Desire for Safety Has Made the Financial World Risky
One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on "too much risk" in recent years. I think it is equally accurate to suggest that the financial system took on too little risk.
Consider the risks that were not taken during the recent credit and "investment" boom. While hundreds of billions of dollars were poured into new suburbs, very little capital was devoted to the alternative energy sector that is suddenly all the rage.
Despite a "global savings glut" and record-breaking levels of "investment" in the United States between 2005 and 2007, capital was withdrawn from a variety of industries deemed "uncompetitive" in large part due to obviously unsustainable capital flows. Very few brave capitalists took the risk of mothballing rather than dismantling factories and maintaining critical human capital through the temporary downspike. Under the two to five year time horizon of our most far-sighted managers, whatever is temporarily unprofitable must be permanently destroyed. To gamble on recovery is far too great a risk.
I don't pretend to know where all that capital, that incredible swell of human energy and physical resources, ought to have gone. But it doesn't take an Einstein to know that it probably should not have gone into building Foxboro Court. Sure, hindsight is 20/20. But lack of foresight really wasn't the problem here.
In 2005, how many macroeconomists or big-picture thinkers were arguing that the US economy lacked suburban housing stock of sufficient size and luxury? We gave the building boom the benefit of the doubt because it was a "market outcome". But the shape of that outcome was more matter of institutional idiosyncrasies than textbook theories of optimal choice. It resulted as much from people shirking risk as it did from people taking big bets.
The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up "super-senior AAA" tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper.
Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed 'em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was "safe", so who cared what it was funding?
Finance is not a closed system, a zoology of exotic contracts and rocket scientist equations. The job of a financial system is to make real-world decisions, "What should we do?" A good investment is a simple answer to that question, with clear consequences for getting it right or wrong. Mom and Pop can have FDIC insured bank accounts, and imagine that there is such thing as a "risk-free return".
But that's a lie, a sugarcoated subsidy. Foregone consumption does not automatically convert itself into future abundance. People have to make smart decisions about what to do with today's capital. If they don't, no amount of regulation or insurance will prevent all those savings accounts from going worthless. When huge institutions treat the financial system like a bank, depositing trillions in generic "safe" instruments and expecting wealth to somehow appear, they are delegating the economic substance of aggregate investment to middlemen in it for the fees, and politicians in it for whatever politicians are in it for. And we are surprised when that doesn't work out?
Of course we should regulate and manage the risks that were the proximate cause of the credit crisis. Anything too big to fail should be no more leveraged than a teddy bear, and fragile, poorly designed markets should be fixed. But that won't be enough. We've trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I've nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.
Investors' childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.
Disclosure: None
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This article has 17 comments:
Lathrop
Vlaicu
---
StocksHaven.com
"Do what you will, capital is at hazard", used to be a truism every investor knew. Now instead we have men trying to criminalize failure after plowing their capital into dumb contracts which offered only downside. The failure was their own, but nobody is willing to own up to it, everyone is trying to blame somebody else instead.
Have a great evening!
Jolly Rancher
The problem is that even the government went to sleep this time, as did Wall Street itself.
von Mises predicted the Great Depression. He should be read.
borenstein
A wise man said once that a little knowledge is a dangerous thing -an idiom proven by this article.
One more time ,in June of 2005 I have warned about the current debacle in an interview with Mark Gilbert(Bloomberg -London).I have reiterated the warning on September 18/2007 During the Brian Sullivan interview(Bloomberg TV).In March of 2007 I have expressed my concern to my clients about the housing sector ,because 20% of all the homes in 2006 were financed by the subprime mortgages.
By May of 2007 ,I have issued another warning about the housimg sector to my clients because of the significant insider selling in the top listed construction companies.
By now most of the key issues have been or are being addressed.
U.S financial system may be exposed to some minor jitters which may be distorted by the market bears ,but basically the system is working.
What had happened to these incredibly simplistic articles two years ago when they would have been relevant.
Now investors should focus on Europe and Emerging Market economies as Armageddon is about to hit them creating record inflows into dollar denominated assets ,enhancing economic and the market rebound-but volatility will continue.
The people are never going to change and regulation just is created to get the flies to trust the spiders. So what has to changed is the system.
If the bank owners were personally responsible for loan losses do you think they would have made all those bad loans? They can socialize the losses and take all the profits, so they do. Fractional reserve loaning is totally corrupt, a government-approved Ponzi scheme.
Loans from fractional reserve banks are inherently \ldblquote liar\rquote s loans\rdblquote , the lie being, the bank is loaning money that it really doesn\rquote t have. The Fed and the thousands of banks creating these liar loans create inflationary conditions that actively discourage thrift: people throw their money at something that hopefully will go up a lot in price in order to hold onto the buying power of their money, trading the certainty of being screwed in the long run for the chance to possibly avoid being screwed at that future time. Debt-money leaks out value like a bucket with a hole in the bottom leaks out water.
This is just going to keep happening until the basic cause gets fixed.
First of all, WE NEED OUR OWN DEBT-FREE CURRENCY, backed by all of the real estate owned by the United States (which is, in fact, all of the real estate within the national boundaries, and really more than that including other nations whose continued claim to existence depends on U.S. defense of that claim; case-in-point, Kuwait, 1991), we should distribute that new currency in monthly equi-dollar amounts to all legal residents (amounts due minors to be held in trust accounts). Also, we need bankers to be held financially responsible for any loss of depositors' money (if they want to gamble with fractional reserves, it's the bank owners who should pay, not taxpayers, and if you lose your own money by depositing it in a fractional reserve bank, again, it\rquote s YOU who should pay, not taxpayers. How can we ever expect things to get right with a system based on socializing losses?
Next, we should REPLACE ALL FEDERAL NON-CONSUMPTION TAXES with a one-half percent(+/-) Tobin-type tax (also known as a "debit tax") on ALL outgoing electronic transactions (avoidable by using cash for all transactions, and, since avoidable, the tax will be arguably being paid voluntarily) in order to:
1. Pay off the national debt,
2. Repair the damage that the U.S. government has done to persons and the free market by favoritism (reparations for having "Constitutionaliz... slavery might be considered) and excessive regulation (e.g., we need about 4 times as many doctors and healthcare professionals as we currently have in order to have enough competition extant to get medical costs back to the realm of affordability, and we would have had them had there been a free market in medical education), and
3. Extract and destroy excess currency as required to avoid inflation.
No other form of Federal non-consumption tax would be allowed (this tax could go to zero when it has done its job if there is no inflation in the system).
The monthly equi-dollar distribution amounts should be of sufficient quantity (assuming $1000, that's $24,000 Federal tax-free per couple, plus whatever wages and other income they bring in) to be considered sufficient replacement for all forms of corporate, farm and personal welfare, including subsidies, welfare, tax incentives, Social Security (to be phased out), Medicare, the Federal Minimum Wage law, and ALL OTHER forms of Federal financial redistribution schemes; there won't be any need for separate Federal retirement accounts since there won't be any income or investment taxes.
For those who like their political solutions morally justified, the monthly equi-dollar distribution amounts can be considered "justified compensation" for the denial of free access to all the property that the government has privatized.
With everybody getting the same monthly amount, and everybody paying the same percentage increase of fiat money, there is no redistribution nor inherent injustice in the plan.
Excess liquidity creates situation of more money chasing less opportunities. Worse and worse investments made as an example. Answer isn't more regulation on whats a fair investment, answer is less liquidity.
I never understood how a home was seen as an asset, more like a liability. Cars, office equipment, and every consumable product we buy depreciates, but homes were always seen as an appreciating asset. Cars get used and lose value, homes get used and lose value as well, a home doesn't get any younger from the day it was built it gets old, it needs nurture and care and so the risk was always there that homes would devalue one day.
On its face an ABS or CMO isnt a bad investement, and is susceptible to legitimate risk assemsent based on its cash flows and credit charactersics. Most analysis didn't understand the fundamental housing market cycle, and understated risk - which led to too low risk premia. THEN as revealed by the market perfromance making mis rated ABS into misrated and intrisically levered CDO, CDOsquared, CDO to the fouth power etc. and then carrying those instruments on a fully levered balance sheet multiplies the risk.
They were wrong about risk levels and risk premia, and they paid for underpriced risk with excess leverage