The Cause of the Financial Crisis in Two Words

The other day I was thinking: ask any knowledgeable observer what caused this financial crisis, and you'll probably get a long, rambling explanation with anywhere from four to ten villains, their identities largely depending on the speaker's ideological/philosophical bent.

But what if that person was allowed only a word or two to capture the essence of the problem? What would the best word(s) be?

Some might say "greed." But that's no good. Greed's a given on Wall Street. If anything, greed is the grease that makes the wheels move over there. The greedy may have become greedier, but this still doesn't supply a satisfying explanation for the whole mess that paralyzed our financial system.

My two words (you're welcome to suggest your own), which provide a prism through which I think most of this crisis can be understood, are simple:

Mispriced risk.

Now for the walk through. First, the obvious stuff. Peel off the outer layer of any CDO and you'll find plenty of mispriced risk. What about that super senior tranche rated AAA, while it rests on mezzanine slices of crappy mortgage securities? Way mispriced.

The infamous Gaussian copula that aided the creation of AAA gold from subprime dross? That's a handmaiden to mispricing. And the credit raters: they're right at the center of the rampant mispricing, slapping AAA labels on stuff they didn't understand as they grubbed around for rating fees.

How did the credit crisis get so large? Mispriced risk. If a AAA corporate bond yields say 3.2 percent, and a AAA chunk of a CDO yields 3.5 percent, what are you going to buy (assuming you trust the ratings, and AAA implies the same level of risk, no matter the security). So money will start pouring into the new AAA category that promises the same low risk but a higher return.

What about credit default swaps? Consider a big issue there: many were sold much too cheaply, considering the dangers they were insuring.

Again: mispriced risk.

What was at the heart of the seize-up in the credit markets in 2008? Remember, the shadow banking system froze up. Counterparties to repo transactions wanted much bigger haircuts on collateral they were taking for overnight lending. Why? Fear of mispriced risk on the collateral. In other words, that collateral purported to be AAA might actually be some variant of C.

You could even argue that excessive leverage ties back to mispriced risk. Why is a bank willing to take on so much leverage? Because it thinks its overall risk is actually fairly small. Just look at the "value at risk" metric, and its widespread adoption, and how it lulls Wall Street into a false sense of security.

For their part, regulators failed to do a number of things that would have helped correct the epidemic of mispriced risk. They failed to insist on greater transparency that would have flushed some of this risk out into the open. They failed -- actually, didn't even attempt -- to reduce the complexity of financial instruments that artfully conceal risk. They simply abdicated their duty to police the financial system as instruments that mispriced risk created a vacuum, sucking in huge piles of cash because investors were enticed by the prospect of a free lunch.

The financial crisis, explained, two words: mispriced risk.

Taleb With a Telling Anecdote on the Regulatory Mess

Nassim Nicholas Taleb weighs in on the regulatory mess in our financial system through a curious tale of being approached while at Davos with the following (legal) proposal to avoid FDIC regulations:

[He] tried to sell me a peculiar investment product. It allowed the high net-worth investor to go around the regulations limiting deposit insurance (at the time, $100,000) and benefit from coverage for near unlimited amounts. The investor would deposit funds in any amount and [the] company would break it up in smaller accounts and invest in banks, thus escaping the limit; it would look like a single account but would be insured in full. In other words, it would allow the super-rich to scam taxpayers by getting free government sponsored insurance. Yes, scam taxpayers. Legally. With the help of former civil servants who have an insider edge.

Got it? I left out the name of the salesman for this scheme for shock value, because it was none other than ... Alan Blinder, a former Vice Chairman of the Federal Reserve Bank of the United States.

So, in case anyone was left wondering, government officials apparently don't feel any regret/guilt/sense of impropriety about crossing over to the other side -- going from regulator to regulatee -- and profiting off the knowledge/connections gained while enforcing financial rules.

But Taleb makes one other must-ponder point dear to my heart:

... the more complicated the regulation, the more prone to arbitrages by insiders. So 2,300 pages of regulation [i.e., the current financial reform bill] will be a gold mine for former regulators. The incentive of a regulator is to have complex regulation.

Second, the difference between letter and spirit of regulation is harder to detect in a complex system. The point is technical, but complex environments with nonlinearities are easier to game than linear ones with a small number of variables. The same applies to the gap between legal and ethical.

I've repeatedly said on this blog that the answer to our financial system's regulatory woes is not a rules-based approach of trying to anticipate every situation, of trying to plug every hole, of trying to cover every contingency in this or any other possible world. It's impossible to do. We need to look at more flexible solutions, such as principle-based regulation with teeth. We're foolish to head back down this path of growing a new regulatory bureaucracy that is doomed to fail as smart financiers parse out endless loopholes.