by Jerome a Paris
Mon Apr 23rd, 2007 at 08:26:23 AM EST
I often say that a good banker is not a banker that makes the right analysis about the risks s/he takes, but one that makes the wrong analysis at the same time as other bankers. Well, the FT's Wolfgang Munchau, instead of telling us this week how France or Germany are messed up, agrees:
A risk shared may be more risky, not less
investors, eager to outperform the markets, take on two different types of risk during a boom. The first is a so-called “tail risk”, the kind of risk that caused the default of Long Term Capital Management almost 10 years ago. These are high risks with a very low probability of occurring, which offer high rewards. The second risk is herd behaviour, as investment managers do not want to underperform their competitors.
Mr Rajan says these two risks reinforce each other. During an asset price boom, investors are eager to take on the low probability tail risks, in the knowledge that others do the same. If the crash comes, they have at least not underperformed their competitors.
That's what we're seeing in financial markets right now: deals that are increasingly aggressive, because "that's where the market is": either you take these (unconsidered) risks, or you do no deals and your banks makes no income and you make no bonus.
Münchau even quotes Minsky: (see below)
The critical part of Minsky’s theory is that during an economic boom, an increasing number of investors gradually move from the first category [risk-averse who can meet their payment obligations out of current cash flows] to the second [speculative investors, who can do the same in the long run, but not necessarily in the short run] and third [Ponzi investors - someone who takes on new debt to meet current obligations, and hopes to finance the ever-rising debt through higher asset prices]. In a Minsky economy, instability is not due to some external shock, but is inherent in the system itself.
Minsky arrived at the pessimistic conclusion that the behaviour of financial markets is not self-correcting, and that this would justify heavy regulatory interference. While I do not agree with Minsky’s overall pessimism, I cannot fault the mechanism through which he derives internally-generated instability.
As Münchau rightly notes about Ponzi investors, "f you have an interest-only mortgage, then I am sorry to say you are in that category". And, as it were, an enormous chunk of mortages in the US in the past couple of years have precisely been in that category:
Similarly, in the banking world, you increasingly see interest-only loans, with principal repayments pushed back into the future and, worse, specific authorisations for investors to take money out of the assets (early dividends) early one, something that bankers usually frown upon - the whole point of lending is that you take less risk than owning the thing, because you have priority access to cash; if investors get their income before you, that deal kinda breaks down... But hey, "it's the market."
I don't want to go into too much detail of what my bank does, but one of the reasons I am working on offshore wind is that I consider it to be a safer bet in the current context: it's a new industrial sector, with little track record so far, something banks don't like too much because that means it's more risky, but it's not an unreasonable kind of risk to take: the long term outlook for renewable electricity is excellent, and any short term problems will have technical, real world, solutions not dependent on what "markets" think of your business or your asset.
We're getting closer and closer to the point where the herd realises that it's been doing crazy things, and when the stampede backwards starts. When it will happen, and what will trigger it is still unclear, but it is increasingly inevitable (one of the strangest things about the financial world today is that many banks seem aware of that risk, and have started hiring restructuring and distressed assets specialists - and yet everybody keeps on doing what "the market" is doing. The fact that a possible crisis is anticipated, and thus somehow discounted, will make the crash all the more unexpected, and thus brutal).
But as we know, once the true magnitude of the crisis hits, governments will be asked to - and they will need to, to avoid further damage to the real economy - step in and pick up the pieces. Systemic risk is still the grandest way for profits to be privatised while costs are socialised. So don't expect Münchau to push his logic to the point where he agrees that "heavy regulatory interference" is a good thing, because it would go against that.