The Role of Expertise in the Financial Crisis
September 23rd, 2008Posted by: Roger Pielke, Jr.
A lot of our work here focuses on the connections between expertise and decision making. Richard Posner of the University of Chicago suggests that the experts are at fault, by creating products and processes that decision makers failed to use correctly:
I do not think that the government does bear much responsibility for the crisis. I fear that the responsibility falls almost entirely on the private sector. The people running financial institutions, along with financial analysts, academics, and other knowledgeable insiders, believed incorrectly (or accepted the beliefs of others) that by means of highly complex financial instruments they could greatly reduce the risk of borrowing and by doing so increase leverage (the ratio of debt to equity). Leverage enables greatly increased profits in a rising market, especially when interest rates are low, as they were in the early 2000s as a result of a global surplus of capital. The mistake was to think that if the market for housing and other assets weakened (not that that was expected to happen), the lenders would be adequately protected against the downside of the risk that their heavy borrowing had created. The crisis erupted when, because of the complexity of the financial instruments that were supposed to limit risk, the financial industry could not determine how much risk it was facing and creditors panicked.
I disagree with Posner’s assertion that the government bears little responsibility. Accurate assessments of risk are central to the functioning of the financial system, and if expertise gets out ahead of ability to effectively use that expertise, then we can find our selves in a situation where risk turns into ignorance. This was the lesson of Long-Term Capital Management and appears to be the lesson in the current crisis. When all is said and done, I would expect that a hard look will need to be taken at the ratings agencies and their role in providing judgments of investment risk. It is governments job to ensure that these agencies are doing their job. Such regulatory oversight appears to have been lacking.
September 23rd, 2008 at 3:53 pm
It seems to me that the SEC clearly should have some of the blame for the problems of Bear Stearns, Lehman Brothers, and Merrill Lynch.
The SEC apparently re-wrote regulations on debt-to-equity for 5 firms (including the 3 above, plus Goldman Sachs and Morgan Stanley). These rewritten regulations (in 2004) allowed those 5 firms to be leveraged at 30-to-1 or even 40-to-1, where all other companies were limited to about 12-to-1:
http://www.parapundit.com/archives/005558.html
Of course, it was those 5 companies who actually did the ridiculously high leveraging.
Also, from that same article, apparently members of Congress (e.g. Barney Frank) encouraged Fannie Mae and Freddie Mac to take on more and more subprime loans (to help out people who couldn’t really afford homes).
There seems to be plenty of blame to go around. (“Billions and billions of dollars of blame,” to apocryphally paraphrase Carl Sagan.)
September 24th, 2008 at 5:26 am
The root cuase of this mess is clearly congress (in addition to utterly irresponsible borrowers).
In 1977 a democratic congress and Jimmy Carter passed the “Community Reinvestment Act”, which required banks to make loans to poor borrowers who often could not repay them. It, and its regulatory implementation, established that using credit history and income requirements for loans decision was “discriminatory”, and could not be used. This was all in the name of “affordable housing”.
Democrats in congress then pushed Fannie Mae and Freddie Mac to buy up these worthless loans by the hundreds of billions of dollars. Because of this huge infusion of money into the market, housing prices skyrocketed in many markets, making the loans seem valuable for a few years. However, this scheme could not last, and it didn’t last.
In 2005, Greenspan warned of a meltdown, and the republicans crafted a bill to establish responsible regulations related to Fanne and Freddie and this market in general, but were stopped on a party line vote with democrats opposing reform. John McCain was one of the sponsers of the reform bill. Barney Frank stated that there was no problem. Why ? Because democrats were getting huge campaign contributions from Fannie and Freddie employees.
Government regulation caused the problem.
September 24th, 2008 at 6:24 am
I blame Jamie Gorelick. She insisted on “the Wall” despite FBI agents warning that some day people would get hurt. We got 9/11. She raked in over 26 million in bonuses as Vic Chairman of Fannie Mae while they were cooking the books. http://volokh.com/posts/1216060102.shtml
Seriously, though, she IS representative of the kind of govt which produced the problem.
September 24th, 2008 at 11:32 am
[...] by Breakthrough Senior Fellow Roger Pielke, jr., cross posted from Prometheus [...]