse consequences with small probability but, in return, offer generous compensation the rest of the time. These risks are known as tail risks. A second form of perverse behavior is the incentive to herd with other investment managers on investment choices because herding provides insurance the manager will not underperform his peers. Herd behavior can move asset prices away from fundamentals.
Both behaviors can reinforce each other during an asset price boom, when investment managers are willing to bear the low-probability tail risk that asset prices will revert to fundamentals abruptly, and the knowledge that many of their peers are herding on this risk gives them comfort that they will not underperform significantly if boom turns to bust. An environment of low interest rates following a period of high rates is particularly problematic, for not only does the incentive of some participants to “search for yield” go up, but also asset prices are given the initial impetus, which can lead to an upward spiral, creating the conditions for a sharp and messy realignment....
But perhaps the most important concern is whether banks will be able to provide liquidity to financial markets so that if the tail risk does materialize, financial positions can be unwound and losses allocated so that the consequences to the real economy are minimized. Past episodes indicate that banks have played this role successfully. However, there is no assurance they will continue to be able to play the role. In particular, banks have been able to provide liquidity in the past, in part because their sound balance sheets have allowed them to attract the available spare liquidity in the market. However, banks today also require liquid markets to hedge some of the risks associated with complicated products they have created, or guarantees they have offered. Their greater reliance on market liquidity can make their balance sheets more suspect in times of crisis, making them less able to provide the liquidity assurance that they have provided in the past. Taken together, these trends suggest that even though there are far more participants today able to absorb risk, the financial risks that are being created by the system are indeed greater. And even though there should theoretically be a diversity of opinion and actions by participants, and a greater capacity to absorb the risk, competition and compensation may induce more correlation in behavior than desirable....
Equally important in addressing perverse behavior are prudential norms. The prudential net may have to be cast wider than simply around commercial or investment banks. Furthermore, while I think capital regulation or disclosure can help in some circumstances, they may not be the best instruments to deal with the concerns I raise. In particular, while disclosure is useful when financial positions are simple and static, it is less useful when positions are complex and dynamic. Ultimately, however, if problems stem from distorted incentives, the least interventionist solution might involve aligning incentives. Investors typically force a lengthening of horizons of their managers by requiring them to invest some fraction of their personal wealth in the assets they manage. Some similar market-friendly way of ensuring personal capital is at stake could be contemplated, and I discuss the pros and cons of some approaches to incentive alignment....
Consider the incentive to take on risk that is not in the benchmark and is not observable to investors. A number of insurance companies and pension funds have entered the credit derivatives market to sell guarantees against a company defaulting. Essentially, these invest- ment managers collect premia in ordinary times from people buying the guarantees. With very small probability, however, the company will default, forcing the guarantor to pay out a large amount. The investment managers are, thus, selling disaster insurance or, equivalently, taking on “peso” or tail risks, which produce a positive return most of the time as compensation for a rare very negative return. These strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an incentive to load up on them. Every once in a while, however, they will blow up. Since true performance can be estimated only over a long period, far exceeding the horizon set by the average manager’s incentives, managers will take these risks if they can.
One example of this behavior was observed in 1994, when a number of money market mutual funds in the United States came close to “breaking the buck” (going below a net asset value of $1, which is virtually unthinkable for an ostensibly riskless fund). Some money market funds had to be bailed out by their parent companies. The reason they came so close to disaster was because they had been employing risky derivatives strategies in order to goose up returns, and these strategies came unstuck in the tail event caused by the Federal Reserve raising interest rates quickly.
If firms today implicitly are selling various kinds of default insur- ance to goose up returns, what happens if catastrophe strikes? Will they start defaulting on obligations to policyholders and pensioners precisely when such protection is most needed? It may well be that the managers of these firms have figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lessons of summer 1998 following the default on Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one— a phenomenon they term “phase lock-in.” A hedged position can become unhedged at the worst times, inflicting substantial losses on those who mistakenly believe they are protected...
But Alan Greenspan was also worried on, May 7, 2005:
Greenspan Warns on Credit Derivatives: Richard Beales and Gillian Tett in New York: Rapid growth in the credit derivatives markets has created considerable uncertainty about how the global financial system might react to any new economic shocks, Alan Greenspan, chairman of the US Federal Reserve, warned on Thursday. The sheer complexity of derivatives instruments, in particular, coupled with the consolidation in the financial industry, made it increasingly hard for regulators and bankers to assess levels of risk, he said...
And me, Brad DeLong, on May 7, 2005:
Translated into English, [what Greenspan] means [is]: "We don't know what financial institutions might be underwater after a large sudden drop in the dollar or spike in interest rates."
And me, Brad DeLong, on September 17, 2003:
If Something Is Unsustainable, It Will Stop: Archive Entry From Brad DeLong's Webjournal: [S]hould the value of the dollar collapse suddenly... the dollar is America's currency. A decline in the real value of the dollar does not increase but instead reduces the real value of America's gross international debts. A fall in the value of the dollar reduces Americans' standard of living by 4% or so, but it does not cause the kind of liquidity and solvency crises that we have seen so often in the past decade. (At least, it does not do so if New York's major financial institutions have well-hedged derivative books: if their derivative books are not well-hedged, all bets may be off.)
