The Investor Problem
Two quotes from Barney Frank talking to Ezra Klein:
What’s the most important part of financial regulation?
Limiting securitization. I believe the single biggest issue here is that people invented ways to lend money without worrying if they got paid back or not by securitizing the loan. When I was younger, the theory was if you had a high risk tolerance, you went into stocks. If you were safe and stodgy, you bought debt. But debt became the volatile aspect here.
[...]
One theory of the crisis is that the problem wasn’t traders and their high tolerance for risk. It was people fooling themselves into thinking this stuff was safe by slapping a triple-A rating on everything.
I agree; the theory has always been that people bought debt because it was safer. The basic problem was that 30 years ago when people lent other people money, they expected to be paid back by the people they lent money to. So they were very careful. Two years ago, most loans were being made by people who were going to sell those loans to other people and didn’t expect to be paid back.
This relates back to what I was saying about executive compensation. It’s true that the compensation schemes prevailing at many financial institutions seemed to involve bad incentives, but the real issue is why didn’t the market sort that out? Why don’t investors demand to be working with firms whose key employees don’t face those incentives? And similarly with securitization. The mysterious thing isn’t that people made bad loans that they were able to package and sell off, the mysterious thing is that they found buyers for the securities.
Ultimately this looks to me to go back to the ratings agencies, an issue Frank sort of dodged. But the ratings agencies are private for-profit companies that also enjoy a kind of government-sponsored monopoly status. In theory their behavior should be subject to market discipline, but in practice it’s not. They screwed up badly. But while lots of companies have gone bankrupt and lots of people have lost their jobs, the ratings agencies are all still in business. And no new competitors are coming to the fore and there’s no real way for anyone to break into the industry.
46 Responses to “The Investor Problem”
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September 28th, 2009 at 11:43 am
Re Matthew’s comment “But while lots of companies have gone bankrupt and lots of people have lost their jobs, the ratings agencies are all still in business. And no new competitors are coming to the fore and there’s no real way for anyone to break into the industry.”
———-
You left out the part about Warren Buffet owning a large chunk of Moodys. And also the part about the nontrival amount of change nice ole granddaddy Warren dumped into the Obama Presidential campaign.
For “good government” no doubt.
September 28th, 2009 at 11:43 am
Yes. And Barney frank is a reliable source on this issue. What’s next, asking a child molester their thoughts on daycare?
September 28th, 2009 at 11:44 am
I thought the whole Ezra interview of Franks did not sizzle as much as expected. Clearly Franks and Congress do not want to take the issue of rating agencies (I guess the fear of USA loosing the sovereign rating). Ezra tried, but did not so forcefully, what is wrong for Congress to take financial reform agenda so late – big banks get that much opportunity for lobbying on issues, public pressure to act is dissipated. Frank essentially said ‘trust us / Congress’ on that that it will take those issues. Hard to believe unless we see and history of Congress on that is not satisfactory.
And finally there was no question about why Franks dropped the requirement of ‘plain vanilla’ financial products.
September 28th, 2009 at 11:44 am
Really, this piece of shit is the reason we’re not getting financial reform. Why the fuck are you treating him like an expert on this issue?
And why the fuck does Ezra Klein keep giving scumbags like Barney Frank and Kent Conrad time and space with which to spew their bullshit?
September 28th, 2009 at 11:47 am
Nobody who links Barney Frank with the financial collapse has anything worth saying on the issue.
September 28th, 2009 at 11:48 am
It is safe to immediately scroll past whatever they say.
You need only skim. It’s like the word ACORN in all caps. Scroll scroll scroll.
September 28th, 2009 at 11:50 am
Have fun arguing with those strawmaen, Joe. With a non-existent sparring partner, maybe you’ll finally get a victory!
September 28th, 2009 at 11:50 am
The tax code penalizes large compensation packages in the form of salary; only the first $1 million or so is deductible as a business expense. So there’s a big incentive to dress up the excess to look like tax-favorable incentive pay.
There are two results. First is that there is a lot more incentive pay than there would be otherwise, which now everyone thinks may be part of the problem. Second is that a lot of what looks like incentive pay is really just straight-up compensation in costume, which explains the stock option backdating scandal and why companies continue to pay out huge bonuses even when the companies do poorly — often they are contractually bound to do so.
Hopefully this is an issue where people from all political persuasions can find something not to like. As for myself, all the empirical evidence I’ve seen indicates that incentive pay was NOT the culprit — despite the intuitive appeal of that explanation — because the companies that went down hardest had upper management with disproportionate economic exposure. Keep in mind that when a company explodes, the CEO is not rubbing his hands and cackling about his golden parachute; generally he loses several times the value of his golden parachute in the form of depreciated stock, not to mention the enormous loss of stature and future earnings from being recognized as a failed CEO. Certainly he’s still very well off from any reasonable absolute perspective, but let’s not pretend that his economic situation does not suffer in a relative sense.
September 28th, 2009 at 11:55 am
Yeah, seeing a comment blame Barney Frank of all people for this financial crisis is almost as hilarious as when Grover Norquist called it the “Reid/Obama/Pelosi recession.”
I’m grateful that they preface their comments that way. It’s functionally equivalent to — and much more compact than — saying “I have nothing to add except Palinesque rancor and tribalism; please ignore the phlegm-flecked diatribe in the following paragraphs.”
September 28th, 2009 at 11:57 am
Pender, Empiracal evidence? There’s no such thin in economics. They have theories. They have ideas. They are not a natural science, and have no real means with which to gather “empirical evidence”. They may use a similar system, but the amount of suppositions and bullshit “Lets pretend to hold this constant!” mechanisms that there is no way to realistically call it “empirical”.
Lets not pretend you’re here to do anything but shill for the wealthy and the powerful. Nothing is more pathetic than someone who dedicates their life to make the the world better for people who already have too much of everything.
September 28th, 2009 at 11:58 am
Pender, yeah. Because it’s not like Barney Frank hasn’t done everything in his power to block or repeal every financial regulation he’s ever come across.
It’s completely insane to claim he’s a tool of the banksters. Why, I’m sure just has a moral opposition to the government doing it’s job.
September 28th, 2009 at 12:00 pm
When the solutions are so straightforward, there is only one answer as to why they are not implemented – everyone in DC is a whore!
There is no good reason why rating agencies’ comp isn’t modified, why CDSs are allowed to exist, why all sorts of derivatives and securitizations aren’t outlawed, and why Glass-Steagal II isn’t implemented.
This administration has known from before they assumed office that Goldman-Sachs was gaming oil futures and they have yet to act. The entire US government is corrupt!
September 28th, 2009 at 12:03 pm
It wasn’t just ratings agencies getting sloppy with their AAA ratings (keyboard typo version of AAA: !!! ). it was also the transferability of AAA ratings from AAA firms that wrote credit default swap insurance on wacky CDOs and other assets to those assets that allowed the buyers of the wacky assets to book them as AAA, based on the “insurance” rating.
September 28th, 2009 at 12:05 pm
It’s easy to blame the rating agencies, but these mortgage-backed security derivatives were inscrutable by design. What’s a rating agency supposed to do when presented with a type of security that’s deliberately designed to be as un-analyzable as possible?
September 28th, 2009 at 12:05 pm
Bingo!
Securitization isn’t a bad thing — in fact, it’s actually a work of genius w/ extreme and various benefits for the public at large. Thing is, though, these securities need to be rated accurately, honestly, and w/o conflicts of interest.
The simplest policy that would go a long way to protecting the public, investors, and the banking system would be nationalizing the debt rating process. (Seriously, letting Wall St rate its own debt is like letting cigarette makers rate the safety of their own products.)
September 28th, 2009 at 12:07 pm
Today it’s Executive pay which in no way incentivizes people to make stupid short term choices for their own short-term well being.
Tomorrow, you’ll claim that there is no way a complete lack of regulation caused people to act as if no rules were in place.
People like you only exist to make BS arguments that make it sound like the sky will come crashing down if anyone does anything to get in the way of finance. So, you end up pretending that economics is Physics, biology, and geology all rolled into one; as if it holds the secrets of life and the universe. In reality, it’s a second-rate social science that has no predictive ability, offers no solutions that has been successfully implemented outside of the systems they were developed in, and only seems to have any promimence because it’s adherants tell the wealthy what they want to hear.
September 28th, 2009 at 12:15 pm
Seriously? They’re supposed to rate the damn thing. And if they can’t figure out the structure in order to do the math, then they don’t rate it. But that wasn’t the problem really. They rated these things on the assumption that real estate wasn’t in a bubble, and that there wouldn’t be a nationwide decline in real estate prices. With that sort of assumption, Stephen Hawking using Deep Blue wouldn’t have been able to come up with an accurate rating.
The fact that Moody’s and S&P don’t really have to care if their ratings are accurate is a huge problem.
September 28th, 2009 at 12:16 pm
The folks who believed they can control markets (risk) are the same folks who believe they can control countries. In the former case, it’s just a math problem to be solved. In the latter case, it’s just the right combination of weapons, troops, and bribes. Even now, after the debacle on Wall Street, the “quants” tweek their formulas as they prepare us for another financial disaster. Even now, after the debacle in Iraq, the Neocons and other so-called internationalists tweek their pet war theories as they prepare us for another war on foreign turf. It some ways their behavior is rather quaint, believing as they do that they, or we, can actually control events, in the markets as well as in foreign lands. Ever the optomists, we Americans.
September 28th, 2009 at 12:18 pm
I believe the single biggest issue here is that people invented ways to lend money without worrying if they got paid back or not by securitizing the loan.
Really? That’s the biggest issue here? What a joke.
This is like saying we need to get rid of loan officers, because they aren’t lending their own money, they’re lending the bank’s money.
September 28th, 2009 at 12:22 pm
I like Frank OK, and he’s my congress member. But his justification of no cramdown was offensively dishonest, and his ridiculous skipping over Dodd’s complaint suggests that he’s going to be pretty useless as things move forward.
September 28th, 2009 at 12:25 pm
…and in fact, Babar, loan officers who had not real stake in the performance of the mortgages they talked people into taking are a rather significant problem, both in the mortgage meltdown, and in predatory lending in general.
It is like saying that, in that both statements are true.
September 28th, 2009 at 12:26 pm
Why doesn’t the issue go to the investors who were relying on the ratings agencies instead of better understanding what they were putting their money in? Especially going forward, now that it’s understood that one can’t rely on the ratings.
September 28th, 2009 at 12:30 pm
What will the regulatory guidelines that Frank might want to put in look like? It would seem that all he would have to do is ask for Goldman Sach’s compensation commitee’s guidlines, that have been in place since it went public in 1998, and make them the law. He could just dust off Lehman’s or Bear Stearns’ compensation guidelines and put them into law too, given they weren’t any different from Goldman’s.
Per the ’skin in the game’ stuff, Lehman, Bear, and many other problems, … are no longer with us precisely because they in fact did keep a piece of what they securitized. Goldman, and to a lesser extent, Morgan Stanley, did not, which is why they are still here, and don’t need to be bailed out. Another non existent problem.
Per the rating agency stuff, that does matter since many regulated entities, like life insurance companies, have to take them into account. Rating agencies don’t effect Wall Street. They do matter, but not for the financial system, but it’s customers, as the term is assumed to mean in the interview.
September 28th, 2009 at 12:31 pm
Barney Frank is opposed to financial regulation.
Economists don’t use empirical evidence.
Like I said: scroll scroll scroll. This rule hasn’t failed me yet.
September 28th, 2009 at 12:32 pm
And no new competitors are coming to the fore and there’s no real way for anyone to break into the industry.
This is not really true. There are now upwards of 10 NRSROs, including some, like Egan-Jones, that are paid by subscribers, not by issuers.
September 28th, 2009 at 12:38 pm
Can someone please explain what financial innovation means?
Seriously. I have no idea. As far as I can tell, there are three things you can do with money: spend it, save it, lend it. While there are variations on these themes, it doesn’t seem like any new innovation can stray very far. So please anyone? An explanation?
September 28th, 2009 at 12:38 pm
When a loan officer lends the bank’s money badly, they do “get rid” of him. It is logically consistent with “firing” Moody’s.
September 28th, 2009 at 12:52 pm
And when you make the bad loan, sell it, and take out an insurance policy against it not being repaid – what do you call it? Not fraud, of course, just smart business – especially when the insurance agency doesn’t have the money and your previous employees funnel tax money to pay you 100% before the agency goes belly-up stiffing everyone else.
September 28th, 2009 at 12:55 pm
Financial innovation means:
First, and primarily, coming up with a product that makes money for the innovators.
Usually, but not necessarily, creating a derivative (i.e. derived from) of an existing financial instrument, e.g., CDSs, CDOs, ABSs.
Some of these innovations such as CDSs were once illegal. In the case of CDSs, you weren’t allowed to issue insurance unless you had collateral in accord with state insurance law. Our legislators, happily for the innovators, did away with those requirements.
Larry Summers was a prime mover in eliminating those requirements.
September 28th, 2009 at 1:08 pm
> This relates back to what I was saying about executive
> compensation. It’s true that the compensation schemes
> prevailing at many financial institutions seemed to involve
> bad incentives, but the real issue is why didn’t the market
> sort that out? Why don’t investors demand to be working with
> firms whose key employees don’t face those incentives?
Because there is no magical Econ 101 “perfect market” with perfect information, no hidden motives, and zero transaction costs where problems get magically worked out as if by an invisible hand? Because the people actually running the Wall Street Casino were skimming enormous amounts of money, and using their financial and political influence to destroy anyone who questioned what they were doing? Because when a financier has $50 million in liquid assets stored around the world plus various chunks of real property he really doesn’t care what the “risk” of his next trade is or what any “market” thinks of him?
Just sayin’
Cranky
September 28th, 2009 at 1:12 pm
> Can someone please explain what financial innovation
> means?
>
> Seriously. I have no idea. As far as I can tell, there
> are three things you can do with money: spend it, save
> it, lend it.
Well, packaging, reselling, and eventually securitizing mortgages was an innovation at the time. I got my first mortgage just before that process became common, and my second and subsequent mortgages after, and the packing system did make it a lot easier and more uniform to get a mortgage and generally easier to be approved in the type of neighborhood where I was living at the time (not to say it made redlining go away; just that you could now shop for a bank that set the redline more in your favor).
Of course, that process was pretty much nailed down and working smoothly by 1990, so I am with you in not understanding what strips, splits, swaps, and CDS brought to that party from the consumers’ or society’s point of view. Sure did let a few thousand people on Wall Street skim off a lotta money though…
Cranky
September 28th, 2009 at 1:13 pm
And that is the type of post that makes would make him a FDP voter in Germany
. Wondering why the market didnt control finance saleries. Seriously?
September 28th, 2009 at 1:20 pm
@26 Brian L: “As far as I can tell, there are three things you can do with money: spend it, save it, lend it. While there are variations on these themes, it doesn’t seem like any new innovation can stray very far.”
The truly new and brilliant innovations in finance have little to do with the actual physical possession of “money.” What has become a fine art on the financial circuit is the ever more inventive and clever ways they have found of stealing other peoples money and, more importantly, of creating the illusion of money where none exists.
At the core of this financial innovation is the simple Ponzi Scheme. Innovators gussy up the old girl and trot her out in different guises. The better the illusion, the more costumers they can attract, and proportionally, the more money they can invent and/or steal.
September 28th, 2009 at 1:33 pm
Its simple, corporations (and LLCs) are limited liability entities. The most any investor can lose is the value of his capital contribution. If one’s own stake is just fraction of the capital invested by others, why not roll the dice?
In contrast, a general partnership (or a sole proprietorship) makes every owner personally liable for all losses. By law, “learned professions” such as doctors, lawyers and (IIRC) CPAs are personally liable for their actions. This is the big reason doctors are so freaked out by malpractice suits, its not just a cost of doing business when the plaintiff has the right to go after personal assets. Even with learned professions, there’s been a dilution of responsibility, general partnership are now rare since forming an LLC or LLP shields a doctor or lawyer from liability for the actions of his partners.
September 28th, 2009 at 2:17 pm
Thank you all for your answers.
It seems we all have the same gut level feeling about what financial innovation truly is. Thankfully we pay these guys bajillions of dollars for it. That’s awesome.
Maybe it will come back to us one day under that awesome tinkle down economics I keep hearing about.
September 28th, 2009 at 2:25 pm
There’s no empirical evidence that this isn’t the “Obama recession”? Really? That the recession started in 2007 isn’t evidence?
It’s easy to blame the rating agencies, but these mortgage-backed security derivatives were inscrutable by design. What’s a rating agency supposed to do when presented with a type of security that’s deliberately designed to be as un-analyzable as possible?
Admit that they can’t analyze it. Really. You think giving everything they can’t analyze a AAA rating is preferable?
September 28th, 2009 at 2:51 pm
speaking of unaccountable for-profit government-approved monopolies, how lame are those credit bureaus, amirite?
September 28th, 2009 at 2:54 pm
j mct:
Per the ’skin in the game’ stuff, Lehman, Bear, and many other problems, … are no longer with us precisely because they in fact did keep a piece of what they securitized. Goldman, and to a lesser extent, Morgan Stanley, did not, which is why they are still here, and don’t need to be bailed out. Another non existent problem.
In my mind Goldman and Morgan Stanley were just as much at fault and were bailed by the taxpayer out via AIG and Bernanke throwing money from helicopters. Maybe they weren’t as bad as the others, but it’s still fair to group them all under the name “Wall Street.” The only reason those two are still in existence is because of the government. But how quickly they forget.
david:
But his justification of no cramdown was offensively dishonest, and his ridiculous skipping over Dodd’s complaint suggests that he’s going to be pretty useless as things move forward.
I’m a renter. Why should I bailout stupid irresponisble homebuyers? Or the real estate industry? Fuck you and your cramdown. Another bubble will just delay the problem.
September 28th, 2009 at 5:34 pm
Frank goes on and on about how “big banks” have been discredited and need to be regulated more stringently but he has dismissed the idea of vanilla products. Also blamed the failure of cramdown on credit unions. I liked the Congressman more when his big donors were unions and developers instead of banks and financial companies.
September 28th, 2009 at 5:35 pm
poptart – go fuck yourself
September 28th, 2009 at 8:13 pm
An excellent point, Cranky! It seems that faulty assumptions about different parties interests being the same, or aligned, is a recurring theme.
Corporate officers and stockholders.
Corporate officers and employees.
Ratings agencies and investors.
Lenders and their customers…
September 28th, 2009 at 9:29 pm
I’m not real big on regulating peoples’ salaries. Instead, there should just be a logrithmic income tax rate, like 0.2 (logI – 4), applied to all income including capital gains.
September 28th, 2009 at 9:52 pm
Why the market didn’t deal with this problem
The reason that anyone would expect the market to have prevented promiscuous securitization, would be the belief that the market for these securitized assets was made up of “investors” in a full sense of that term. Instead, these markets, all of our financial markets, are dominated by rent-seekers.
Common usage right now would consider anyone an “investor” who takes accumulated money and uses it to buy an ownership stake in something that he expects will yield a return. No attention is paid in this usage to the key factor of whether or not the investor uses any knowledge of the workings of the asset he has purchsed an ownership stake in, either to decide which particular one of competing such assets he will purchase, or in the subsequent management of the asset he has purchased at least part ownership in. But while “investment” in this sense in our markets is as extinct as the dinosaurs (Perhaps there are some venture capitalists still practicing it out there somewhere, but not anywhere near the Street), only investment of this sort, only markets dominated by these sorts of investors, have any likelihood to do any of the good things that we imagine such markets do, such as job creation, or the enforcement of market discipline and sound practices on the assets traded in those markets.
Markets dominated by rent-seekers, folks who just want their money to work for them, and have no knowledge, energy or attention to contribute to a process in which that capital is intelligently directed to where in the real economy it will be used best, and then overseen in that real economy use, will do nothing but create bubble after bubble. Market-to-market value, what the “investor” imagines he will be able to get the next sucker down the line to pay him for the asset, and not any underlying values, will come to dominate the market valuations of assets when the investors have no idea how to assess underlying valuations, and no interest in learning. Untethered from any underlying valuations, asset prices are left free to blow up into bubbles, as money coming into the market for a quick and easy ROI inflates the price of assets further, upping the ROI further, and thereby drawing in more “investment” money. Of course it ends badly. Of course such markets discipline nothing, and create no jobs except for croupiers, dancing girls and side-boys.
Either stop callng this “investment”, or stop thinking of investment as at all a good, sound, or reputable thing
September 28th, 2009 at 10:28 pm
joe from Lowell loves Barney’s Frank
September 29th, 2009 at 3:57 pm
[...] the question of the role that the credit rating agencies played in the financial crisis. [h/t Matt Yglesias] Frank avoids it even though most of the issues he raises point directly back to the fact that [...]
October 2nd, 2009 at 1:15 am
Hmmm? Did anybody see what the Emperor was wearing? This financial collapse that took everyone by surprise and required immediate action in the form of massive amounts of taxpayer wealth was the last play of the Bush/Cheney elitists club. It should be obvious to anyone paying attention that the last scam of this daring duo of dastardly deeds was a well thought out well timed heist of the privileged class who so skillfully suckered the religious right, the conservative right, the patriotic right, the mentally challenged, anti liberals, the wing nut fringe, the greedy investor, and a lot of just plain folk into their bubble of trouble. Many democrats are not what they seem/claim as they helped bait the trap and continue to share the rewards. It should be equally obvious that the current administration is just a continuation of the previous pack of thieves. This nation has been ripped to the tune of tens of thousands of dollars per every man, woman, and child, yet still has not seen the nakedness of the Emperor! There is no democracy left in America. Look at all the Kings men. Geihtner, Summers, and Bernacke are rolling in our doe laughing at our utter inability to realize that government of the people, for the people, by the people does not exist. We have a secret government of the rich, by the greedy self centered egotistical elite, for themselves. The big trouble is the fact that having it all is still not enough. The business model of today in which the captain sinks his own ship and can be seen in the first lifeboat on his way to Bermuda, foretells of the demise of mankind due to the willingness of the elite to destroy the very environment that keeps us all alive. Well done you financial geniuses!