Saturday, February 13, 2010

Too Big to Fail: The Evidence

Ironically, Cafe Hayek takes issue with my Austrian claim that bankers were (in general) ignorant of the risks they were taking, hence could not have been taking these risks due to their knowledge that they were "too big to fail" and thus would be bailed out. Or at least I think that's what Russ Roberts is suggesting, because he is disputing what I said, and what I said is that TBTF did not cause the crisis--not that the thought of a bailout never crossed any bankers' minds. (If I were one of them and it crossed my mind, however, I would have said to myself: "Maybe. But I'm not going to count on it.")

Roberts cites a speech by Andrew Haldane,an official of the Bank of England, who claims that at an undated meeting of unnamed bankers, an unnamed individual said that bankers had no incentive to run severe stress tests because in a severe event, they would lose their jobs and then "the authorities would have to step in."

Props to Russ for this interesting evidence, which I hadn't seen before. But it's not exactly unambiguous.

Consider a banker who, as posited in the anonymous scenario, thinks that a disastrous financial situation would get him fired. What difference would it make to this allegedly self-interested banker that the bank would subsequently be bailed out?

Of course, as the bailouts actually unfolded, the bankers did not get fired in many cases--but according to Haldane's anecdote, the bankers did not know that in advance.

So, as I said, when it comes to the TBTF, corporate-compensation, and ABCT theories of the crisis, we're in a high-conviction, low-evidence zone. However, we are not in an evidence-free zone. Consider, on TBTF:

1. Many banks that were too small to be bailed out (except by the FDIC, in which case the bankers would definitely be fired) invested in the same AAA-rated MBS as the big banks that got bailed out.

2. Commercial bankers like Sandy Weill and investment bankers (e.g., Jimmy Cayne, Ralph Cioffi, and Matthew Tannin at Bear Stearns) lost many millions--in Weill and Cayne's case, $1 billion each--because they were fully invested in their banks' stock right up to the end.

Cafe Hayek quotes Cayne: "The only people [who] are going to suffer are my heirs, not me. Because when you have a billion six and you lose a billion, you’re not exactly like crippled, right?" What is the point of this quotation: That Cayne didn't care about his heirs, so he didn't care about losing $1 billion, so that's why he knowingly allowed Bear Stearns to take risks that led to its collapse?

That is certainly not the implication of the passage when it is read in context.

3. If one reads the rest of the book from which the quotation is drawn, one finds that Cayne was consumed by the construction of a new skyscraper headquarters for Bear Stearns that would symbolize the permanence of the success of this once-underdog, scrappy, Jewish firm. Is it really plausible that Cayne would risk that success, his life's legacy, because, in the event that the risk brought down Bear Stearns, the firm might get bailed out (by being absorbed, in the event, into arch-rival JP Morgan)?

Similarly, as I document in my introduction to the Critical Review financial-crisis issue, Cioffi and Tannin, who were the only ones at Bear Stearns who actually knew what was going on, revealed in secret emails to each other (discovered by the FBI) that they were true believers in the accuracy of the triple-A ratings. They were mistaken.

Again, as the crisis unfolded, all the books on the crisis show that the principals were shocked, frantic, and bewildered. If they had deliberately taken risks because they had a bailout in the back of their minds, would they not have have reacted with knowing cynicism and serenity?

(More documentation will appear in the revised introduction to the book version of Critical Review's financial-crisis issue, The Causes of the Financial Crisis, forthcoming from the University of Pennsylvania Press.)

4. I'm still waiting for somebody to explain why these bankers who were supposedly insensitive to risk--due to being TBTF, or due to their compensation incentives--bought government-guaranteed or AAA-rated MBS 93 percent of the time.

AA-rated MBS were riskier, paid higher returns, and got exactly the same capital relief as AAAs. They would have been the MBS of choice if both the capital-relief theory of the crisis, which I favor, and the TBTF or corporate-compensation theories of the crisis were true. Subtract the capital-relief motive, though, and BBB or lower-rated securities would have been the choice. But never, ever, AAAs.

I submit that the bankers--like the regulators--simply did not realize that this was the first-ever significant nationwide housing bubble. And they did not realize how fragile the bubble was, due to subprime lending. Meanwhile, the Basel regulators encouraged them to leverage into the bubble by buying AA- or AAA-rated MBS. That is the crisis in three easy sentences.

The crisis has ideological ramifications. So economists of libertarian bent want to blame it on TBTF. Those of leftist bent want to blame it on bankers greedy for bonuses. Is it so difficult to imagine, though, that both the regulators and the bankers, being human, were ignorant of what was to come?

That, I think, is what Hayek might have said.


Anonymous said...

Russ Roberts has a competing book and is picking nits.

aje said...

I don't find Russ' criticism convincing - even if they were incentivised to run stress tests, the key issue is what kind of stress tests they would have run? Is there *any* evidence that they would have helped them navigate the financial crisis?? More here:

Bill Woolsey said...

The creditors of the banks should be considered too.

Did those lending to the investment banks believe that they would be bailed out?

One explanation of the impact of Lehman failing was that lenders who had expected bailouts began to doubt them.

Anonymous said...

As I have stated to Professor Roberts, this should be settled via econtalk. But, I would prefer a more in-depth discussion of voice vs. exit.

Macro said...

The moral hazard argument does explain many of the facts you mention above. The problem is that the conventional moral hazard explanation is not accurate as a theoretical construct. I have paraphrased below some arguments that I made in this post here .

As Bill Woolsey mentions, the chain of causation starts with bank creditors factoring in even a less than 100% probability of a bailout and adjusting their required rate of return downwards. Even a small probability of a partial bailout will reduce the rate of return demanded by bank creditors and this reduction constitutes an increase in firm value.

If each incremental unit of debt issued is issued at less than its true economic cost, it adds to firm value. The optimal leverage for a bank is therefore infinite.

Increased leverage and a riskier asset portfolio are not substitutable. The above arguments show that risk taken on via increased leverage is distinctly superior to the choice of a riskier asset portfolio – Unlike increased leverage, riskier assets do not include any free lunch component.

Regulatory capital requirements force banks to choose from a continuum of choices with low leverage and risky assets combinations on one side to high leverage and “safe” assets on the other. Given that high leverage maximises the moral hazard subsidy, banks are biased to move towards the high leverage, “low risk” combination.

High-powered incentives encourage managers/traders to operate under high leverage. Bonuses and equity compensation help align the interests of the owner and the manager.

Risk from an agent’s perspective is defined by the skewness of asset returns as well as the volatility. Managers/Traders are motivated to minimise the probability of a negative outcome i.e. maximise negative skew. This tendency is exacerbated in the presence of high-powered incentives. Andrew Lo illustrated this in his example of the Capital Decimation Partners in the context of hedge funds (Hedge fund investors of course do not have an incentive to maximise leverage without limit).

The above is a short explanation of the consequences of moral hazard that explains the key facts of the crisis – high leverage combined with an apparently safe asset portfolio of AAA assets such as super-senior tranches of ABS CDOs. Contrary to conventional wisdom, a moral hazard outcome is characterised by negatively skewed bets, not volatile bets.

The best piece of evidence on the crisis I have found so far in the public domain is the UBS shareholder report. It is quite technical and jargon-laden but I have analysed the relevant sections to justify the above assertions at the end of this post here.

Matěj said...

Also, what about this paper:

Bebchuk, Lucian A., Cohen, Alma and Spamann, Holger: "The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000-2008" (November 24, 2009). Available at SSRN:

The standard narrative of the meltdown of Bear Stearns and Lehman Brothers assumes that the wealth of the top executives of these firms was largely wiped out along with their firms. In the ongoing debate about regulatory responses to the financial crisis, commentators have used this assumed fact as a basis for dismissing both the role of compensation structures in inducing risk-taking and the potential value of reforming such structures. This paper provides a case study of compensation at Bear Stearns and Lehman during 2000-2008 and concludes that this assumed fact is incorrect.

We find that the top-five executive teams of these firms cashed out large amounts of performance-based compensation during the 2000-2008 period. During this period, they were able to cash out large amounts of bonus compensation that was not clawed back when the firms collapsed, as well as to pocket large amounts from selling shares. Overall, we estimate that the top executive teams of Bear Stearns and Lehman Brothers derived cash flows of about $1.4 billion and $1 billion respectively from cash bonuses and equity sales during 2000-2008. These cash flows substantially exceeded the value of the executives’ initial holdings in the beginning of the period, and the executives’ net payoffs for the period were thus decidedly positive. The divergence between how the top executives and their shareholders fared implies that it is not possible to rule out, as standard narratives suggest, that the executives’ pay arrangements provided them with excessive risk-taking incentives. We discuss the implications of our analysis for understanding the possible role that pay arrangements have played in the run-up to the financial crisis and how they should be reformed going forward.

DWAnderson said...

I think Macro's analysis is largely correct. TBTF decreased the incentives for creditors to exercise their monitoring function and thus decreased the chances that the problems identified in the post would be discovered and rectified.


To big to fail is a joke.