Three Myths about the Crisis Jeffrey Friedman http://causesofthecrisis.blogspot.com/2009/09/three-myths-about-crisis-bonuses.html
... | To be sure, banks that bought mortgage-backed securities to reduce | their capital cushions were, indeed, knowingly increasing their | vulnerability if the securities went sour.[6] But absent the Recourse | Rule, there is no reason that banks seeking a safe way to increase | their profitability would have converged on asset-backed securities | (rather than Treasurys or triple-A corporate bonds); thus, they would | not have been so vulnerable to a burst housing bubble. The Recourse | Rule artificially boosted the profitability of a certain type of | investment that the Fed, the FDIC, and the other regulators thought | was safe. | We know in retrospect that the capitalists who took advantage of the | Recourse Rule, such as those at Citibank, were making a mistake. But | not all capitalists did. JPMorgan, for instance, recognized the danger | and escaped destruction. None of these capitalists were irrational; | all were self-interested; yet they had different perceptions of how to | pursue their self-interest, based on different perceptions of risk. | In relatively unregulated markets, this diversity of viewpoints is | precisely what makes capitalism work. One capitalist thinks that | profit can be made, and loss avoided, by pursuing theory A; another, | by pursuing theory B. These heterogeneous strategies compete with each | other, and the better ideas produce profits rather than losses. In a | complex world where nobody really knows what will work until it is | tried, competition is the only way that people’s endless capacity | for error can be checked, and loss is the regrettable but inescapable | result. | In the banking industry, however, bankers’ heterogeneous ideas | were homogenized (although not entirely) by the Recourse Rule, which | loaded the dice in favor of the regulators’ idea of where risk | did and did not lie. The regulators thought that AA or AAA tranches | of asset-backed securities were 60-percent safer than individual | mortgages. This was not an “irrational” theory, either: The | tranching structure created by Moody’s, Standard and Poor, and Fitch | had a lot to be said for it, and even the little-known fact that the | SEC had effectively conferred oligopoly status on these three rating | companies[7] did not guarantee that disaster would follow. But the | crucial fact is that the Recourse Rule imposed a new profitability | gradient over the bankers’ calculations, producing the same effect | intended by all regulations: It altered their behavior, the better to | align with the regulators’ ideas--in this case, their ideas about | prudent banking. By thus homogenizing the inherently heterogeneous | competitive process, the regulators inadvertently made the banking | system more vulnerable--if, in fact, the regulators’ theory was | wrong. | If we seek the sources of a systemic failure, a logical place | to look is among the legal rules that govern the system as a | whole. Unfortunately, these rules, being legal mandates, have not | survived a competitive process, so if they are based on mistaken | ideas, we all suffer the consequences. That turned out to be the case | with the Recourse Rule. | Contrary to popular belief, then, the crisis of 2008 is best described | as a crisis of regulation—not a crisis of capitalism. _______________________________________________ http://mccmedia.com/mailman/listinfo/brin-l_mccmedia.com
