There are a wide range of investments where buyers are not protected against poor judgement or defective products, beyond some limited disclosure requirements and laws against outright fraud. Hedge funds are one example, but the most important case is that of the stockmarket – there’s nothing to prevent you setting up a company to sell dog food over the Internet and selling shares for whatever people are willing to pay, and no one is suggesting that this is going to change.

If we are going to continue with investment banking in anything like its current form, it will have to be on a similar basis to stockmarkets and hedge funds, which means it needs to be kept clearly separate from banking in the ordinary sense, both in terms of financial connections (to prevent regulatory arbitrage) and in terms of consumer protection, so that no one is under the impression that they are dealing with a bank backed by some kind of guarantee.

This is the most amazing financial and economic crash in human history: no one did anything wrong, no one committed any fraudulent/criminal acts, there was no bezzle, none of the changes to regulations made in 1998 had any affect on later events, similarly the gutting of the financial regulatory apparatus 2001-2006 had no effect, and not a single widely-held theory of Economics™ [word spoken in deep booming voice] was proven incorrect. Amazing.

Cranky

I don’t think is true. First off, although it is a staple of textbook finance it is not true that higher returns necessarily equals higher risk; a good argument can be made that in reality investors often pay good money to chase after risk (and the possibility of getting better-than-normal returns), depressing the returns. And if higher returns are earned through informational advantages, then higher-return investments are actually more of sure things.

In the case of the super-senior tranches being discussed here, I don’t believe that the promised returns were remarkably high given the level of risk assumed (i.e., little to none).

I suppose this is similar to how a con-man only needs to know a couple of tricks to make a good living, as there are always plenty of people that don’t know how it works. And as Madoff proved, even a time honoured and well known con can be made to work (for a time) if you dress it up right.

The point of the ignorant-buyer phenomenon is not that all buyers are ignorant, or even that most buyers are ignorant, but that if you create an investment that is only attractive to the ignorant, then only the ignorant will invest in it.

Everyone wants more return and less risk. The non-ignorant understand that there is a tradeoff between these variables, and that you can’t have more return without there being more risk somewhere. There is no perpetual profit machine.

So if you offer something with high return and low apparent risk, the non-ignorant will understand that there is hidden risk somewhere, probably hidden in the exact instrument you are selling, and they will go elsewhere. It’s the ignorant who will buy in to risk-hiding instruments expecting a free lunch.

So, for a certain kind of social Darwinist or Objectivist, who doesn’t pity the fools and instead believes that they deserve to be parted from their money, everything is fine, right? Wrong. Everyone is ignorant about something. The purpose of financial innovation is to produce new tricks to fool investors and/or regulators who know the old tricks. As the complexity and variety of financial instruments increases, the finance sector finds and exploits new deposits of untapped ignorance.

P.S. The Quiggin I thought I knew had more sense than to write that last paragraph. Starting out by assuming something you know to be false based on recent events is no way to craft a policy.

I can’t see how, unless businesses are funded by commercial banks only. Most largish businesses in the US are funded by various forms of market borrowing (auction-rate securities, commercial paper, bond issues), not by bank loans.

When looking at an “investment” product like these securitized mortgages, do you really have to analyze them and find fundamental flaws in the internal structure of their risk allotment, to be able to say that the worm was in the bud? Wasn’t that obvious just from the externals, from the fact that these products offered something for nothing?

The whole idea behind the senior tranches was that the “investor” would make money by doing nothing but forking over some of his cash, which would then multiply by breeding with itself, with no need for the “investor” to exercise any sort of oversight or control over the thing invested in, real estate. You can characterize these products as complex all you want, and yes, adding another layer of abstraction between the homeowner and the mortgage holder does create complexity, but that abstraction itself just makes the moral standing of these products as rent-seeking opportunities, not investments, all the more clear and simple. I imagine that the people pushing these safe tranches made the pitch very simple, “Look, you’re going to be able to sit back and clip coupons on an investment for which the sap originator did all the work, and those saps over there buying the junior tranches are taking all the risk.” I’m sorry, but anyone past the fifth grade would understand the moral hazard in this pitch, of loan originators maybe not doing the same due diligence for mortgages they planned to unload on the saps down the road, that they did when the business was still honest, and the lender was expected to retain oversight of the security for the loan. Anyone who read the papers would have understood that the overheated market in homes, created in no small part by the effect of securitizing mortgages, had, by many sober observers’ estimation, inflated home prices to the point that even homeowners in the safe tranches would be underwater should prices ever deflate to sane valuations. Anyone paying any attention at all would have understood that the junior tranches, in such an inflated market, and with the problem exacerbated by the related refi industry encouraging people to use their inflated home prices to leverage “free” ATM money to finance their lifestyles, would be exposed to if home prices even leveled off, and that a fall in prices that started in the unior tranches would trigger a general deflation in prices in all tranches. Anyone with any moral sense would have questioned the ethics of a scheme for drawing profits from a scheme in which other did all the work and assumed all the risks, and, having a moral sense, would have been circumspect, and looked around at the whole complex of lies and treachery on which this “investment” was built, have seen that the structure was rickety, and not a good idea just in terms of enlightened self-interest. But, you know, everything is hopelessly complicated and opaque, however inherently simple, to people who just aren’t paying any attention at all. If we set up a system in which people are not just allowed, but positively encouraged, to throw something as powerful as large sums of money around without requiring of them any circumspection, of course it will end as badly as that beginning, original sin, that had that worm of wilfull ignorance in the apple.

I don’t disagree with any of the proposed regulatory remedies. But I think one more measure is needed, a measure to address directly the real problem this financial crisis has revealed—that we have far too many people with far too much excess money out there seeking sinecure rents. There is much, much more money than common sense and common decency out there, and that imbalance is deadly. It’s not just a matter of malallocation, that they could be directing this money to actual capitalization of enterprises that would produce needed goods and services, instead of throwing it at onanistic something-for-nothing schemes. There is a huge danger to the real economy of leaving so much money that it’s no longer money but has grown to be the Wrath of God, out there unsupervised, in the hands of a class of folks who have neither the inclination nor the ability to oversee its workings in the real economy. Let Capital slip its leash of human oversight, and it gathers itself naturally into bubbles and pyramids. Add to the suggested regulatory oversight the confiscation of excess income that individuals cannot allocate safely, much less wisely, and you have the reasonable, sane, moderate solution. If people won’t suprervise their excess money, then the people must.

Since then the size of investment bank balance sheets has ballooned which demonstrates a significant change of business model. There are probably many reasons for it: reduced revenues from broking client transactions, competition for market inefficiency profits and for staff from hedge funds are plausible reasons. However it is clear that crossover institutions like Citi and JP Morgan had an advantage in the very large mortgage transactions that would have knock-on benefits for other business. Glass Steagall and other regulatory loosening might well have facilitated these changes.

It is also clear that investment banks were not used to keeping large institutionally significant risks on their books for extended periods and financial institutions have demonstrated again and again that they are no good at managing big new things. There is a fundamental difficulty with managing something that is new and if it is going wrong may not go wrong straight away and in that sense CDOs and sub-prime were no different to, say, Latin American debt or internet stocks.

The CDO affair has many similarities with the far smaller split capital investment trust debacle. These similarly split pools of investments into different parts for sale to different investors. The first issues were excellent but as the market developed appetite for one part was outstripped by the tax advantage fuelled demand for the other which left the industry sitting on what were by the original criteria undervalued slices and as a result rocketing leverage.

To me this does suggest that something plausibly achievable and useful could have been done if someone had insisted that the investment banks show good reasons for the changing nature of their balance sheets and for keeping large slices of their own issues on their books—something that used to be seen as a sign of failure. I can’t see that a conservative presumption here would be harmful. Glass Steagall reform may have prevented that being done effectively because a homogenisation of balance sheets would be only to be expected.

In summary abolishing Glass Steagall and related reforms may have done damage by unleashing fundamentally new business models, muddying the waters for regulators and removing a firewall. I can’t see that there was anything remarkably dangerous resulting from CDOs and imagine that they will return in smaller but still significant volumes without repeating this disaster. The worst damage they will have caused is the legacy of increased concentration and decreased diversity in financial services institutions. Agency issues are real and as intractable in practice as they are in theory.

This stuff was rated better than AAA, with the result that lots of banks were willing to carry it on their own books, using Enron-like special investment vehicles to skirt the Basel 2 requirements for capital adequacy

It was not rated better than AAA. There’s no such thing. It was considered safer than a “normal” AAA, and understandably so – in order to suffer a loss, another AAA tranche would have had to be completely wiped out. The problem being, of course, that it turned out the risk of the subordinate AAA tranche being wiped out was a lot less than AAA (plus the correlation of underlying assets was much higher than assumed, rendering subordination much less effective). Also, Basel II meant they did not need to use “special investment vehicles” (not actually a term in use – do you mean “structured investment vehicles”, “special purpose vehicles” or something else?) to hold the risk, because the capital requirements for super-senior tranches of securitisations was extremely low, especially under the IRB. It was even more cost-effective for insurance companies to hold these exposures, which is one reason why monolines and multiline insurers (especially reinsurers) ended up with so much of it.

I’m not sure why transferring the super senior risk on the first deal to AIG demonstrates there was never a sound basis for it, per se. Certainly AIG’s outsized market share in the later years should have been a warning sign, but there many players in the intervening years. The returns on super senior tranches were very low indeed, commensurate with the perceived risk. Consequently it didn’t make sense for institutions subject to gross leverage limits to hold such exposures, nor those with large exposure limits. But for institutions built around a low risk, low return model, with the right (or wrong, as it turned out) capital adequacy rules, it seemed to make sense.

Or (I haven’t read the book) were Tett’s young bucks going around telling people the risk was zero – not effectively zero, actually zero zero?

Clearly not, or if they were, only a complete idiot would have believed them. There is no such thing as a zero risk investment, including a US government bond maturing tomorrow.

Getting back to the OP, I’m not convinced that offloading the super-secret-special tranche to AIG was such a smoking gun. “We have reduced the risk of default to a historically unprecedented 0.0001%” (or whatever) isn’t incompatible with “We don’t like carrying monster debts even if the risk of default is a historically unprecedented 0.0001%”. Or (I haven’t read the book) were Tett’s young bucks going around telling people the risk was zero – not effectively zero, actually zero zero? If that was the case, well…

I will note that regulatory arbitrage is an exceptionally broad category of trading strategies. And a category which is difficult to clamp down on. Governments have been writing tax law for thousands of years, with little progress in eliminating tax avoidance. We have to face the struggle between writing strict legislation which could open up many opportunities for arbitrage with empowering strong regulators, which allows for the possibility of capture.

Why not attempt something approaching Gary Gorton’s solution (Slapped in the Face by the Invisible Hand, hyperlink removed so as not to offend the post gods) where the government treats all short term informationally insensitive debt as equivalent to demand deposits, rather than walling off banks and investment banks?