This past week, I've been drafting a blog post in my head (yes, it's been that kind of week) about the role that risk played in the 2008 financial crisis. I kept seeing smart people making analogies to "the Enron debacle," and I just felt that this analogy was not apt. I assume that references to the Enron debacle are shorthand references to the accounting scandals that plagued the beginning of this century, which involved Enron, WorldCom, Tyco, HealthSouth, RiteAid, and more. In each of these stories, the financial picture given to the marketplace didn't seem to match up with reality, making some investors be caught off guard when the picture was revealed. These stories are fraud stories. At these firms, certain individuals knew that the picture was off, and criminal prosecutions and civil litigation tried to sort out which individuals knew what and when. These trials seemed to throw too wide of a net and induced some big fish caught in the net to surrender whether than flounder and risk a greater penalty. (OK, I went too far with that fish-net analogy. I apologize.)
Another way to read those 2001 stories is as stories of risk-taking. Either risk-seeking companies painted too rosy a picture to try to buy time for actuals to catch up with disclosed financials or individuals had too great an appetite for legal risk -- sidling up too close to the edge of an accounting rule or guideline. But generally, the risk story is eclipsed by the fraud story. So, is the 2008 financial crisis going to be a risk story or a fraud story? I think this is important because it is going to drive the regulation that will inevitably follow. The 2001 scandals were fraud stories, and SOX is basically an anti-fraud statute that re-allocates responsibility for fraud and tries to prevent fraud. SOX does not address risk-taking directly, although some make the argument that SOX stifles risk-taking.
I would argue that at least given what we know now, the 2008 financial crisis is a risk story. Different individuals and firms underassessed the risk of certain financial transactions and products. Homebuyers underassessed their ability to refinance mortgages and the potential appreciation of their homes; mortgage lenders underassessed the potential appreciation of collateral and credit risk; mortgage asset-backed security buyers underassessed the risk of those products; financial firms entering into credit default swaps to hedge the risk of those products underassessed counterparty risk; and so on. Although the system was meant to reduce overall risk of mortgage lending, the system could not withstand the shock to its system when housing prices fell. (Think of it as all the nation's insurers selling hurricane insurance, and then several hurricanes hitting at once. And, unfortunately, those insurers weren't regulated and required to maintain reserves.) If this is just a risk story, then regulation just needs to backstop the risk for these "perfect storm" "once in a century" types of shocks. Some risk stories don't even need regulation -- think of the "take or pay" cases from the 1980s between pipelines and producers of natural gas who never envisioned that demand would be less than supply of natural gas.
But of course, risk stories don't sell. They don't sell to the media, the regulators, the investors or the voting public. Surely mispricing of risk couldn't cause this collapse, could it? If we're going to put $700 billion into fixing the system, then the problem has to be as big as the cure. In other words, the bailout only sells if there is a fraud story. Our markets are efficient, and efficient markets price risk well, if not perfectly. If there was mispricing of risk, that must have been because there was fraud in the system. So, enter the FBI. The FBI is now investing not only Fannie Mae and Freddie Mac, but also Lehman Brothers and AIG for "misstatements." According to one unnamed government official "it was 'logical to assume' that those four companies would come under investigation because of the many questions surrounding their recent collapse." If there is one thing that we may have learned from the "Enron debacle," it's that federal prosecutors tend to find what they are looking for. Although, Attorney General Mukasey has said there will be no "2008 Financial Crisis" task force, a la the 2002 Corporate Fraud Task Force. Stay tuned.
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1. Posted by will on September 24, 2008 @ 21:51 | Permalink
Surely mispricing of risk couldn't cause this collapse, could it?...Our markets are efficient, and efficient markets price risk well, if not perfectly.
not really, there are some rare occurences that cannot be predicted with any accuracy. see Taleb: http://www.edge.org/#taleb
also "The Black Swan" and "Fooled by Randomness."
2. Posted by Jeff Lipshaw on September 25, 2008 @ 3:55 | Permalink
Great post, Christine. The system took too much risk, and underestimated the impact of leverage. Now it is de-leveraging. To your point, it's too hard to figure out either who does or who bear the brunt of the decline in value of our collective net worth, so let's figure out who to blame!
My suggestion is that we are all either addicts or co-dependents in this particular crisis.
3. Posted by Jake on September 25, 2008 @ 20:52 | Permalink
I too applaud this very insightful post.
But I wonder whether the current financial crisis is a "risk story" or the denouement of a story that was too good to be true.
4. Posted by A.J. Sutter on September 26, 2008 @ 8:17 | Permalink
I'm not usually a Frank Knight fan, but this is an instance where his distinction between risk and uncertainty might be helpful. I think this is an uncertainty story, misapprehended as a story about risk.
"Risk" suggests that the probabilities of outcomes are known. The financial system -- especially with credit default swaps, collateralized debt obligations to the nth power, etc., embroiled in the subprime business -- is too complex for the probabilities of failure to be known. The system is really operating in a state of Knightian uncertainty. Part of the problem is that the players mistakenly were treating the system as if risk the relevant concept, and moreover believed that they could calculate those risks properly.