I really dig Andrew Clavell. But he is misguided in his criticism of an excellent piece by Martin Wolf.

Here’s Andrew:

[I]ndividual mortgage borrowers demanded their chance to improve their social and financial standing with scant regard for the potential consequences of their actions. MBS Investors (read hedge funds, money market funds, pensions, mutual funds as well as banks) demanded ‘attractive’ yields for the perceived risk, and had incentive structures and abundant liquidity available to encourage risk taking.

Mortgage borrowers and mortgage-asset investors were both long housing assets, the former with a call option on the upside, the latter by shorting puts on the downside for yield premium. Investment banks, at whose doors Mr Wolf et al are laying the blame for the outcome of this misguided speculation, just saw an opportunity to intermediate this activity and did so successfully. It was their own badly conceived warehousing of some of the assets which is causing them so much mark to market pain at present, but that is not the issue.

Are we supposed to blame the bankers for being oil in the cogs in the capitalist engine? Are we suggesting that banks should have desisted as they knew a bubble was developing? Why are we ready to pronounce them the bad-guys again? Purely since their pay is the most public and the most despised by outsiders. So let’s regulate it. Claw it back. Withhold it for 10 years.

Never mind that politicians and central bankers set the tone for investors (loosely, the American dream). They don’t get paid much, so let’s not blame them. Let’s also not claw back their salaries or appropriate large fractions of their fees from lucrative speaking tours or book sales following their exit from public duty.

Never mind that the majority of ordinary people are illogically risk seeking in housing markets, or dot com shares. Ordinary people don’t get paid like bankers, so let’s not blame them. Let’s not try to educate ourselves properly about finance before we wreak such destruction.

Never mind all that. Blame the intermediary who earned too much.

Andrew is quite right to note that there is plenty of blame to go around. Ordinary folk herded into scam mortgages, taking a rational bet that this year would be like last year and they could catapult themselves into the upper middle class by taking a chance on the biggest home they couldn’t afford. Institutional managers herded into structured products promising high yield at next to no risk, products that seemed to violate the most elementary rule of finance (no arbitrage), and were shocked, shocked when after four years of great bonuses, their clients learned there was risk after all. And bankers of all ilks and alphabets, I-bankers, C-bankers, M-bankers, discovered there was great money to be made, intermediating (originate and sell!), dealmaking (LBOs, baby, it’s a new era of infinite leverage and no defaults!), and shoving risks where stockholders and regulators couldn’t see them (SIVs are just innovative!). People who face opportunities with stratospheric upsides and largely externalized downside costs take chances. Fundamentally, the behavior of bankers was no different than that of homebuyers with dollar signs in their eyes, the guy who ran a “mortgage company” from an e-mail server in his basement, or you and me in their situation. So, why should we pick on them?

We should pick on them. It’s not because they’re bad people. Most bankers are very nice people. We should pick on them because, as Andrew says, banks intermediate. They are a point where all the lunatics meet to transact, a point where applying pressure can change everything. We can rant and rail against human nature, but who cares? People is people, God bless ’em. But banks are formal institutions, amenable to laws, regulations, and litigable norms and standards that are easily reshaped. We don’t have to throw up our hands at frailty and corruption and watch reruns from the 1930s over and over again. We can actually mess with banks (and other financial intermediaries) in ways that indirectly shape the behavior of the rest of us (and that are not terribly intrusive to most of us). It simply isn’t true, in the general case, that human desires are exogenous and “demand will find supply”. The explosion of misbehavior on all sides of the credit market over the past several years was not caused by a burst of theta-waves from the Earth’s core. We allowed our institutions to evolve to a place where misbehavior was ordinary, caution uncompetitive, prudence a firing offense. If we change the institutions, we change the behavior. We can do that, and we should do that.

I’m skeptical of proposals (by Wolf and others) with regard to bankers’ pay, not because they are harsh, but because they are circumventable. Escrowed cash and restricted stock can be pledged and hedged, regardless of formal prohibitions. (We simply haven’t invented a decent compensation instrument that can’t be cashed out. That would be a profoundly useful financial innovation.)

Unsurprisingly, when Martin Wolf and Andrew Clavell agree, it’s worth paying attention. Wolf:

An alternative suggestion is “narrow banking” combined with an unregulated (and unprotected) financial system. Narrow banks would invest in government securities, run the payment system and offer safe deposits to the public.

Wolf backs off of this suggestion far too quickly. (“The drawback of this ostensibly attractive idea is obvious: what is unregulated is likely to turn out to be dangerous, whereupon governments would be dragged back into the mess.”) Much of this danger could be ameliorated with one parsimonious regulatory principle for the nonbank financial sector — An absolute prohibition on scale. There should be hard limits on the quantity of gross assets under any one entity’s control, combined with strong norms of independence (copycat investing is prima facie poor practice that opens up managers to investor lawsuits), along with antitrust like scrutiny of coordinated action. This would represent a big change. The current legal environment creates artificial economies of scale (the complexity of securities law), rewards herding (“safe harbor” provisions, “Nationally Recognized Statistical Rating Organizations”) and punishes independence (managers who make unusual choices face investor liability). The maximum permissible size should be absurdly small by today’s standards.

Obviously, this is a radical proposal, unlikely to happen anytime soon. But we may yet get to the point where all our choices are scary, so we’d best have some good options ready to go, just in case. One way or another, we have got to improve a financial sector that extracts a large fraction of collective wealth, allocates capital poorly, and creates periodic bouts of instability and human misery. Most of the men and women who work on Wall Street are fine people. But in Manhattan as much as in Michigan, broken institutions ought not be protected from bouts of creative destruction. America’s vaunted financial system does not adequately serve the purposes it is meant to serve. That has to change. Ideally, we should encourage private innovation and follow a cautious, incremental path to something better. But regardless of how we get there, a lot of people who have been well compensated under existing arrangements aren’t going to like the changes. Too bad.

This entry was posted on Thursday, January 17th, 2008 at 4:26 am PST.
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