> the 2007-2008 era financial crisis revealed that the bankers are incompetent at assessing risk
I think we need the inverse of Hanlon's razor[0] to be a thing. "Never attribute to stupidity that which can be adequately explained by systemic incentives promoting malice." A Hanlon's handgun, if you like.
What I remember from reading about the 2008 financial crisis isn't that bankers were incompetent. It's that various parties started packaging up financial instruments to make them look like less risky instruments, so that they could be sold to suckers. Then they insured themselves against those instruments blowing up. This suggests they knew well what they were doing.
In fact, banks aren't in the business of assessing risk. They're in the business of making money, which they often do through assessing risk. The important point is that assessing risk (or giving loans, or mortgages, etc.) isn't their raison d'etre, but a way to make money they've specialized in. If there's a way to make easy money by doing something else entirely, or by compromising their core competence, there are strong economic incentives to do that.
This applies to all other companies doing anything else as well. There's few organizations that consider doing things they do well as a terminal value; usually, it's only instrumental in getting money. That's something IMO we have to keep in mind if we're trying to make accurate predictions of future behavior of a company.
The loan packaging and insurance was a symptom of the underlying problem that drove the 2008 crisis: transatlantic transactions that worked to evade regulations to control systematic risk.
This process started, if you had to pick a place, with a US bank issuing a mortgage. The cash part eventually wound its way to various short-term "risk-free" assets, one of which being short-term asset-backed loans to European financial institutions. The mortgage asset got packaged up and sold on to the broader capital markets, of which European financial institutions participated. So, the US banking system basically created a market in which European financial institutions could buy mortgage-backed paper, financing the purchase at good short-term rates generated by the cash created by issuing the backing mortgages.
Of course, banking regulators know that just letting banks go hog-wild creating asset-liability pairs is going to end up badly, so this is where the regulatory arbitrage comes in. Under US banking regulations, banks had limits to the assets on their books. There's a strong incentive to offload them into the capital markets - the banks realize an immediate profit, and clear out valuable space on their balance sheet. European banks, on the other hand, had a more complex leverage limits that took into account the perceived riskiness of various assets that they owned, with AAA-rated assets giving the highest leverage limits.
So that, in a nutshell, is what happened in the run-up to 2008. Banks generate more profits when they create more risk, so there's regulatory limits on risks. US banks evaded those risk limits by selling the risk on to the capital markets, and US regulators assumed that this process was systematically safe. EU banks evaded those risk limits by blindly levering up to buy whatever AAA-rated dollar-denominated assets the US capital markets handed to them, and EU regulators assumed that high leverage on AAA-rated assets was systematically safe. Neither regulatory regime had a good holistic view of the financial asset vortex brewing in the Atlantic.
Anyhow, my overall point is "so that they could be sold to suckers" doesn't really tell the entire story. The asset packaging was done in order to take as much risk as possible under US and EU banking regulations, taking advantage of transatlantic differences in regulatory regimes.
Thanks for a much more detailed account of the crisis. Yes, I simplified in my post, but your more complex story still doesn't read to me as "people were being incompetent"; I see in it a tale of a complex system getting exploited in several different places at the same time, and shaking itself apart in the process.
Entirely tangential: the first time I saw your handle here several years ago, I initially misread it as "trust vectoring" (don't know why, I knew of the term "thrust vectoring" before). Ever since, this phrase stuck with me, and I feel it applies to the 2008 crisis.
I think that still is more or less a polite way of saying that American banks found suckers in Düsseldorf and Frankfurt to sell to. Sometimes in multiple steps: First sell to Deutsche Bank, they sell to suckers in Düsseldorf.
There was also plenty of domestic mortgage over-expansion; Anglo-Irish blew up by lending to far too many speculative property projects. The book on this is excellent.
I remember talking to people involved in those kind of projects at the time and even they noted that Anglo-Irish never seemed to turn down an opportunity to lend money.
Don't forget the part where the ratings agencies systematically failed to accurately assess the riskiness of the MBSs because they didn't want to piss off their customers (the banks / their mortgage issuance wings).
All financial crises have a common trait: A few smart people exploiting the market.
The smart people in the 2008 crisis were those who had been bundling CDOs to hide the bad debt in the decades before, as well as those who insured themselves against the blowup _knowing that it would blow up_.
They _depended_ upon the majority of financial institutions believing the lie that the property market would never crash.
That's the stupidity in Hanlon's Razor for the 2008 crisis, exploited by the few smart ones.
I was just a few of years out of school,I think it was 2006. Walked into a local bank branch to get some stuff sorted out.The women tried to sell me some private pension scheme,which was popular at the time.I asked her what would happen if the bank would fail,to which she responded with uncontrollable laughter and finally managed to say: banks don't fail. Well,I thought, I'm sure as hell I won't be buying products from this bank..We all know what happened 2 years later.
While this person obviously didn't empathize with your concerns, it should be mentioned that bank tellers are often under pressure from higher ups to sell products to walk-in customers, regardless of whether they need them or not. And the easiest way to sell is to basically tell the customers that their concerns aren't valid.
The most egregious example of this is the Wells Fargo scandal, where new accounts were created for customers without their knowledge [1]. Similar complaints can be found with pretty much all major banks. It's a natural consequence of a culture where employees are ordered to upsell customers on lines of credit, new credit cards, and other financial products.
>It's that various parties started packaging up financial instruments to make them look like less risky instruments, so that they could be sold to suckers.
This was enabled by fraud. At the root of it were the people fraudulently stating borrowers had incomes higher than they really were.
I would say that was a symptom rather than a cause - once people stopped caring about the quality of mortgages (because they would be sold off and packaged up and sold on) it was pretty much inevitable that this would happen.
They can’t be sold off if they never passed the underwriting tests in the first place. Intentionally not verifying incomes and/or fraudulently staying higher incomes is what allowed for plausible deniability to rate them higher than they should have been.
>What I remember from reading about the 2008 financial crisis isn't that bankers were incompetent. It's that various parties started packaging up financial instruments to make them look like less risky instruments, so that they could be sold to suckers.
First of all, I disagree: I think risk mispricing ("House prices can't fall across the country"), or incompetence, was the big problem.
But suckers get suckered every day. If big money-runners can't be bothered to understand what they are buying, I don't feel sorry for them.
>Then they insured themselves against those instruments blowing up.
This is standard financial practice. Why would they hold a huge, one-sided bet on the housing market on their books?
Didn't AIG end up on the wrong end of a vast quantity of that "insurance" - which turned out well (it certainly turned out splendidly well for the AIG employees selling the stuff).
Incompetence played a large role. I knew a couple of people who were interning at investment banks at the start of the financial crisis. The banks had absolutely no idea who owned each piece of the synthetic instruments - including the underlying collateral - that were on their books. Keep in mind that the insurance wasn't there to protect themselves - it was there to ensure that the product would receive an AAA credit rating - which made it palpitate to institutional investors who were restricted from purchasing or otherwise stayed away from riskier assets. It turns out that you can't accurately insure (or price) instruments when you don't have some knowledge of the thing that secures the instrument.
Seems to me if the banks piled up a bunch of junk, didn't track who owned what, took advantage of the lack of bad information to make crap insurance look just good enough to fool the ratings agencies, and sold the resulting AAA-rated instruments for AAA prices, then the banks did a perfectly competent job making money for themselves.
The ratings agencies did a bad job, but that doesn't mean they weren't able to do better. They make more money doing a bad job so that's what they did.
The real incompetents were the investors, but the whole system was telling them they didn't need to be competent, that's what the ratings agencies were for.
The real incompetents are the developers of the system. It's clearly optimised to create the illusion of useful business activity out of bad-faith value manipulation and outright market fraud.
Of course they're not considered incompetent if they personally do well out of it. So perhaps the real problem is more systemic.
The behaviour of ratings agencies is very well depicted in 'Big Short', which essentially says that if one company won't do it, other will always agree to issue AAA rates.
The underlying individual assets didn't really turn out to be poorly rated. The problem was they assumed a low-level of correlation between the risk of individual assets. Basically, they believed default risk for a house in Milwaukee essentially an independent variable compared to default risk in South Carolina. They made that assumption because there had never been a nationwide (or global really) housing crash.
That assumption actually drove nationwide demand for mortgages, which lowered rates, thereby creating the correlation they assumed didn't exist.
I think we need the inverse of Hanlon's razor[0] to be a thing. "Never attribute to stupidity that which can be adequately explained by systemic incentives promoting malice." A Hanlon's handgun, if you like.
What I remember from reading about the 2008 financial crisis isn't that bankers were incompetent. It's that various parties started packaging up financial instruments to make them look like less risky instruments, so that they could be sold to suckers. Then they insured themselves against those instruments blowing up. This suggests they knew well what they were doing.
In fact, banks aren't in the business of assessing risk. They're in the business of making money, which they often do through assessing risk. The important point is that assessing risk (or giving loans, or mortgages, etc.) isn't their raison d'etre, but a way to make money they've specialized in. If there's a way to make easy money by doing something else entirely, or by compromising their core competence, there are strong economic incentives to do that.
This applies to all other companies doing anything else as well. There's few organizations that consider doing things they do well as a terminal value; usually, it's only instrumental in getting money. That's something IMO we have to keep in mind if we're trying to make accurate predictions of future behavior of a company.
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[0] - https://en.wikipedia.org/wiki/Hanlon%27s_razor