American Unemployment Rate Approaches 10%

[Berkut]

But that doesn't explain why knowledgable financial institutions made immense one way bets on markets that (a) *everyone* knew were overvalued and (b) whose future perfomance depended on cleaning ladies putting 60% of their paychecks into a mortgage payment.

1) Financial types are more stupid than they let on.
2) Financial institutions were run by people with hugely misaligned incentives.

Wait, I thought you said it was because of Reagan?

[Admiral Yi]

1) Financial types are more stupid than they let on.
2) Financial institutions were run by people with hugely misaligned incentives.

And yet financial institutions have been known to operate for months, even years, without failing.  Presumably there was something that differentiated the subprime crisis from normal operations.

[DGuller]

1) Financial types are more stupid than they let on.
2) Financial institutions were run by people with hugely misaligned incentives.

And yet financial institutions have been known to operate for months, even years, without failing.  Presumably there was something that differentiated the subprime crisis from normal operations.

Same can be said of any other bubble.  Those who became victims of the bubble must've operated normally before they became victims of the bubble.

[Admiral Yi]

Same can be said of any other bubble.  Those who became victims of the bubble must've operated normally before they became victims of the bubble.

OK, let's say the same of the dotcom bubble and the commercial real estate bubble that brought down the S&L's.  Wall Street didn't get burned when those bubbles burst.  Has Wall Street gotten stupider since then, or have the incentives gotten more perverse?

[Sheilbh]

And yet financial institutions have been known to operate for months, even years, without failing.  Presumably there was something that differentiated the subprime crisis from normal operations.

Actually the past 30 years has had a number of banking crises and financial system collapses.  Russia had one, Japan, most of Asia, Brazil also had a large one.  I believe the majority of the IMF's work over the past 30 years has been dealing with precisely this sort of crisis.  All that's different is that this one's affecting the US not the developing world.

This chart compares Japan and the US:


I can't find a chart but there was a very interesting one in the FT a while ago that showed that basically the number of banking and financial system crises globally has been at about the level of the pre-war years for the past 30 years.  Between 1945 and the 70s there were very few, indeed almost none.  This sort of thing has been happening for a while.  What's difficult about it is that it's hit the US which means that IMF-like solutions can't be imposed and which also means the whole world is hit due to American economic strength and globalisation.

[Sheilbh]

I still can't find the charts but there's a few which may do.  Unfortunately I couldn't find them online so I've had to save these and attach them to posts.  Hopefully this'll work.

First a map of bank crises since the late seventies:

[Sheilbh]

Second a frequency of crisis chart.  The 56 are emerging, transitional and developing countries:

[Sheilbh]

And finally a crisis severity average chart:

[alfred russel]

I don't buy the "misaligned incentives" argument: I'd argue that current compensation aligns incentives more than any previous system we had. Stock as a percent of compensation has grown, often through incentive plans.

Are incentives misaligned from shareholders? Absolutely. There has never been, and never will be a system that perfectly aligns the interests of shareholders and management.

But the concept that no one seems willing to consider is if this crisis was in part due to the alignment of incentives between management and shareholders. Stock is considered a very risky asset class--high risk, high reward. A diversified investor is likely to want the company to maximize its expected returns regardless of the risks of the company (for example, I'd invest 100 in a coin toss if I lost everything in a tails, but won 250 if heads). The employees, bondholders, communities and customers probably don't share this willingness (I would not, for example, be willing to wager my salary on the same bet).

[DGuller]

Same can be said of any other bubble.  Those who became victims of the bubble must've operated normally before they became victims of the bubble.

OK, let's say the same of the dotcom bubble and the commercial real estate bubble that brought down the S&L's.  Wall Street didn't get burned when those bubbles burst.  Has Wall Street gotten stupider since then, or have the incentives gotten more perverse?

One difference is that Wall Street had no inherent role to play in those bubbles.  The subprime bubble was all about Wall Street, it wouldn't be possible without Wall Street buying up the mortgages and leveraging the hell out of them.

[DGuller]

I can't find a chart but there was a very interesting one in the FT a while ago that showed that basically the number of banking and financial system crises globally has been at about the level of the pre-war years for the past 30 years.  Between 1945 and the 70s there were very few, indeed almost none.  This sort of thing has been happening for a while.  What's difficult about it is that it's hit the US which means that IMF-like solutions can't be imposed and which also means the whole world is hit due to American economic strength and globalisation.

Interestingly enough, between 1945 and 1980 is also the period between Great Depression and Great Deregulation.  Coincidence?

[Admiral Yi]

One difference is that Wall Street had no inherent role to play in those bubbles.  The subprime bubble was all about Wall Street, it wouldn't be possible without Wall Street buying up the mortgages and leveraging the hell out of them.

:huh:Eh, that's sort of the question, isn't it?

[DGuller]

I don't buy the "misaligned incentives" argument: I'd argue that current compensation aligns incentives more than any previous system we had. Stock as a percent of compensation has grown, often through incentive plans.

Are incentives misaligned from shareholders? Absolutely. There has never been, and never will be a system that perfectly aligns the interests of shareholders and management.

But the concept that no one seems willing to consider is if this crisis was in part due to the alignment of incentives between management and shareholders. Stock is considered a very risky asset class--high risk, high reward. A diversified investor is likely to want the company to maximize its expected returns regardless of the risks of the company (for example, I'd invest 100 in a coin toss if I lost everything in a tails, but won 250 if heads). The employees, bondholders, communities and customers probably don't share this willingness (I would not, for example, be willing to wager my salary on the same bet).

The biggest part of misaligned incentives is precisely the conversion of investment banks into public companies.  This played a big part in investment banks becoming less prudent.  The bonus structure rewarded short-term rewards at expense of long-term viability.  Getting a big bonus out of a bunch of shareholders is a lot easier than getting a big bonus out of Mr. Goldman and Mr. Sachs.

[DGuller]

One difference is that Wall Street had no inherent role to play in those bubbles.  The subprime bubble was all about Wall Street, it wouldn't be possible without Wall Street buying up the mortgages and leveraging the hell out of them.

:huh:Eh, that's sort of the question, isn't it?

What I meant to say is that Wall Street wasn't in the business that gave rise to previous bubbles.  That's why I put "inherent" in it.  They are not in the Internet business, they're not in the S&L business.  They were, however, squarely in the business of creating highly leveraged financial instruments, which is what the subprime bubble was really about.

[Hansmeister]

I was reading an article in Forbes a few weeks ago about a smallish Texas bank that refused to go along with the subprime mess and maintained conservative lending pracices.  For that they were constantly harrassed by Gov't regulators for failing to expand lending to risky low-income groups.

The bank is sitting quite pretty now (which is why they wrote an article about them), but it makes clear how central pressure by gov't regulators to expand lending was to creating this crisis.