Friday, April 08, 2011

DeLong Stands in a Cloacus Maximus and Gazes at the Stars

DeLong confesses that he thought he was functioning in a sane and well-ordered world, and now learns to his dismay that he was not. Inter alia:
 First, I thought that the highly leveraged banks had control over their risks. With all of the industry's experience at quantitative analysis, with all our knowledge of economic history, with bosses who understood the importance of walking the trading floor--I thought that our commercial and investment banks were professionals at risk management.

But our highly-leveraged banks and shadow banks did not have control over their risks. Indeed if you read the documents from the SECs case against Citigroup for its 2007 earnings call, Citigroup did not know what their subprime exposure was and had a frackingly difficult time finding out. Managers seem to have genuinely thought that their underlings were following the originate-and-distribute business model they said they were. Back when Lehman Brothers was a partnership, every 30-something in Lehman Brothers was a risk manager because they all knew that their chance of becoming really rich depended on Lehman Brothers not blowing as they rose their way through the ranks. But if the high-fliers' bonuses are based on the mark-to-model performance of their positions over the past 12 months, you've lost that every-trader-a-risk manager culture. I thought the big banks knew this, and had compensated for it.

I was wrong.
Copy that, big guy, and we'll be a long time figuring out just how such a classically implausible hypothesis (banker self-destruct)  could turn out to be so crashingly true.   My own best guess is that the reasons are diverse and sticky.  Part of it is heads-I-win, tails you lose: individual traders could figure what the hey, if I take I big risk and win, I get a big payday if I lose--well, what the hey.  But this doesn't explain why the CEO--an equity owner, and king of the hill--would touch the match that would blow off his own crown jewels.

On closer scrutiny, some instances are easier to explain than others.  Citibank, for example--in retrospect it is pretty clear that Sandy Weill was pretty good at buying bank assets but he had no interest in actually running them--and neither he nor anybody else ever figured out exactly how to do so (nor has yet, so far as I can tell).  Merrill--this almost beggars belief, but by all available public evidence, Stan O'Neal really never did understand what kind of business he was in.  No, strike that: he understood the business of kiss-up kick-down  bureaucracy, and he had no trouble cutting off thousands of employees.  But he seems never to have grasped the concept of risk, and he seems never have  been willing to listen to anyone who wanted to tell him.  Jimmy Cayne the bridge player at Bear Stearns--hard to tell exactly what was going on in his mind but he seems to have figured that somebody else would solve is banking problem while he was trying to figure out whether to raise three no trump.  Dick Fuld at Lehman--perhaps he once understood trading but by the end, he and his echo chamber of lackeys seem to have talked themselves into the view that it just could not happen to them,  As to AIG--sure, everyone says it was just one little teeny unit (that almost blew up the solar system).  But then the next question has to be--where were the grownups?  My own guess is that they were just all too busy trying to bring order out of the disarray resulting from the disgrace of Hank Greenberg.

History is written by winners, of course, and so it is the folks at Goldman and JP Morgan Chase who tell us that Lloyd Blankfein and Jamie Dimon really did walk on water--and, more precisely, that their banks really did try to assess risk, really did know how to listen to bad news.    Could be, although even here there is room for nuance--Goldman, for example seems to enjoy an extraordinary knack for making up its own rules (or the close corollary, sending its minions off to Washington to make up the rules for it).  Side insight: wouldn't it be true that the chief beneficiary of the AIG salvage operation is not AIG but its great counterparty, Goldman Sachs?   Others like to point to Lazard as one firm that did not go corporate (until later) and that stayed out of the headlines.   Narrowly true, although in that Lazard wasn't really a "bank" like the others, the fact may not be entirely relevant.

So you can make up a plausible story here, at least in retrospect.  But the consoling folklore that capitalism can't self-destruct because interested parties will respond to the proper incentives--the world seems far muddier, far more complex than that.

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