Incestuous Finance

I wonder how far it is possible to limit systemic risks insofar as financial entities continue to be black boxes vis-a-vis other financial entities and continue to be closely intertwined with each other. Reducing systemic risk might necessarily entail a regulated reduction of such intertwinings. Financial businesses are not like other businesses; it is too difficult to determine whether they are truly solvent and, via leverage, they can create disproportionate losses for those financial entities who do business with them. It is not part of their core contribution to the economy that they should so promiscuously trade with and invest in each other. They are required to efficiently distribute investment throughout the economy in non-financial businesses. This is their purpose. So long as regulation does not interfere with their ability to do this in a competitive fashion, it is unlikely to harm the economy at large. Though the proliferation of new financial instruments and the increased face value of these derivatives provides certain efficiencies on a day to day basis, it appears that the long run cost they impose outweighs the benefits. They decrease transparency and increase leverage: both effects increase risk, and the rewards previously reaped have not been close to commensurate--though it would require a huge econometric study to prove this claim I am making.

Reforms in Money Management and Corporate Governance

Over the last few weeks Carl Icahn, the billionaire financier, and John Bogle, who founded the hugely successful Vanguard group of investment funds, have offered some related ideas to improve the financial system.

Icahn wants a national law that takes power from the management of public companies and gives it to owners. The means to this end would be a federal law that permits shareholders to change the state in which the company is incorporated. Corporate law is mainly determined at the state level, with each state having a more or less different legal regime in place. Currently, Delaware law gives exorbitant power to managers of publicly traded companies at the expense of shareholders. Therefore, most of these companies have been registered (by management) in Delaware. And under current state law the approval of the incumbent board of directors is necessary to change the jurisdiction of incorporation. Given the incestuous relations between managements and boards, the boards choose to remain in Delaware. But, there are states with much more shareholder-friendly corporate laws. Icahn insists (rightly, in my opinion) that shareholders, being the owners of the company, ought to have an unimpeded choice in this matter of jurisdiction. The economic assumption underlying Icahn's shareholder rights campaign is that shareholders, rather than managers, have such incentives as will lead them to maximize corporate profits and optimize the risk/reward ratio in corporate decisionmaking. After all, shareholders benefit from success and suffer from failure. Managers benefit disproportionately from success, but do not necessarily suffer losses from failure since (with the connivance of corrupt boards) their compensation is so often contracted at a high rate in the event of failure and at an obscenely high rate in the event of success. Delaware law, largely through the "business judgment" rule, leaves managers largely unaccountable. Corruption and incompetence result.

Bogle wants a national fiduciary law imposed on money managers that requires them to put investors' interests first. It would entail active engagement by institutional investors in those companies in which they hold stakes; and these investors control 70% of the shares in large public companies, making them a potentially significant force in holding managers and boards to account. It would also mean an end to publicly traded money management firms because they have irresolvable conflicts of interest--the fiduciary responsibilities they owe to their shareholders conflict with those owed to their investors. Over the last few years, these funds paid no heed to the risks of their investments in financial companies--over which, collectively, they had effective control as majority shareholders. They seemed unaware that their clients, the investors in their funds, faced normal investment incentives (the possibility of profit or loss), whereas the management of these financial companies had quite different incentives. If they made profits they won big; but, if they lost money, well, it was only other people's money. Result: financial companies followed the trace of their incentives and took risks that benefited management, but were sub0ptimal for shareholders. Also, the money managers themselves had incentive structures that did not align with their investors'; once again this created suboptimal investment strategies. This idea of emphasizing the fiduciary duty of money managers to increase their activism in overseeing their investments is obviously similar to Icahn's focus. But, Icahn just wants to open the door to activism and facilitate would-be activist shareholders; Bogle seems to think he can pressure reluctant money managers into this sort of activity (one which many of them are probably incompetent to execute and which most are inexperienced in pursuing). Icahn's approach looks more likely to have an impact, but Bogle's certainly would not hurt and might even have a gradual effect through altering investors' expectations of money managers and focusing their attention upon a new way to compare the achievements of different money managers.
Bogle also notes that most investment funds overcharge their investors. This is true, but it is also a function of the free market in action. After all, a presuppostion of the existence of the fund industry is that different funds achieve different performance. Is it not reasonable that high-performing funds should charge more for superior service? In reality, there is limited correlation between the level of charges and the level of performance. But, people who fail to realize this are stupid and natural selection will take care of them (that is, the amounts invested by the stupid will on average earn smaller returns than those of the intelligent, relegating to the stupid, over time, an ever declining share of total investments). The only necessary or desirable regulation of fee structure is that which ensures clarity and transparency.

The best funds are those in which the management of the fund has essentially the same incentives as the investors--because the management is substantially invested in the fund and expects most of its return to come in the form of return on its investment, rather than in the form of fees or performance bonuses. This description fits Berkshire Hathaway and probably the majority of the most successful hedge funds. A recent paper in the Journal of Finance, "Role of Managerial Incentives and Discretion in Hedge Fund Performance", found that the three key characteristics of hedge funds that are positively associated with high returns are managerial ownership, a well-designed structure of pay for performance provisions that is hard to cheat (like high-water mark provisions), and, when the other two factors are present, managerial discretion. Index funds are a reasonable alternative to one of these managed funds since they avoid the conflicts of interest and offer low fees. On the other hand, if the rule of the day is an ill-regulated financial system with misplaced incentives, the index funds will still suffer from the resulting underperformance of the market and the economy.

The Financial Crisis and the Need for Regulatory Control of Systemic Risk

The financial crisis has at least this epic characteristic: wheresoever we start from, we start in medias res. A definitive analysis of the causes remains elusive and is difficult to perspectivize as we witness the intensity of responsive action. But, I think the source of the conceptual challenge presented may be defined as one of dynamic interrelations among a multitude of variables, some of which variables are not well understood. On this conceptual level it reminds me of climate science: there are so many interactions in progress at once that the only guide to prediction is probabilistic analysis.
One of the many analyses I've encountered is titled much after my own taste: "Our Epistemological Depression", in The American magazine (http://american.com/archive/2009/our-epistemological-depression). The quality of the analysis strikes me as decidedly mixed; the author hands out too many half-truths in the guise of full explanations. I will discuss the useful ideas. The best part for my purposes is a paragraph that briefly and effectively summarizes most of the causes thus far identified:

Some of the causes of our contemporary crisis are well known by now. There were governmental errors: monetary policy that was too loose; government monitoring agencies that were too lax; and government policies specifically intended to encourage home ownership among African-Americans and Hispanics that had the unintended but quite anticipatable effect of extending mortgages to those who lacked the ability to repay them. There were perverse alignments of market incentives, incentives that put personal interests at odds with corporate interests, and corporate interests at odds with the public interest. There were principal-agent problem within firms, where traders were remunerated with bonuses for selling collateralized debt obligations without regard to the long-run viability of the underlying assets. Rating agencies were corrupted because they were paid by the sellers of the goods they rated, offering unreliable evaluations that redounded against the purchasers of mortgage-backed securities. Large profits were made by companies that packaged and sold mortgages and mortgage-backed securities without needing to be concerned with their ultimate viability. It turns out that intermediation of risk reduces the incentives for adequate risk management: so long as risk is intermediated, from a mortgage loan broker to a commercial bank to an investment bank to an investor, there is really no incentive, at each stage of the game, to have adequate risk-managing policies in place.

That last point seems questionable: I think there is an incentive for anyone exposed to the risk--which would certainly include investors. The problem is that most investors hire others to manage their investments, and these people have more to gain from aggressive, risky investment strategies than they have to lose from such strategies. That is, the managers' incentives are not well aligned with the investors'. I will add that no one in a position of substantial political or financial power seems to have considered the magnitude of the housing and financial bubble. In valuation terms, this bubble was much larger than the tech bubble of the 1990s--and could be expected to produce a commensurately larger impact on the economy when it inevitably collapsed. I think this aspect, at least, is a matter of common sense, that it's even stupidly obvious.

Many other factors were better concealed during the run up: the corruption, the governmental manipulations of the market, the misplaced incentives, the pervasiveness of stupidity even among those few with clear incentives not to be stupid, the unpredictable way in which derivatives permitted risk to be reallocated among market players, and, finally, the extra topping of the varieties of moronic experience.

Financial institutions ended up heavily exposed to risks, often in the form of derivatives, which the executives did not understand. There was a pervasive lack of due diligence throughout the system. If you cannot classify and quantify and continuously monitor your risks, you should not undertake them in the first place--and, if you happen to be in a position to pose systemic risk to the financial system, the regulators ought to prevent you from undertaking them. Otherwise, knowing that they will be saved from themselves in a crisis, such operators would rationally seek higher risks (and the possibility of proportionately higher rewards). This predicament--in which an entity is positioned to reap all rewards, but does not face all risks--is called moral hazard. On a macroeconomic level it results in misaligned incentives and correspondingly misallocated resources; it reduces economic growth and efficiency. Example: huge investment in superfluous housing stock, instead of more productive pursuits like funding start-ups and technological innovation. It also invites corruption and breeds anti-capitalist sentiment. Activites that induce the threat of systemic risk must be regulated to mitigate the risk of moral hazard.

I see two challenges to this imperative. First, to be effectual the rules ought to be fairly uniform internationally. This limits the threat of unfair competitive advantage between nations. Also, it minimizes the chance that entities in lightly regulated markets could accumulate massive systemic risk the way that AIG, for example, recently did with its CDS business in London. Otherwise, risk-mitigating efforts would be like squeezing a balloon: squeezing the risk out of one area would merely result in it migrating to another, with no overall reduction in the systemic risk.  

Second, we face the problems of distinguishing what constitutes systemic risk and what suffices to reduce moral hazard. In other words, we will have to draw arbitrary lines in devising and enforcing this new regulatory system. Since complexity should not be an end in itself, and seems to make risk management more difficult, regulators should call a halt to any activity they do not understand. This understanding may, of course, come from consultants hired to decipher a particular entity's activities--whose consultancy fees the regulators should have power to pass on to the entity that created the excessive complexity. Also, to reduce moral hazard, the executives (and possibly the directors as well) managing the entities in question must have a significant (which means unhedged) personal financial exposure to them if they fail and should not be eligible to participate in any bailout. Systemic risk arises from either the sheer size of the entity (like Citigroup) or the high degree of leverage that the entity operates under (like Long Term Capital Management or AIG's Financial Products unit) or a combination of the two factors (like Lehman Brothers). Once an entity crosses the threshold (however arbitrarily defined) beyond which it is deemed a systemic threat, a more stringent and intrusive set of regulatory controls and requirements would be applied. Naturally, this would give some entities an incentive to stay relatively small to avoid the regulatory costs and exposures. I do not see a problem with this.

The experience of this crisis will re-educate financiers, businessmen, investors, regulators, elected officials, maybe even some of the public. They may now see and action Buffet's dictum that one should only invest in businesses one can understand. Perhaps politicians will refrain from inciting bubbles through corrupt quasi-governmental institutions such as Fannie Mae and Freddie Mac. Investors may recognize, now that reality is back upon them, what a poor value proposition most money managers and mutual funds and hedge funds actually offer, what a scam most of those guys are running as though it were an ordinary state of affairs (which, laughably, it is). Maybe regulators will stand up for themselves and impose their rules upon even the rich and powerful. And, just possibly, as the federal government's fiscal options contract severely, an effective cost-cutting program will be formulated for our bloated entitlement programs--before that ever-growing brood of fat vampires suck the last drops of blood out of us. But I wouldn't hold my breath.