Archive for February, 2010
Moral Hazard and Agent Intentionality
A common objection to the moral hazard explanation of the financial crisis is the following: Bankers did not explicitly factor in the possibility of being bailed out. In fact, they genuinely believed that their firms could not possibly collapse under any circumstances. For example, Megan McArdle says: “I went to business school with these people, and talked to them when they were at the banks, and the operating assumption was not that they could always get the government to bail them out if something went wrong. The operating assumption was that they had gotten a whole lot smarter, and would not require a bailout.” And Jeffrey Friedman has this to say about the actions of Ralph Cioffi and Matthew Tannin, the managers of the Bear Stearns fund whose collapse was the canary in the coal mine for the crisis: “These are not the words, nor were Tannin and Cioffi’s actions the behavior, of people who had deliberately taken what they knew to be excessive risks. If Tannin and Cioffi were guilty of anything, it was the mistake of believing the triple-A ratings.”
This objection errs in assuming that the moral hazard problem requires an explicit intention on the part of economic agents to take on more risk and maximise the free lunch available courtesy of the taxpayer. The essential idea which I outlined at the end of this post is as follows: The current regime of explicit and implicit bank creditor protection and regulatory capital requirements means that a highly levered balance sheet invested in “safe” assets with severely negatively skewed payoffs is the optimal strategy to maximise the moral hazard free lunch. Reaching this optimum does not require explicit intentionality on the part of economic actors. The same may be achieved via a Hayekian spontaneous order of agents reacting to local incentives or even more generally through “natural selection”-like mechanisms.
Let us analyse the “natural selection” argument a little further. If we assume that there is a sufficient diversity of balance-sheet strategies being followed by various bank CEOs, those CEOs who follow the above-mentioned strategy of high leverage and assets with severely negatively skewed payoffs will be “selected” by their shareholders over other competing CEOs. As I have explained in more detail in this post, the cheap leverage afforded by the creditor guarantee means that this strategy can be levered up to achieve extremely high rates of return. Even better, the assets will most likely not suffer any loss in the extended stable period before a financial crisis. The principal, in this case the bank shareholder, will most likely mistake the returns to be genuine alpha rather than the severe blowup risk trade it truly represents. The same analysis applies to all levels of the principal-agent relationship in banks where an asymmetric information problem exists.
Self-Deception and Natural Selection
But this argument still leaves one empirical question unanswered – given that such a free lunch is on offer, why don’t we see more examples of active and intentional exploitation of the moral hazard subsidy? In other words, why do most bankers seem to be true believers like Tannin and Cioffi. To answer this question, we need to take the natural selection analogy a little further. In the evolutionary race between true believers and knowing deceivers, who wins? The work of Robert Trivers on the evolutionary biology of self-deception tells us that the true believer has a significant advantage in this contest.
Trivers’ work is well summarised by Ramachandran: “According to Trivers, there are many occasions when a person needs to deceive someone else. Unfortunately, it is difficult to do this convincingly since one usually gives the lie away through subtle cues, such as facial expressions and tone of voice. Trivers proposed, therefore, that maybe the best way to lie to others is to first lie to yourself. Self-deception, according to Trivers, may have evolved specifically for this purpose, i.e. you lie to yourself in order to enable you to more effectively deceive others.” Or as Conor Oberst put it more succinctly here: “I am the first one I deceive. If I can make myself believe, the rest is easy.” Trivers’ work is not as relevant for the true believers as it is for the knowing deceivers. It shows that active deception is an extremely hard task to pull off especially when attempted in competition with a true believer who is operating with the same strategy as the deceiver.
Between a CEO who is consciously trying to maximise the free lunch and a CEO who genuinely believes that a highly levered balance sheet of “safe” assets is the best strategy, who is likely to be more convincing to his shareholders and regulator? Bob Trivers’ work shows that it is the latter. Bankers who drink their own Kool-Aid are more likely to convince their bosses, shareholders or regulators that there is nothing to worry about. Given a sufficiently strong selective mechanism such as the principal-agent relationship, it is inevitable that such bankers would end up being the norm rather than the exception. The real deviation from the moral hazard explanation would be if it were any other way!
There is another question which although not necessary for the above analysis to hold is still intriguing: How and why do people transform into true believers? Of course we can assume a purely selective environment where a small population of true believers merely outcompete the rest. But we can do better. There is ample evidence from many fields of study that we tend to cling onto our beliefs even in the face of contradictory pieces of information. Only after the anomalous information crosses a significant threshold do we revise our beliefs. For a neurological explanation of this phenomenon, the aforementioned paper by V.S. Ramachandran analyses how and why patients with right hemisphere strokes vehemently deny their paralysis with the aid of numerous self-deceiving defence mechanisms.
Jeffrey Friedman’s analysis of how Cioffi and Tannin clung to their beliefs in the face of mounting evidence to the contrary until the “threshold” was cleared and they finally threw in the towel is a perfect example of this phenomenon. In Ramachandran’s words, “At any given moment in our waking lives, our brains are flooded with a bewildering variety of sensory inputs, all of which have to be incorporated into a coherent perspective based on what stored memories already tell us is true about ourselves and the world. In order to act, the brain must have some way of selecting from this superabundance of detail and ordering it into a consistent ‘belief system’, a story that makes sense of the available evidence. When something doesn’t quite fit the script, however, you very rarely tear up the entire story and start from scratch. What you do, instead, is to deny or confabulate in order to make the information fit the big picture. Far from being maladaptive, such everyday defense mechanisms keep the brain from being hounded into directionless indecision by the ‘combinational explosion’ of possible stories that might be written from the material available to the senses.” However, once a threshold is passed, the brain finds a way to revise the model completely. Ramachandran’s analysis also provides a neurological explanation for Thomas Kuhn‘s phases of science where the “normal” period is overturned once anomalies accumulate beyond a threshold. It also provides further backing for the thesis that we follow simple rules and heuristics in the face of significant uncertainty which I discussed here.
Fix The System, Don’t Blame the Individuals
The “selection” argument provides the rationale for how the the extraction of the moral hazard subsidy can be maximised despite the lack of any active deception on the part of economic agents. Therefore, as I have asserted before, we need to fix the system rather than blaming the individuals. This does not mean that we should not pursue those guilty of fraud. But merely pursuing instances of fraud without fixing the incentive system in place will get us nowhere.
Mark-to-Market (MtM) Accounting is usually cast as a villain of the piece in most financial crises. This note aims to rebut this criticism from a “system resilience” perspective. It also expands on the role that MtM Accounting can play in mitigating agents’ preference for severely negatively skewed payoffs, a theme I touched upon briefly in an earlier note.
The “Downward Spiral” of Mark-to-Market Accounting
If there’s anything that can be predicted with certainty in a financial crisis, it is that sooner or later banks will plead to their regulators and/or FASB asking for relaxation of MtM accounting rules. The results are usually favourable. So in the S&L crisis, we got the infamous “Memorandum R-49” and in the current crisis, we got FAS 157-e.
The most credible argument for such a relaxation of MtM rules is the “downward spiral” theory. Opponents of MtM Accounting argue that it can trigger a downward spiral in asset prices in the midst of a liquidity crisis. As this IIF memorandum puts it: “often dramatic write-downs of sound assets required under the current implementation of fair-value accounting adversely affect market sentiment, in turn leading to further write-downs, margin calls and capital impacts in a downward spiral that may lead to large-scale fire-sales of assets, and destabilizing, pro-cyclical feedback effects. These damaging feedback effects worsen liquidity problems and contribute to the conversion of liquidity problems into solvency problems.” The initial fall in prices feeds upon itself in a “positive feedback” process.
I am not going to debate the conditions necessary for this positive feedback process to hold, not because the case is beyond debate but because MtM is just one in a long list of positive feedback processes in our financial markets. Laura Kodres at the IMF has an excellent discussion on “destabilizing” hedge fund strategies here which identifies some of the most common ones – margin calls on levered bets, stop-loss orders, dynamic hedging of short-gamma positions and even just plain vanilla momentum trading strategies.
The crucial assumption necessary for the downward spiral to hold is that the forces exerting negative feedback on this fall in asset prices are not strong enough to counter the positive feedback process. The relevant question from a system resilience perspective is why this is so. Why are there not enough investors with excess liquidity or banks with capital and liquidity reserves to buy up the “undervalued” assets and prevent collapse? One answer which I discussed in my previous note is the role of extended periods of stability in reducing system resilience. The narrowing of the “Leijonhufvud Corridor” reduces the margin of error before positive feedback processes kick in. The most obvious example is reduction in collateral required to execute a leveraged bet. The period of stability also weeds out negative feedback strategies or forces them to adapt thereby reducing their influence on the market.
A healthy market is characterised not by the absence of positive feedback processes but by the presence of a balanced mix of positive and negative feedback processes. Eliminating every single one of the positive feedback processes above would mean eliminating a healthy chunk of the market. A better solution is to ensure the persistence of negative feedback processes.
Mark-to-Market Accounting as a Modest Mitigant to the Moral Hazard Problem
As I mentioned in a previous note, marking to a liquid market significantly reduces the attractiveness of severely negatively skewed bets for an agent. If the agent is evaluated on the basis of mark-to-market and not just the final payout, significant losses can be incurred much before the actual event of default on a super-senior bond.
The impact of true mark-to-market is best illustrated by highlighting the difference between Andrew Lo’s example of the Capital Decimation Partners and the super-senior tranches that were the source of losses in the current crisis. In Andrew Lo’s example, the agent sells out-of-the-money (OTM) options on an equity index of a very short tenor (less than three months). This means that there is significant time decay which mitigates the mark-to-market impact of a fall in the underlying. This rapid time decay due to the short tenor of the bet makes the negatively skewed bet worthwhile for the hedge fund manager even though he is subject to constant mark to market. On the other hand, loans/bonds are of a much longer tenor and if they were liquidly traded, the mark-to-market swings would make the negative skew of the final payout superfluous for the purposes of the agent who would be evaluated on the basis of the mark-to-market and not the final payout.
Many of the assets on bank balance sheets however are not subject to mark-to-market accounting or are only subject to mark-to-model on an irregular basis. This enables agents to invest in severely negatively skewed bets of long tenor safe in the knowledge that the low probability of an event of default in the first few years is extremely low. It’s worth noting that mark-to-model is almost as bad as not marking to market at all for such negatively skewed bets, especially if the model is based on parameters drawn from recent historical data during the “stable” period.
On Whether Money Market Mutual Funds (MMMFs) should Mark to Market
The SEC recently announced a new set of money market reforms aimed at fixing the flaws highlighted by Reserve Primary Fund’s “breaking the buck” in September 2008. However, it stopped short of requiring money market funds to post market NAVs that may fluctuate. One of the arguments for why floating rate NAVs are a bad idea is that regulations that force money market funds to hold “safe” assets make mark-to-market superfluous. In fact, exactly the opposite is true. It is essential that assets with severely negatively skewed payoffs such as AAA bonds are marked to market precisely so that agents such as money market fund managers are not tempted to take on uneconomic bets in an attempt to pick up pennies from in front of the bulldozer.
The S&L Crisis: A Case Study on the impact of avoiding MtM
Martin Mayer’s excellent book on the S&L crisis has many examples of the damage that can be done by avoiding MtM accounting especially when the sector has a liquidity backstop via the implicit or explicit guarantee of the FDIC or the Fed. In his words, “As S&L accounting was done, winners could be sold at a profit that the owners could take home as dividends, while the losers could be buried in the portfolio “at historic cost,” the price that had been paid for them, even though they were now worth less, and sometimes much less.”
As Mayer notes, this accounting freedom meant that S&L managers were eager consumers of the myriad varieties of mortgage backed securities that Wall Street conjured up in the 80s in search of extra yield, immune from the requirement to mark these securities to market.
Wall Street’s Opposition to the Floating NAV Requirement for MMMFs
Some commentators such as David Reilly and Felix Salmon pointed out the hypocrisy of investment banks such as Goldman Sachs recommending to the SEC that money market funds not be required to mark to market while rigorously enforcing MtM on their own balance sheets. In fact the above analysis of the S&L crisis shows why their objections are perfectly predictable. Investment banks prefer that their customers not have to mark to market. This increases the demand from agents at these customer firms for “safe” highly rated assets that yield a little extra i.e. the very structured products that Wall Street sells, safe in the knowledge that they are immune from MtM fluctuations.
Mark-to-Market and the OTC-Exchange Debate
Agents’ preference for avoiding marking to market also explains why apart from investment banks, even their clients may prefer to invest in illiquid, opaque OTC products rather than exchange-traded ones. Even if accounting allows one to mark a bond at par, it may be a lot harder to do so if the bond price were quoted in the daily newspaper!
Mark-to-Market and Excess Demand for “Safe” Assets
Many commentators have blamed the current crisis on an excess demand for “safe” assets (See for example Ricardo Caballero). However, a significant proportion of this demand may arise from agents who do not need to mark to market and is entirely avoidable. More widespread enforcement of mark to market should significantly decrease the demand from agents for severely negatively skewed bets i.e. “safe” assets.