Tuesday, June 01, 2010

Moral Hazard Isn't The Answer

HL Mencken noted that 'for every human problem there is a neat simple solution and it is always wrong'. Such simple solutions includes the idea that 'moral hazard' by bank executives largely contributed to the 2008 financial crisis. The examples given are always INVESTMENT bankers, who make great bonuses when they do deals, and then leave large liabilities that are toxic. Also, one can point to rich guys like Bear Stearns CEO Jimmy Cayne, who lost over one billion dollars but still walked away rich, worth over $500MM. It was heads they win, tails taxpayers lose, a game maximized at infinite variance.

This narrative is pretty ubiquitous, so I'll give just two references: Russ Roberts in his paper "Gambling with Other People's Money: How Perverted Incentives Caused the Financial Crisis" (he podcasts on it here), or Barry Ritholtz's book Bailout Nation.

While anticipated financial bailouts do not increase lending prudence, I don't think they were very significant in the creation of the housing bubble. The 2008 crisis hit all banks, not just investment banks. Most non-investment bankers get much more modest salaries and bonuses, often largely in at-the-money options in their firm's stock, with 5 to 10 year horizons. So, looking at the accompanying chart, which shows the KBW Bank Index since 1994, we see that since 1998, bank stocks were pretty flat, with a slight 25% bump around 2006, but the index now is still below its 1997 level. When I left KeyCorp in 1999 I had a bunch of options priced around $25-30, and as I left I had to exercise them. Who knew that if I had stayed, those options would be worthless, as the stock now trades around $8, light-years away from being in-the-money. Most of my retirement savings would have been erased with the 2008 crisis had I remained there (and I'd be living in Cleveland--a twofer!).

This crash has been incredibly painful for your average bank decision maker. The Jimmy Caynes and Jamie Dimons may be rich, devious, and reckless, but it's naive to anthropomorphize banks via their titular leaders. As Bob Rubin, the erstwhile financial genius demonstrated when he said he knew nothing about Citibank's exposure to mortgages, these signature guys aren't too involved in the nuts and bolts of their ALCO meetings.

Your average bank decision-maker thought that lending to people with little income, to buy houses, was not that risky. Why this was so is interesting and complex, but I don't think it was as calculated as merely, 'well, I'll get rich lending the money, but won't lose much when it all goes downhill', because your average bank executive, at say Washington Mutual, Wachovia, or KeyCorp, just lost most of their retirement savings, and they won't be getting a do-over.

Update: Russ Roberts responds over at Cafe Hayek:
by 1998 [bank stocks] had nearly quadrupled, the time period when housing prices started to take off. Yes, it was flat for a while, but between 2003 and 2007, the heyday of subprime, [the KBW index] went from 70 to almost 120. I suspect those were some very good years for banking executives. Yes, they probably could not exercise their options immediately and some of them may have been stupid enough to hold on to them forever, but I would guess that they did just fine.

I'm sure the top executives over 10 years did just fine, as that select group tends to get out-sized compensation in all sorts of forms. But the decisions were made at all levels, especially the hundreds of mid-level executives who don't make millions, but it was they who really made the decision to originate and/or warehouse mortgages with 'innovative' underwriting standards (unlike Bob Rubin or Jimmy Cayne, who probably did not know, and never knew, what the distribution of loan-to-value ratios or other obligor metrics on mortgages were). If you assume these mid-level executives received 20-100% of their base salary in at-the-money options each year, they lost a lot of their wealth recently. They aren't poor, but if they thought this was a significant possibility back in 2005, they wouldn't have done it.


Michael F. Martin said...

There's a big difference between the Jimmy Caynes and the Jamie Dimons.

I've been devouring *Fool's Gold* by Gillian Tett. Everybody is crazy about the Lewis book, but this one seems better researched than the Lewis vignettes. Less compelling narrative, but more data. (Still compelling though!)

mnl said...

Yours is a good point and I agree: the average bank exec did not consciously engage in a moral hazard rationalization. But let's not overlook the power of "organizational climate", the banking culture, or the political and business zeitgeist of the time. Such architects could easily be the genesis of a moral hazard that at once steered lending into unsafe (if not immoral) practices all while allowing, "Your average bank decision-maker [to think] that lending to people with little income, to buy houses, was not that risky."

That is, the "moral hazard" can still be very much at the root of the problem without every minion and mortgage loan officer consciously engaged in it. Through the everyday system of corporate hiring, rewards, bonuses and promotions such wrong (i.e. moral hazard) lending practices simply became the de facto standard.

Unknown said...

So you're proposing that bank executives didn't face serious moral hazard because they DID face real risks to their personal well-being if their banks took gambles and lost. It occurs to me that it should be possible to quantify the potential risks and benefits that bank executives faced as they bought up housing loans made to people with low or no income. Has anyone bothered to try to measure those risks and benefits, rather than just theorizing about them?

Anonymous said...

I work for the subsidiary of a major european bank. I work in the credit area. Our portfolio is 40% mortgages & our loss history is exemplary with extremely low losses throughout the credit crunch period.

Moral hazard played no part in my credit decisions which have contributed to a business that remains well capitalised and liquid.

Through share options I've lost 90% of my retirement savings.

Eric is right, the majority of bankers have been punished for the sins of the few.

Anonymous said...

Falkenstein: "I had a bunch of options priced around $25-30, and as I left I had to exercise them. [..] Most of my retirement savings would have been erased [...]"
Anonymous: "Through share options I've lost 90% of my retirement savings. "
Are you saying you kept the bulk of your retirement savings in options on the bank you worked for? Strange asset allocation, to put it politely.

Tal said...

Agree with the commenter above me. I'm now questioning Eric's rationality overall, given this info about his financial planning skills.

Anonymous said...

I'm now questioning Tal's reading comprehension skills.

Eric Falkenstein said...

p1: I admit Dimon seems to come out of this crisis better than most.

2: When you exercise, you lose a lot of option value. I exercised and sold my stock, in this case. Yet, I should add I didn't foresee the depth of the 2008 bank crisis. I was lucky, because I know a lot of good bankers who lost most of their nest egg. I wasn't watching banks really closely in 2002-08, and like to think I would have gotten out if I had been closer to the action, but that's hindsight, and who knows.

Anton T said...

Is there a reason on spite of your continuous comments taleb has guetten richer, more famous etc. and you are still a loser?

Eric Falkenstein said...

Well, lots of people I find pompous, pretentious, or clueless are very successful. There are also lots of bad books on the bestseller list. I can honestly say that doesn't make me feel like a loser, and I bet even Taleb would not say that one should judge oneself via such comparisons.

But thanks for reading!

Yeti said...

Sorry to get back to my previous comment (anon 12:36 AM), but I think this is a crucial point. You say, "When you exercise, you lose a lot of option value. [...] I would have gotten out if I had been closer to the action, but that's hindsight, and who knows"
When risks can potentially ruin you, you have to get out of (or hedge) that position, no matter what "the action" is and no matter if it "costs you some option value".
By the way, apart from that a great blog (one of the few I read regularily).

DaveinHackensack said...


Don't let commenters such as Anton L. get you down. I know blogging must seem pointless sometimes when you get comments like that, but you offer a unique, expert, viewpoint, and your efforts here are appreciated by many readers. For every commenter, there are probably a few dozen lurkers who are grateful that you take the time to blog.

Keep up the excellent work.

Anonymous said...

well said, DiH. Count me as one of the lurkers.

Anonymous said...

Me three!