Month: December 2009

From a WSJ column:

To be fair, the Orszags and Mr. Stiglitz acknowledged that “the extremely rare events located in the tail of a distribution are often quite difficult to analyze accurately.” Even so, they noted that White House budget gnomes had tested Fan and Fred’s capital against “the financial and economic conditions of the Great Depression.” The result: “[G]iven 1990 levels of capital, both Fannie Mae and Freddie Mac had sufficient capital to survive.”
 
[…]
 
The crucial point is that assessing systemic risk is difficult to impossible—and the likelihood of coming to a reliable consensus about it is even lower. Both Orszags and Mr. Stiglitz were officials in the Clinton Administration and saw the debates about Fan and Fred that the Clinton Treasury began in the late 1990s, only to get clobbered by the companies’ lobbying machine. Yet the three amigos still saw fit to put their names to a paper dismissing any risk of failure.
 
Why should anyone think that regulators—or economists—will predict the next systemic debacle any better? We only know better about the past. When the next problem erupts, as in 2002, smart people will be on both sides of the argument. And when large, systemically important companies are threatened with curbs on their business, they will pay Nobel laureates to write studies that explain away the dangers, and hire lobbyists to block any reform. A future Treasury secretary may also dismiss critics of a future Fannie Mae, or Goldman Sachs, as “ideologues,” as Hank Paulson did in 2007-2008.
 
The very existence of a systemic risk regulator, or council of regulators, will assist the largest and riskiest firms by creating an illusion of stability in a world made less stable by the implicit guarantee that this regulator would convey. It would be an accident waiting to happen, and one made inevitable by the institution created to prevent it.

Clever people rationalizing away risk destroyed Long Term Capital Management and countless other leveraged financial businesses. (As the column suggests, the incentives facing bureaucrats and politicians make this problem even more acute for government-managed enterprises.) The idea is generally: we’ve looked at all the angles and done simulations and the odds of a ruinous meltdown are so small we’re not going to worry about it. The problem is that the models used to estimate risk are sensitive to errors in the assumptions. That’s what “extremely rare events located in the tail of a distribution are often quite difficult to analyze accurately” means. If the distribution is statistically abnormal the tails of the distribution might be fatter than you think, in which case those extremely rare events might not be so rare. For businesses that deal with statistically normal returns distributions, such as casinos and life-insurance companies, the risks are relatively easy to determine. Those are well understood businesses with almost no risk of failure as long as they are well capitalized and well managed. By comparison, the risks for a highly leveraged negative-gamma financial scheme are much more difficult to pin down. Fannie Mae was essentially a colossal short-put position on the mortgage industry. Was the risk of ruin 1 in 1,000,000 or one in a hundred? Who knows. A cursory look at the history of financial debacles suggests that such events happen much more frequently than many models have predicted. A reasonable person with extensive private-sector financial experience as a trader or fund manager would know better than to bet the ranch on the accuracy of a model whose worst-case outcomes involve unknown probability of unbounded loss. More likely he would want to be on the other side of that trade. Yet Congress jumped right in and kept doubling down when it should have been cutting its losses, and is now repeating the error with the FHA. Orszag and Stiglitz apparently didn’t understand this back in the day. Do they understand it now?

When people like these are in business and miscalculate they go out of business. If they’re lucky they then get to go to work for someone who has a better understanding of risk than they did. But when they’re in government and miscalculate they may pay no penalty or even be promoted, and the risks they rationalize may be ignored until institutions fail. I don’t mean to single out Orszag and Stiglitz, who probably meant well and were not responsible for Fannie Mae (Congress was). But the public sector is full of such people, and as the government expands they become more influential and their mistakes become more costly.