Bell Curve The Law Talking Guy Raised by Republicans U.S. West
Well, he's kind of had it in for me ever since I accidentally ran over his dog. Actually, replace "accidentally" with "repeatedly," and replace "dog" with "son."

Monday, September 22, 2008

Valuing Risk

[This is an offshoot of RbR's thread re "Moral Hazard."] At the start of this discussion, I argued investors on Wall Street had been, "perfectly responsible and rational. They knew they would get rich when the big risks worked out and would get bailed out when they did not." As this conversation has continued, however, I have gradually been convinced (esp. by Handfish and Pombat) that I was wrong.

Oh, I still think investment bankers knew there was a fair chance they would not suffer the full consequences of failure. I still think they knew (at least subconsciously) that as a group they were, "too big to fail," and that government would bail them out if things got too bad. I still think Wall Street could see the historical pattern of bailouts as clearly as anyone else.

But I no longer think they were responsible and rational. I think there is a deeper lesson here: The free market simply does not correctly value risk. Many investors were simply gambling, just as many homeowners were gambling: Wall Street and Main Street exhibited the same behavior. This message is there for all to read in the skyline of Las Vegas: As a society, we so consistently under-value risk that you can build an entire industry on that premise. The free market cannot be expected to value risk correctly when its participants systematically under-value it.

So while letting firms go belly up may be satisfying, it will not teach the market any lessons. Increasing the cost of failure only provides deterrent where there is rational valuation of risk. Instead of altering incentives, we need to alter the law. You can hike the penalty for drunk driving all the way to capital punishment, but sometimes you just have to take away the keys. We need to ban certain overly-risky financial instruments (like derivatives) outright, and also require stronger liquidity ratios for institutions that indulge in speculation. Games need to be regulated and gamblers need limits, and maybe it is as simple as that.


The Law Talking Guy said...

I would offer a more institutional analysis. Take a firm like Lehman Brothers. Investment bankers were rewarded for success. Those that take risks and succeed are rewarded with huge bonuses; those that take risks and fail, or that don't take risks and succeed, are punished or let go. Now, the difference between the winners and losers may be random, but the rewards were not. All were encouraged to be risky. At the top of the chain, this system was instituted by those whose only goal was to see an increase in stock price in the (very) near term. They were rewarded handsomely for success. Failure at the top in this arena meant some sort of golden parachute. Because of speculation in stock, the stockholders were not around long enough to care about anything other than increasing stock prices in the short term. The directors and management, with their stock options, had similar interests.

The people on the hook for the long term stability of the company - the ordinary employees whose jobs depended on it and the rest of financial sector as a whole - had no meaningful oversight role. The US taxpayer was in the same boat: denied by conservatives (and business campaign donations) of any meaningful oversight role even though the government always knew it would have to bail out serious problems. The failure was in Washington too, by the legislators who were motivated only to win the next election.

So the problem, to my mind, is that the moral hazard was built into the system for all the individuals, which played out in the institutions.

So long as these institutions are not fixed, so long as we have the wrong set of incentives, the only way to prevent risky behavior is by legislative fiat.

I take issue with the premise that, as a society, we systematically under-value risk. Nobel prize winners Kahnemann and Tversky suggest that risk-taking is more likely when a person seeks to avoid losses than to make gains. They would suggest that the motivation for excessive risk was more the fear of being fired for failing to make the big bucks that the more risky investment banker next to you was making, rather than envy of his big bonuses. I think that may well be true. Similarly, the CEO that pursued a strong stock price at any cost was less punished, even in failure, than Mr. Slow and Steady was. So the fear of failure, rather than lure of wealth, may have been the motivator. I think this suggests how to reform the institutions.

If bonuses (or firing) was linked to aggregate performance of an investing group, not individual performance within that group, prudence might have won out. Similarly, if a CEO is rewarded or punished for a running average of 5-years stock prices, rather than last quarter's closing, they might be more willing to adopt a prudent approach and eschew excessive risks.

Spotted Handfish said...

I agree with you LTG. Moral hazard may be implicit in the system of share trading, and this is because the time frame for buying and selling is much shorter than the potential run on shares. You may know it is a house of cards, but you can make money while people are still buying. Then when that continues you have to buy back in to make profits at the same rate as the other alpha-males. Next thing you know you have to stay in the market, and we have "the great moderation" fuelled by debt rather than value. Risk gets ignored.

My biggest villain in all this is Greenspan. His view during the dot com bubble and the subsequent housing bubble was that the Fed should mop up after the bubble has burst. Spotting the bubble during the event is difficult he stated. Really? Maybe, as has been suggested by others here, ignoring the risks is a fair indicator (let alone price-earnings ratios of over 100, or house lending to those who can't afford it).

One question is will people/firms start pricing in risk now? (I think that gets a "rhetorical" tag.)

I also believe the firms now are not getting a total free ride and are paying a price for being propped up by the US government. It does mean that the government is taking on some of the built up risk (built up from property and from shares). So what will this mean for the US dollar with this inherent risk? Nothing if the US government has been fiscally responsible and managed their debt levels...

Dr. Strangelove said...

The thoughtful "institutional analysis" provided by LTG illustrates some of the mechanisms that enable the free market to under-value risky assets. The time-frame issue that Handfish offers another mechanism that enables risk to be ignored.

But why are there no countervailing mechanisms? Why did the market not self-correct? The answer perhaps simple: the market just doesn't do that. It is not an organism with homeostasis. It does not magically produce order out of chaos. The market does not handle these types of investment well because people do not handle it well.

Remember the "new economy"? Remember when the Dow was going to hit 100,000 and there would never be inflation again? People convinced themselves they could not lose. I must question the applicability of the risk-aversion research by Kahnemann and Tversky to these particular types of investments... Las Vegas, state lotteries, etc. clearly demonstrate that certain types of risk are systematically under-valued--and the stock market sure looks a lot like Vegas.

I'm afraid I must also disagree with LTG's assessment of the psychology. I suspect the brokers and traders were more motivated by big payouts and big bonuses than the fear of being fired. I think they liked the party atmosphere. They enjoyed the thrill of "winning" and racking up more clients, more money. They got on a roll.

Look: we need Social Security because we can count on most folks failing to provide for their own retirement. As Pombat notes, people would rather have instant gratification now than save money for a rainy day. Why should Wall Street be any different?

The Law Talking Guy said...

Amen to social security. A secretary in my office yesterday told me that she just cashed out her 401K (from her prior firm) because "she didn't want to lose any more money."

I blanched.

The Law Talking Guy said...

Dr.S is right, of course - for some, there was a party atmosphere, and they had little fear of losing because they didn't even recognize that they were engaging in risky behavior! The smarter ones did realize it, but didn't dare do otherwise.

The fun part is that Bush is now saying that the taxpayers won't lose anything because the govt will just hang onto the umnovable mortgage paper until the market returns from its "crisis," then it can sell the mortgage paper again. Ummm... If the paper had value like this, its current holders would not give it away in a fire sale. How irrational is the market supposed to be under this scenario? It's scared?

The same person told us six years ago that Iraq would pay for the war out of its oil money (and be over within weeks).

Spotted Handfish said...

Apparently Paulson is related to Nigerian royalty...

Raised By Republicans said...

Of course they are rational. Just because they have bad information doesn't mean that their actions based on that poor information were irrational.