Panic

 Richard Vigilate quoted in an article in Barron’s Magazine. 

Here is our response to Nicole Gelinas:    

A couple days ago we had a piece up on National Review Online.  Professor Arnold Kling and Nicole Gelinas  both comented on it. 

Mr. Kling was off to such a great start, and then without warning he’s just gone plain silly.

Some of his confusion is unsurprising. Everyone, but everyone who comments on the crisis seems to buy into the basic moral hazard/too big to fail argument: The reason the banks went bad is that bank executives and investors alike were so convinced the banks would be bailed out that executives took risks they otherwise would have avoided and investors kept investing regardless of these mounting risks.

It all sounds so plausible, for about two seconds. Then it just sounds absurd. Sorry, but bank executives holding hundreds of millions  of stock in their own institutions (in poor Dick Fuld’s case almost a billion in Lehman stock) do not cold bloodedly max out on risk because the government might bail possibly, even probably bail them out if they get in trouble. Nor did that actually happen, by the way. Find us the top people from Bear or Lehman or Wachovia who think that betting on a government bailout is a good career move.

Bear and Lehman were known for having especially high levels of executive ownership. Didn’t help them.

In the case of bondholders there is some more plausibility to the moral hazard argument, but the very thing that makes it plausible also reveals it as being at most a minor factor. There is some reason to believe that the major banks throughout the run up to the crash were all able to borrow somewhat more cheaply because of their likely access to government assistance. If this is true, it helps explain how the banks got so big. A discount of 10 or 20 bps off the cost of capital for a bank with a trillion dollar book of business will pay for a lot of toga parties.

The moral hazard argument breaks down because as we now know, the problem was not that Citibank was able to borrow at AAA rates when it should have been paying AA rates. The problem was the Citibank was actually a C credit and markets did not have a clue. Even the most feckless bondholders do not lend to C credits at AAA rates on the possibility that the government will save them.

The spread between what markets were charging Citi for money and what markets should have been charging can only be explained by massive ignorance of Citi’s condition not indistinct hopes of a bailout, hopes which, as the government’s handling of Lehman showed, were not especially well founded.

The absurdity of the moral hazard argument can hardly be made more clear than by quoting Mr. Kling’s own formulation.  “If I believe that it is government’s policy to bail out unsecured creditors, then I will invest in debt from Citicorp or Freddie Mac with hardly a care in the world about what’s on their balance sheet or how they manage their business. I know they’ve got Uncle Sugar behind them. They could be transparently bankrupt, and if I think they will get bailed out I have no reason not to invest.” To make the argument work Mr. Kling uses the words (which we have italicized) “believe”, “know”, and “think” as synonyms. The argument only works if bondholders know they will be bailed out and moreover bailed out without fuss or delay. They did not “know” any such thing.

The great exceptions of course are Fannie and Freddie. And Mr. Kling reveals the weakness of his argument in making the exceptions stand for the whole. Markets did believe that Fannie’s and Freddie’s bonds, like FDIC insurance, were ‘all-but’ full faith and credit obligations of the U.S. Treasury. And they had good reason to believe it since Uncle Sam encouraged this impression at every opportunity. And then, while most of the great banks were merely politicized by the government’s give everyone who can spell his name and walk a straight line (though not at the same time) a mortgage, Fannie and Freddie were Congress’s own pet banks.

As it turned out of course the Twins junior bondholders who took the governments winks and nods as a contract were were sorely disappointed when the government decided to roast them over the nearest open fire.

So much for the great too big to fail myth. Then there is Mr. Kling’s complaint that making the banks more transparent, as we propose, would never work because they can never be made completely transparent and therefore risk cycles can never be eliminated. What is there to say except that only a professor of economics could say something so silly.  So investors can’t have perfect knowledge. Therefore it wouldn’t help for them to have more knowledge? The risk cycle can’t be eliminated; therefore we should all continue playing blind man’s bank?

Please check out our column featured today on NRO.

Gabcast! Richard Vigilante on the Grandy & Andy Morning Show

My Friend David Frum and why he is worth 10 dozen Tunkus and why this post is not as off topic as it seems.

Last week Tunku with the unpronounceable last name, whose previous claim to fame was being the worst WSJ op-ed editor in living memory, decided to reveal to the world why David Frum disagreed with most conservatives (including Andy and me) on health care reform, arguing that Republicans should have compromised.

Did Tunku offer some devastating critique of David’s argument for compromise (which would not have been hard, I am sorry to say)? Nope. Not a bit.

His argument was that David is a suck-up, what Tunku calls “a ‘polite-company conservative’ (or PCC), much like David Brooks. . . .  A PCC is a conservative who yearns for the goodwill of the liberal elite in the media and in the Beltway—who wishes, always, to have their ear, to be at their dinner parties, to be comforted by a sense that liberal interlocutors believe that they are not like other conservatives, with their intolerance and boorishness, their shrillness and their talk radio.”

This argument would be despicable except that it is so pathetic that despising it would take too much energy.

Judging motive is always a disaster. Even if one gets it right, the net effect is to allow one to dismiss the arguments of one’s opponent without engaging them. Judging motive shields the intellect from dissent. It makes people dumb.

When the critic gets the motive wrong, and obviously wrong, the whole thing just gets downright embarrassing.  Despite Tunku’s “what I call a ‘polite-company conservative’” phrasing it’s not as if  his charge was in any way original. We’ve heard the same argument for decades, applied not only to the two Davids, but to George Will, William Safire, even Bill Buckley (mentor to not only both Davids but me as well) or almost any conservative writer more influential, more famous, and more talented than the critics.

It sounds so plausible—unless you spend more than two seconds thinking about it. After two seconds you remember a few things. Like David Frum is roughly fifty years old, comfortably circumstanced, has  a great career, is well-connected socially here and in Canada and DOES NOT EVER WANT TO BE INVITED TO ANOTHER COCKTAIL PARTY or at least not to one hosted by liberals showing off apostate conservatives.

Ditto David Brooks, George Will and the rest. They are famous and successful because they are enormously talented. They don’t suck up; they get sucked up to, an experience sadly denied to most of their critics.

(I would never speculate on Tunku’s motives of course. Be it noted, however, that with fewer than 200,000 Google cites (barely a ripple in Google terms), Tunku is a writer toiling in well-deserved obscurity, who seems never to have gotten as much attention before as he has from his piece on DF.)

Andy and I have known David Frum for almost 35 years (since Yale where we hung out with all the other elitist conservative conspirators who now run the world.) In all that time neither of us have ever seen any indication that David even a little bit craves the company or approval of liberals. Not to tell tales out of school, all the evidence in our extensive files suggests he doesn’t like them very much. In our experience his own dinner and cocktail parties are populated mostly by distinctly unfashionable but very bright people who don’t like liberals any more than David (or Danielle) do. (Or maybe we are just on their distinctly unfashionable but very bright list, which we could live with.)

David isn’t pretending to be anything, for anyone. He is today what he has been since he was seventeen: a gentle man of very conservative views, who is more inclined to seek agreement than argument. Unlike your humble authors he does not glory in conflict for its own sake. (This occasionally put us on different sides back at Skull and, oooops, I mean Yale. At least half the time, David was right.)

All the more honor then is due David for the times when he has not only gone to bloody battle but led the charge. Or are we confused? Was that Tunku what’s-his-name who stopped Harriet Miers cold when “real conservatives” like the leaders of the Federalist Society (also friends, also Yalies, also part of the conspiracy)  were doing all they could to put a conservative hack on the Court.

Oh, and while we are at it, I have known Dave Brooks (and his astonishingly beautiful wife Jane) only a few years less than Andy and I have known David Frum. Guess what, he’s not sucking up or faking it either. When I met David B. he was a moderate liberal and a terrific writer who, partly under the influence of Bill Buckley, later became a moderate conservative and an even better writer. That’s what he is. Never pretended to be anything else. Do conservatives think the world would be a better place if there were no conservative writers the Times judged acceptable to its overwhelmingly liberal readers who otherwise might never hear a conservative voice?

By the way, for those of you who don’t get out much, liberals hate Dave Brooks, and the Times withstands a good deal of pressure from those people Dave is supposedly sucking up to, but who for some odd reason want him fired.

I worship the ground above which Sarah Palin ever so delicately hovers. (And don’t even get me started on the ankles) Both Davids loathe her. I love Ann Coulter. (Ditto  the ankles) I am pretty sure Ann loathes both Davids, (though I don’t actually know that.) I consider Rush Limbaugh a serious public intellectual and overwhelmingly positive force (or at least that’s my impression from a decade ago when his show fit into my schedule.) David F. thinks he is a plague.

Ok, we disagree.  But why does that disagreement need to be EXPLAINED?

RV

PS  The reason this post is not as off topic as it appears is that the misjudgment of motive is central to the conventional but very confused narrative of what caused the banking crisis.  See our piece “The Myth of Moral Hazard”, among others.

An excellent summation of why the pessimists on employment are wrong–at least in the short term. Deep recessions routinely cause excessive job loss, as businesses over-react to near term perils; dramatic productivity increases, as need for labor exceeds businesses worst fears; and lagging but very strong rebounds in employment as GDP rises and productivity inevitably drives employment.

Of course this does not happen if GDP does not rebound. But the notion that GDP can rebound without an eventual surge in employment never turns out to be true.

Your investment advisor likely puts together your portfolio in the same way the busted banks put together their own portfolios of mortgage-backed securities

In Part I we talked about the first big idea that your investment advisor probably shares with your banker, especially if your bank is one of the big important ones that almost blew up the world 18 months ago.

That first big idea is: “risk drives return.” How much your investment portfolio earns for you, over time, depends on how much risk you are willing to take: the more risk, the more reward.

We ended last time by saying that the old masters, like Warren Buffett’s teacher, Benjamin Graham, taught just the opposite: the way to increase return is to REDUCE or eliminate risk whenever possible.

Your investment advisor does not believe this is possible because doing so would mean out-judging the market. And that, your advisor says, can’t be done.

Here’s why. The principal method for reducing risk in securities investment is to make sure you don’t pay too much. Benjamin Graham wanted a 50 percent margin of safety for stocks: he wanted to pay 50 percent less than he though the stock was worth.

Your investment advisor, like your banker, does not think that is possible because he does not think that any investor can, on a regular basis, get prices more right than the market. So trying to out-figure the market on price is a fool’s errand.

And if you can’t out-figure the market on prices, practically speaking you can’t reduce risk, you can only “manage” risk in an “efficient” manner.

Basically this means that your investment advisor will assemble a “diversified portfolio” of securities from various “asset classes” such as stocks, bonds, REITs, etc. Depending on your age and goals and “risk profile” he will put you more into stocks, which he regards as more risky, or more into bonds, which he regards as less risky.

What he will NOT do is look under the hood too carefully at WHICH stocks and bonds he is putting you into. As long as the picnic basket is diversified, he believes the details don’t matter. His goal is to get for you the average historical return of the various asset classes in which you are invested, NOT to do better by, say, favoring IBM over GE.

Why? Because of what we just discussed. He does not believe that he or anyone else is qualified to judge the price/value of individual securities in that way. He does not believe he can judge whether GE or IBM is a better value.

He goes by the averages.

And that is what crashed the banks. The banks put together their own portfolios of mortgage-backed securities in the exact same way your investment advisor puts together your investment portfolio.

The bankers were absolutely sure—just as they had been taught in business school—that they did not need to know the details of Jim’s mortgage, or Sally’s or Bob’s. They did not need to know if Bob was a drunk, or Sally had just been fired, or Jim was a pathological liar. They were playing the percentages.

The problem is that once you decide that looking under the hood is old fashioned, you begin to cut yourself off from vital information. You fire the green-eyeshade guys who run the data, you change your systems so that eventually it becomes difficult or even impossible to get the information should it suddenly seem important.

That’s how we got into a situation where it was impossible for the CEO of any great modern bank to get an answer to a simple question like: How many of the homeowners whose mortgages we have a stake in can actually afford the houses they are living in.

That’s how we got into a situation in which neither the regulators nor the bankers nor investors could know for sure whether Bear, or Lehman, or Citi, or Morgan, or Goldman, or Wachovia were “really” broke or just suffering the effects of market Panic.

So what you want to ask yourself today is, “When was the last time my investment advisor looked under the hood?”

Your investment advisor went to the same school as your banker.

Panic is a book about ideas, about the ideas that created the crisis, the ideas that your banker, the people who regulate your banker, your Senator (either party) and your investment adviser all still believe.

So as we have been doing media interviews for Panic we have been searching for a way to explain that theory in seconds or minutes.  We have found that it is easiest not to talk about the banking system, but about what your investment advisor probably tells you, because that is an experience most people have had or will have.

Sit down with any one of 95% of American investment advisors and they will do the exact same thing. They will ask about your age,  your health, your family situation, your investment goals, and your feelings about risk, and how much risk you are willing to take.  They ask all these questions because the first thing they want to do is create a “risk/reward” profile for you.

And that right there is the first big element of “modern portfolio theory”, the theory that blew up the banks. Your investment advisor, like your banker, wants to know how much risk you can accept because he believes that “risk regulates return.” He believes that over time how much money investors earn in the market depends on how much risk they are willing to take. The more risk, the more return.

Yes, they really believe that. They learned it in business school. As we show in Chapter 5 in Panic (The Reign of Risk) virtually every basic finance textbook used in undergraduate and graduate finance programs today states this point as absolute dogma:  More risk = More return.

Now of course your investment advisor doesn’t believe that any old crazy risk will make more return.  No, Modern Portfolio Theory is understood as the SCIENCE of arranging your portfolio so that you will get paid for all the risks you take and don’t  take any “inefficient” (i.e. crazy) risks by accident.

Still, this first belief, “risk drives return”, is absolutely fundamental to your advisor’s world-view. It means that your advisor rejects the investment methods of the old masters, men like Benjamin Graham, author of The Intelligent Investor and also Warren Buffet’s teacher.

Graham and the other old masters taught just the opposite idea. They believed that the way to get rich was to identify every risk in your portfolio and ruthlessly eliminate it.

Graham gave his students 11 basic rules for investment. Every single one was a rule for reducing risk or, as Graham would have put it, “increasing the margin of safety.”

Why doesn’t your investment advisor believe in Graham’s rules?

Simple. In business school he was taught those rules were impossible for any investor to follow in practice. Trying to do so would just get an investor in trouble.

Why?  Well that takes us to the second great idea, and tomorrow’s column.