Ptolemaic Finance vs. Shiller’s The Subprime Solution
posted by Frank Pasquale
But you’d be wrong. The new Ptolemy’s of finance are back, adding epicycles to a libertarian approach that gets more embarrassingly discredited with each passing month.
One blogger at DealBreaker apparently believes that the shadow banking system has something to teach current advocates of regulation:
As it turn out, the really [sic] risks in the system were being created not by hedge funds but by boring old investment banks and insurance companies. Sure there have been hedge fund failures but none on the scale and with the repercussions of the recent failures of Bear Stearns, Lehman Brothers, and the government sponsored mortgage companies. Hedge funds might not have had all that many rules governing their behavior but their incentive pay structure seems to have regulated their risk far better.
Ever heard of Long Term Capital Management? And what put the pressure on “boring old investment banks and insurance companies” to keep taking on greater risks and more leverage? Might that be the returns promised by new instruments based on the junk paper generated in a Wild West, anything-goes mortgate market?
What’s astonishing about this post is that the “incentive pay structure of hedge funds” is exactly the type of “heads I win/tails you lose” compensation agreement that encourages money managers to take reckless risks. As I understand it, a 2 & 20 agreement means that the fund gets to keep 2% of assets under management, regardless of returns. Of course it’s going to pioneer ever-riskier investments–it has to pay for its exorbitant fees somehow. And it has no downside risk . . . a pleasant position that all those Lehman and Merrill managers who made their millions during the boom years now occupy as they contemplate ways to enjoy their gains.
We need a comprehensive re-think of how to deal with these disastrous short-term incentives. Meanwhile, the McCain campaign has a response straight out of the Hoover playbook: “We cannot tolerate a system that handicaps our markets and our banks . . . .” As the NYT notes, “he has never departed in any major way from his party’s embrace of deregulation and relying more on market forces than on the government to exert discipline.”
My only hope at this point is that both candidates read a book like Robert Shiller’s The Subprime Solution (reviewed here). His recommendations:
Shiller blames the subprime crisis on the irrational exuberance that drove the economy’s two most recent bubbles–in stocks in the 1990s and in housing between 2000 and 2007. He shows how these bubbles led to the dangerous overextension of credit now resulting in foreclosures, bankruptcies, and write-offs, as well as a global credit crunch. To restore confidence in the markets, Shiller argues, bailouts are needed in the short run.
But he insists that these bailouts must be targeted at low-income victims of subprime deals. In the longer term, the subprime solution will require leaders to revamp the financial framework by deploying an ambitious package of initiatives to inhibit the formation of bubbles and limit risks, including better financial information; simplified legal contracts and regulations; expanded markets for managing risks; home equity insurance policies; income-linked home loans; and new measures to protect consumers against hidden inflationary effects.
The same types of people who were allergic to regulation in the 1920s are among us today. They helped undermine the SEC’s authority, larded regulatory bodies with industry apologists, and are beginning to look like worse enemies of capitalism than Marx. Hopefully Shiller can be a Keynes for our age, saving the capitalists from themselves.
PS: Here’s a longer excerpt from Shiller’s introduction:
[A] subprime solution means embracing the following goals:
First, improving the financial information infrastructure so that the greatest number of people can avail themselves of sound financial practices, products, and services. This means delivering enhanced financial information, better financial advice, and greater consumer protection to larger segments of society, and also implementing an improved system of economic units of measurement. These steps will set the necessary groundwork, so that all consumers and households can make financial decisions based on the best possible intelligence rather than rules of thumb or, worse still, mere whimsy. Better financial information and decision making would, by themselves, check the incidence of bubbles.
Second, extending the scope of financial markets to cover a wider array of economic risks. Such an initiative would include, in the first instance, vastly expanded markets for handling real estate risk such as the new futures markets in Chicago, and also markets for other vital economic risks as well. These broader markets, coupled with a more sound information infrastructure, would provide the financial foundation for a variety of new initiatives that would help to inhibit the growth of bubbles.
Third, creating retail financial instruments—including continuous-workout mortgages, and home equity insurance—to provide greater security to consumers. Today the typical household has as its principal investment its home. A home represents a highly leveraged exposure to a single, stationary plot of real estate—about the riskiest asset one can imagine. The standard mortgage provides no protection against difficulties in repaying the lender due to changes in the marketplace. But mortgages can and should be designed to compensate for these changes by including provisions to ensure homeowners against their major risks. Other retail institutions can protect those who have paid off their mortgages, and they can protect non-homeowners from economic contractions as well.
Now that Paulson is in the driver’s seat, let’s hope some of this sinks in.
September 15, 2008 at 11:16 pm
Posted in: Corporate Law, Current Events
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Responses (5)
James Grimmelmann - September 16, 2008 at 7:54 am
As I understand it, a 2 & 20 agreement means that the fund gets to keep 2% of assets under management, regardless of returns. Of course it’s going to pioneer ever-riskier investments–it has to pay for its exorbitant fees somehow.
The excess incentive to risk comes from the “and 20″ part, not the “and 2″ part. 2% is high but hardly exorbitant for an actively-managed fund, especially one are as active as the typical hedge fund.
Jonathan Lubin - September 16, 2008 at 8:26 am
Large hedge fund and private equity fund investors often are able to get fund sponsors put skin in the game and invest alongside the fat cats so as to align incentives properly.
Maryland Conservatarian - September 16, 2008 at 1:48 pm
“But he insists that these bailouts must be targeted at low-income victims of subprime deals.”
Victims?? An interesting experiment would be for a group of like-minded progressives to pool their money and then lend it out to similar low-income borrowers in arrangements that more closely resemble “prime” deals…then wait to hear who is described as the “victim” on subsequent defaults.
Bill - September 16, 2008 at 6:13 pm
It seems as though the Bush Administration actually wanted more oversight for Fannie and Freddie (see this article from the NY Times). And who was blocking this legislation? I’ll let Barney Frank tell you:
And here is Mel Watt from N.C.
The role that politicians and activists played in “nudging” the financial system needs to be addressed as well. Claiming this was a problem of laissez faire policies or animal spirits is too simplistic.
anon - September 16, 2008 at 6:18 pm
You are an anti-libertarian hack of the most pernicious kind.
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