Our Institutions, Ourselves

[Editor's Note: Matthew is one of our most venerable alums. He is attracted to financial crises like the moth to the flame.]

Generally speaking we ask more from our institutions than from ourselves. We expect our courts to be impartial, our priests to be celibate and our banks to be conservative even as we are partial, promiscuous and profligate. On one level this makes perfect sense since we set institutions to create a buffer between us and the consequences of our actions. The problem is that the more successful our institutions are at managing risk on our behalf, the more risk we are able to assume as individuals without concern for the consequences. This is the very definition of moral hazard.

Time was when margins of institutional safety were much slimmer and thus personal responsibility for one’s affairs more necessary. Particularly in the world of finance you could be sure there would be a major disruption to markets every generation or so. In a two-steps-forward-one-step-back fashion bankers and their ilk would think up new products that would spur greater investment that would spur greater prosperity until there was a panic and everything came crashing down. [1]

As markets became more sophisticated finance types thought up clever and not so clever ways to avoid crashes that were only sometimes effective but which basically involved the same methods used today–pooling and pumping money into the system and telling everyone to be calm. J.P. Morgan acted as de facto central banker for the last part of the 19th and the first part of the 20th century helping to prop up the U.S. Treasury and staving off the worst during the 1907 Panic. A few months after his death Congress passed the Federal Reserve Act and the system of central banking we still have came into being. But bank panics stopped being a regular threat to the financial system only when Congress began insuring depositors through the FDIC.

As the government and our financial institutions got better at managing risk, the less individuals needed to worry about sudden changes in their economic circumstances. This in turn allowed them to lower their personal reserves and take on more risk in attempts to make quick profits. In other words they could more easily speculate. And speculate they did.[2]

When a limited number of people speculate it won’t have an impact on the general market. When speculative manias sweep up entire nations, however, it distorts the market and a correction becomes inevitable. The Fed responded to the crash following the internet bubble by lowering interest rates. This in turn allowed people to borrow money more cheaply which meant they could increase their leverage. A lot of that easy money found its way into real estate which produced increasingly good returns as more money gushed into the sector and drove prices still higher. The Fed, which had tried to stave off one contraction with interest rate cuts, contributed to a second bubble in asset prices. When the correction came the elaborate mechanisms that seventy years of financial innovation had put in place weren’t enough and today the financial system teeters on the brink.

Foremost in at least the cable networks—and apparently in many Americans’ minds—is the question: Who is to blame? Did our institutions fail by not preventing the moral hazard or did we fail by rushing to take advantage of it? Our search for a scapegoat would be funny if it weren’t so pathetic.

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1. Many financial innovators, as is their wont, came [Aislabie/South Seas Bubble], to [Ivar Kreuger] a [John Law] bad [Michael Milken] end [Myron Scholes].

2. If you have ever bought an individual stock and can’t read a balance sheet you are a speculator.

Comments

  1. A voice from the dust, and a wise one it is.

  2. Steve Evans says:

    Excellent definition of “speculator”.

  3. In honor of recent events, I just read Upton Sinclair’s The Moneychangers, published a hundred years ago, and a thinly-veiled fictional account of the J.P. Morgan 1907 bailout and the machinations (including some of his own) that preceded and precipitated it.

    As you suggest, the blame can be much more widely spread today, although I tend to attach slightly more of it to those who knew better than to those who merely should have known better.

    Incidentally, it seems like it was a good old-fashioned bank run that did in Washington Mutual. Despite a mammoth portfolio of bad loans, they were well-capitalized and not too highly leveraged and probably could have survived had people not started panicking and withdrawing their FDIC-insured funds.

  4. WaMu was well-capitalized? According to who? WaMu? The writing was on the wall for these guys long before any supposed bank run started. They had a decent deposit base to be sure, but these guys were still writing neg-am loans until 3 months ago.

  5. I admit that I don’t know anything about money except that I always seem to need more than I have.
    My question to you is… How can CEO’s and board members be allowed to make so much money when the business goes bankrupt? They get millions of dollars. “golden parachutes”
    There are laws that prevent people from profiting from their crimes. Inmates have been denied money from books written about their crimes. Why don’t these fat cats have to return their money to the company? I have never understood how any job could be worth the salaries that they make. I could buy a lot of eggs and milk with 50,000,000.00 dollars!

  6. Scott C,

    The short answer is because it’s not a crime, thank goodness, to be a bad manager. But let’s be clear that CEO compensation and the current problem are unrelated although both are symptoms of the same problem–risk transferance to disparate investors such that no one has an incentive to monitor bad behavior. Lots of companies, but certainly not enough, have claw-back provisions built into employment contracts. This is particularly popular in the money management industry–maybe we’ll see it spread to Main Street in the coming years.

  7. If incompetence were criminal 90% of people would be in jail. There is already a mechanism built in for controlling this. Shareholders elect the board, and the board appoints CEOs and sets compensation. Shareholders largely choose to do nothing about executive pay, or apparently feel that their money is well spent paying these jokers. But they already have the power to change this without any new laws or regulations.

  8. woodboy,

    While shareholders theoretically have power to pay management less or even get rid of them entirely, in reality they are largely disempowered due to a collective action problem which expresses itself in what is popularly known as the Wall Street Rule: Sell a stock rather than try to change a company’s policies. An individual shareholder usually has no power to tackle agency costs. Rather than spend time and money tilting at windmills he rationally decides to leave. That isn’t as much of a choice as you make it sound. But it does lead back to the question of what we as individuals really ought to expect from our institutions.

  9. “WaMu was well-capitalized? According to who? WaMu? The writing was on the wall for these guys long before any supposed bank run started.”

    Well-capitalized compared to the 30-1 leveraged investment banks. Obviously they had been in trouble for a long time, but the run was the final nail in the coffin. In one of the more hilarious episodes of the whole mess, they gave their new CEO a $7.5 million signing bonus only about a month ago, in addition to a generous severance package. Despite enormous pressure for him to forgo these benefits, to which he is legally entitled for his three weeks of work, I have not heard so far that he will do so.

  10. Yes, I realize individual shareholders have no clout. But the mechanism is there. You just have to own enough of the stock to make a difference, so big activist investors or PE/LBO firms will sometimes make management changes if they are in a position to do so. My point is the system is in place, even though it is difficult or impossible for individuals to actually use.

    I expect nothing from my institutions, except that they will do whatever is best for themselves at any particular point. That is why I choose not to “invest” or trust management of any company, but rather speculate on their stock prices.

  11. It’s true that WaMu was not as highly leveraged as the investment houses, but this does not represent any particular restraint on the part of WaMu so much as the fact that they were regulated by OTS instead of the SEC and weren’t allowed to use so much leverage. They’ve been shopping themselves for months with no takers because their loan book was so bad, and they knew they could cherry pick the good assets out of receivership when they eventually failed. Their bonds were trading at 20%+ yields months ago. I would say the run on the bank was just depositors realizing what the credit and equity markets did long ago–this company was doomed.

  12. If you have ever bought an individual stock and can’t read a balance sheet you are a speculator.

    Awesome.

  13. Not to say that most people who can read a balance sheet and buy individual stocks aren’t also speculators. And not to say that speculators are necessarily bad. They are most definitely bad, however, when they are putting their families at risk–which an increasing number of them wantonly do.

    My mother gets upset with me because I occassionaly pay someone to take my money in exchange for my pleasure at a casio (much like other people might pay someone to take their money in exchange for their pleasure at a movie theater). Yet she treats the stockmarket exactly as one might a roulette wheel–putting money down on feelings and touts. She has lots of company.

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