Suckers And Transparency: Preventing Another Financial Crisis

The Market

from the can-we-outlaw-suckers? dept

In continuing to try to understand the root causes of the financial crisis, we find that the whole story just keeps getting more interesting. While lots of folks are trying to blame one single thing (free markets, regulations, greed, poor people, rich people, bankers, mortgage lenders, hedge funds, short sellers, the President, Congress, etc.), the truth is that almost all of those explanations aren’t just wrong, they’re highly misleading. The problems involve a whole bunch of different things that combined to create the incentives that resulted in this situation — and preventing it from happening again is hardly an easy proposition.

Finding the last sucker

Earlier this year, in talking about a highly questionable investment firm that was investing in startups, we wrote about how the venture capital game has always been about finding the last sucker to invest. It used to be the public markets, but when that dried up, apparently some VCs moved on to basically skirting public offerings by getting firms like the one described in the post to effectively trick unsophisticated investors out of their money and put it into a “fund” that then went to startups. It was the same process — but actually less regulated than the public markets, and much more open to fraud.

The more I read about and understand different aspects of the current financial crisis, the more it becomes clear that basically the same thing happened here, but just on a much, much larger scale. It was a giant game of hot potato, where folks were passing along toxic assets looking for the last sucker to take them — except the process of finding that last sucker became so valuable, that many of the firms in the business of finding new bigger suckers… found themselves. In many cases, the suckers were, in fact, unsophisticated investors like the school districts we described recently, but the various banks got so tied up in the process that they started betting on these things themselves.

Becoming the last sucker

While we’ve been trying to avoid the blame game, the more details come out, the more it looks like an awful lot of the trouble actually comes from the ratings agencies, such as S&P and Moody’s. As we discussed in the story about the school districts, the ratings agencies screwed up pretty massively, by taking collections of poorly rated loans, and effectively claiming that all together, they suddenly became low risk assets. At some level you can see where they were coming from. If they were basing their decisions on the idea that default rates were independent, then bundling a bunch of questionable assets is a potential diversification strategy. You’re assuming that only a small percentage will default, and you can look at historical numbers to figure out the risk. But, the problem is that these aren’t independent, and as defaults start happening it leads to more defaults — and the ratings agencies were simply fooled by their own models.

That’s the generous interpretation, at least. The other is that there was outright fraud going on at the ratings agencies, and there’s some evidence there was a fair amount of fraud. My guess is there was a little of both. The ratings agencies were pushed to rate these financial products highly, and so they created models that would support a high rating. Basically, rather than creating models that actually judged the risk, they created models that told them what they wanted them to say, because, in part, their business model depended on it. It was, as noted, garbage in, financial crisis out.

A lot of this becomes clear in Michael Lewis’ excellent (as usual) discussion with a hedge fund guy who recognized this early (and made quite a bit of money doing so). What’s fascinating is how much work even he had to do before he realized how fragile the whole setup was. When the financial crisis first went into full swing, many folks pointed the blame finger at hedge funds that were shorting bank stocks, like this guy. However, as the Lewis profile makes clear, he wasn’t to blame. He was accurately telling everyone that the financial system itself had been built on a myth — and the mythmakers were believing their own myth.

The end result is that the race to find that last sucker resulted in plenty of suckers being taken — but when there weren’t enough of those, the banks basically made themselves the next sucker in line, and convinced themselves that they weren’t suckers. While there was almost certainly some amount of fraud involved in all of this, part of the problem was that everyone started believing their own bogus models in order to convince themselves that there would always be a later sucker (or, even worse, that they didn’t need a later sucker).

So how do you prevent suckers?

And that leads us to the crux of the problem. How do you prevent suckers? At some point, you can just say, well it should be “buyer beware,” and to some extent I agree with that sentiment. But, when all of the other incentives are as screwed up as they were in this situation, then even the “aware” buyer finds that almost every single datapoint he or she is using is wrong. That’s what was happening here. You could look pretty deep at many of these assets and everything was saying they were solid, when the reality was they were not. In cases of outright fraud by ratings agencies, you can pull out the blame finger, but in many cases it wasn’t so much fraud as it was the “experts” deluding themselves. How do you stop defrauding suckers, when it’s the suckers defrauding themselves… and then earnestly convincing everyone else in the process?

Radical transparency

The one thing I keep coming back to as a solution is to put in place some aspect of radical transparency on pretty much all aspects of financial instruments, both on the debt side and the equity side. On the equity side, I’m surprised that more folks haven’t picked up on Umair Haque’s point that quarterly reports are obsolete and not nearly transparent enough. What if public companies provided ongoing reports that revealed a lot more than they do today. And, similarly, any debt instrument provided much more detail concerning what was actually making up the investment.

The reason school districts got stuck with worthless CDOs was because the information they got wasn’t transparent at all. Sure, the prospectus was a book three inches thick, but all that information was actually used to obscure what the product was. Hell, the districts thought they were buying actual bonds, not making a side bet on how those bonds would do (what the CDO actually represented). But if there were real transparency within these instruments, and everyone buying into them could easily understand what was actually at stake, then they wouldn’t be so reliant on ratings agencies and their crappy models. They’d be able to build their own models — or openly share and discuss models with others.

While there will always be some “last sucker” out there, we can limit the risk of such things by limiting the suckers as much as possible — and the way to do that is to become much more transparent and open with information.

Filed Under: bailout, blame, financial crisis, ratings, suckers, transparency