Friday, February 13, 2009

Prophecy Gone Wrong

My brother Viranjit, aka Kaku who is a high-tech engineer, has a surprisingly deep interest in socio-economic issues, with thoroughness to match. Seeing my last post about the Cato ad he explored "my" University of Chicago website and found two papers of interest for different reasons.

The first (and the one I'll focus on) is an authoritative paper opposing more regulation of the financial derivatives market, which includes sub-prime mortgages and CMOs. It was written about 10 years back by 1990 Nobel laureate (in Economics) Prof. Merton Miller.

He says that: a) Regulating this market further will impose an undue burden and stifle it, and drive away business from the US to overseas competitors. b) There will of course be winners and losers, but no chance of a system wide failure because of the strong and well capitalized institutions participating in this market, the tough oversight by the SEC, and the rigorous credit rating of the participants by S&P, Moody's, etc. c) The customers are mostly sophisticated institutions that need to freely use this market for hedging or risk-based investment purposes. They ought to know how the securities work and the attendant risks, and if they don't they'll learn to do so in a decade or so as the market matures. d) The valuation of these financial derivatives is typically very complex and dependent on the model being used, so it is very hard to specify disclosure requirements.

As Kaku says, "it is almost comical to see Prof. Miller's arguments so completely refuted by the causes of today's financial crisis" and wonders if "he is man enough to eat his words (which are still used as evidence by so many on the right)."

I've been taught by and interacted with Prof. Miller up close, and he was as fine, brilliant and witty a person that you could meet, with a heart to match. His paper here should not detract from his seminal work in finance that earned him the Nobel prize (including the famous Modigliani and Miller theorem of dividend irrelevance that's a staple in finance classes.) He passed away in 2000 at age 77, and so cannot retract his words.

I also think he deserves some benefit of the doubt as his stance was based on market conditions in the mid 1990's. He didn't see the explosion of sub prime mortgages and CMOs in the early 2000's that made Paul Krugman rightly and urgently call for more regulation, and for Greenspan to wrongly and disastrously oppose this. Had Miller been alive and observed the new developments, he may just for all we know have changed tack and weighed in on Krugman's side.

Here are the condensed reasons for blaming lack of regulations for letting the financial crisis occur, contrary to Miller's assessment:

a) The principal - agent problem. The "agent" here is the mortgage originator who gets paid on selling mortgages, even over-valued ones to financially unsound borrowers. Or it's the fund manager who makes large and risky bets on CMOs. If the bet pays off the fund manager gets filthy rich, and if it doesn't, it's the investor loses heavily and the fund manager pays nothing. In either case the "agent" has incentives not to act in the Principal's (investor's) interest.

b) The information asymmetry problem. The buyer or investor does not know or understand the risks involved in the funds like the originator does. This is especially true when the securities involved are highly complex and what is in them is not revealed. So the buyer is at a disadvantage unless regulations force greater transparency.

c) The time horizon mismatch. This can cause agents like fund managers with near term outlook to take risks or pump up short term performance that is not sustainable. The consequences eventually catch up with the investors, but by then the agent (hopes that he) has left.

d) Cozy regulator and rating agency relationships with their target entities. The S&P and Moody's are hired and paid by the very firms whose credit they rate - an inherent conflict of interest. Miller lauds "the two way nature of the flow of top regulators and top executives" within the industry, but this can be a curse instead of a virtue, as such connections weakens oversight.

e) Systemic shocks. Everyone is happy and buoyed up by bubbles in stocks or the rising tide of real estate prices. But a reversal of this trend causes a downward spiral that (absent of safeguards) sinks a lot of boats.

f) Letting the ignorant and the stupid self-destruct. This is a harder sell, but we may need laws to protect the ignorant from their own bad decisions, just as we have laws to compel use of seat belts while driving, or those banning the use of heroin or crack.

Moreover, special interests and right-wingers have bastardized the term "free markets." It should mean freely traded goods and services in a competitive setting without the burden of distorting taxes, duties or undue restrictions. What it shouldn't mean is lack of checks on deception, the selling of spurious products, withholding information about what's being sold, or failure to mandate safety standards. Regulations compelling transparency in where money is being invested and in the detailed disclosure of returns, and better scrutiny enhances free markets, not detract from them. It may also prevent the havoc wreaked by future Bernie Madoffs, or ill-conceived CMOs.

The other U. of C. paper that Kaku looked up is titled "Are CEOs Rewarded for Luck? The Ones Without Principals Are." Note the spelling of "Principals" as they're referring to main investors, not ethics. This topic needs a separate discussion, and this academic paper is (as typical) fairly long and involved. You can see the conclusions at p. 23 - 24: essentially that a major chunk of the CEO salary depends on luck (the fortunes of that industry rather than individual performance) and the problem is worse for poorly governed firms. It undercuts some big arguments for large US-style CEO compensation.

The findings aren't surprising. For instance, compare the salaries in past years of the CEOs of the Big Three US automakers with their Japanese (Toyota, Honda, etc.) counterparts who make a fraction of that. Look at the fortunes of these respective companies now. Still, there are defenders of the US (and detractors of the Japanese) system: see for example this Feb. 23 BusinessWeek article titled "Japan: No Model For Executive Compensation." I am underwhelmed by the logic and the case sought to be made out here, though.


Anonymous said...

Just about nobody is against having laws. Libetarians only win under a million votes in the election. What we want are sensible laws, and in a manner that doesn't impede business.

In many ways, Washington and their mandates have caused this mess. The first was to force banks to lend to achieve their housing goals of 70% plus. Then minorities must get their piece of the pie, so banks are forced to create sub-prime. Then Congress dismantles Glass Stegal Act that was designed to keep commercial and investment banking apart. I think the last one was designed to allow the vast pool of deposits to be comingled with the crazy derivatives so everyone could have a party.

Glass Stegal was a crucial piece that maintained moderation. You talk about hedge fund managers being allowed to rampantly speculate and wreck havoc if they're wrong. If there wasn't so much capital, the damages would be minimized. In other words, I don't want to mix my Las Vegas money with my grocery money, and Glass Stegal did just that.

And to your point about Japanese CEO being paid a lot less than US ones, I agree to a point. A lot of the excess pay of the US CEO's are not warranted. However, Japan is much more manufacturing based and those industries are much more matured where there is no need to pay them so much. But in the US we have much more innovation which commands a higher premium. Besides, no one thinks Japan is a paragon of economic virtue since their country is in a 20 year recession.

But the compensation on Wall street is definitely changing. People were paid with small salaries and big bonuses. Their net worth was dependant on where their stock prices went. That has to change so the traders are not betting the farm so their stock prices go up.

Sandip Madan said...

You make good points. Repealing the 1933 Glass-Steagall Act in 1999certainly exacerbated the problems leading to the current crisis. I haven't looked deeply enough into whether letting the Act stand without additional regulations would have averted disaster.

On CEO compensation the different nature of US and Japanese businesses may account for some differences. Still, there are wide variations in CEO pay between the two countries even in very similar businesses. For example, the Big Three auto companies in the US are as mature than their Japanese counterparts.

Anonymous said...

Kenrod says:

Nobody says there shouldn't be regulations. In fact, the gov't should have been there all along strengthening the SEC. In a basketball game, we expect there to be referees. But when the refs want to play in the game then it's no longer fair. In this case, the gov't has taken over GM,chrysler, Bear sterns, etc. Instead they should have been allowed to fail and the stronger ones take them over.

And I think the SEC should be totally reformed. This agency has not uncovered a single scandal since it's founding in 1933. No not one. They catch petty crooks but the big fish have eluded them. Madoff wasn't uncovered by them. In fact, they scoffed at the evidence when presented to them years earlier.

The reason the SEC is not effective because it has an incestuous relationship with the community it regulates. People move from one side to the other, and vice versa.

Sandip Madan said...

We are absolutely on the same page about the need to eliminate (as you aptly put it) incestuous relationships, as well as for the "right" regulations.

The govt does not want to bail out financials but it has been almost forced to, to keep the whole system going. About GM, Chrysler, etc., there's a strong case for letting them declare bankruptcy, and Tom Friedman agrees with you on this, too. But if the govt does decide to bail them out, it may as well become an owner (at least temporarily) instead of a pure donor.

Anonymous said...

And to do a bit of prophecy of my own, I predict Hillary Clinton will no longer be Sec' of State in a year. She will resign and start her 2012 campaign for the WH. Gov. of Louisiana has already started his campaign for the Dems nomination.

This all points to the weakness of the Obama administration which is already becoming unpopular. And the honeymoon isn't over yet. We're falling over a cliff.

Sandip Madan said...

Well, that's quite a prophecy - let's see. I've not given up on the Obama crowd quite yet.. :-)

Anonymous said...

To paraphrase Shakespeare's Julius Caesar, "Yonder lies Cassius(Hillary) with that lean and hungry look... such men(women) are dangerous."

I think she's always had the ambition. The key is to find Obama in a weak position. If she challenges him, then I think he will be a one termer. Besides, I don't think she fits in Dept of State. Not that she's not good at foreign affairs, but she's more of a go getter than an administrator.


Sandip Madan said...

Gaze not at this damsel who hath stolen my heart with such a jaundiced eye... :-)

Anonymous said...

Hell hath no fury like a woman scorned.

On another subject, I thought Obama's speech to the Congress was miserable. There was no details, no inspiration and more of the blame game. And having four of his cabinet nominees turned back, I think the bloom is off the rose.

I was more impressed with Louisiana's gov Bobby Jindal's response. He must be the next rising star of the GOP.


Sandip Madan said...

I thought just the opposite. May be beauty simply lies in the eyes of the beholder. :-)

Anonymous said...

I thought Gov. Jindal looks a lot like you. And I'm sure you don't think you look that bad?:))

What I thought Obama's speech lacked was any address of nuclear. I'm quite sure we won't make any sizable dent in energy dependence unless we include nuclear. And he doesn't address the Moral Hazzard in bailing out all these delinquints who don't pay their bills.