Financial Crises Recipe: Moral Hazard, Herding and Returns
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By Didier Sornette and Yannick Malevergne
Sunday Mar 30 2008
FINANCIAL TIMES
Financial Crises Recipe: Moral Hazard, Herding and Returns
Y. Malevergne [1,2] and D. Sornette [3]
[1] Institute of Business Administration, University of Saint-Etienne, France
[2] EM Lyon Business School, Lyon, France
[3] Department of Management, Technology and Economics ETH Zurich, Zurich, Switzerland
Long version (1430 words) of an 850-words op-ed to be published in the Financial Times
At the time of writing, the US market in particular, and the rest of the world as a consequence, is suffering from a serious case of hangover, resulting from having swallowed three bubbles in rapid succession: (i) the "new economy" ICT bubble starting in the mid-1990s and ending with the crash of 2000 followed by a mild recession and severe market drops; (ii) the real-estate bubble launched from 2003 in large part by easy access to large amounts of liquidity as a result of the active monetary policy of the US Federal Reserve lowering the Fed rate from 6.5% in 2000 to 1% in 2003 and 2004 in a successful attempt to alleviate the consequences of the 2000 crash; and (iii) the innovations in financial engineering with the CDOs (collateralized Debt Obligations) and other derivatives of debts and loan instruments eagerly bought by insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations and so on. According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance grew from USD $150 billion in 2004, to close to USD $500 billion in 2006, and to $2 trillion by the end of 2007. Since 2007, large losses by major institutions and often related operational and regulatory mishaps have been reported in the media. The one-trillion dollar questions are: How deep will be the losses? And how severe could be the ensuing recession?
A general and arguably more important question for the future is to understand why market crises have been accelerating in frequency and amplitude in the last two decades and what can be done to prevent future ones. Since the lessons learned from Nick Leeson's destruction of Barings in 1995 and from the Enron collapse in 2001, one could think that major-institution-threatening frauds are a thing of the past. Since the debacle of LTCM in 1998, the hedged-fund managed by two Nobel Memorial prize winners, one could think that the dangers of complex financial innovations and of rocket science with its supercomputers and armies of PhDs would have been learned. The present credit risk crisis has all these ingredients, as if financial actors and the market have simply forgotten or refused to consider the lessons of the past.
Market economy and capitalism are the modern expression of freedom, to create, innovate, produce and trade. However, to work efficiently, capitalism has to be moral, as emphasized from its very early days by Adam Smith himself. The unfolding sub-prime crisis and the subsequent credit crunch constitute vivid consequences of a deeper moral crisis, characterized by individual and collective losses of the sense of responsibility by major financial actors: sub-prime loans were sold by salesmen enticed through their compensation structure to turn a blind eye to the credit-worthiness of their clients; banks did not hedge these loans adequately, as their securitization in the deep financial markets led to an alluring sense of safety and large gains; investors with liquidity surpluses (stemming in part from the loose monetary policy) requested new investment vehicles providing both high yields and an illusion of diversification. The present crisis is essentially similar to previous financial turmoil. They all share the following three fundamental ingredients.
First, from executives to salesmen and trading floor operators, incentive mechanisms promote a generalized climate of moral hazard. Justified by the principles of good corporate governance, executive compensation packages have a perverse dark side of encouraging decision makers to favor strategies that lead to short-term irreversible profits for them at the expense of medium and long-term risks for their firm and their shareholders. Even if the number of CEOs facing forced turnover has increased 3 to 4-fold during the past 20 years while, simultaneously, most contractual severance agreements require the forfeiture of unvested options, lump-sum payments and waiving forfeiture rules often compensate for such losses. There is something amiss when the CEOs of Citibank and of Countrywide walk out of the mess they created for their firms with 9 figure compensation packages. It is often the case that firms finally turn out losing significantly more when the risks unravel than their previous cumulative gains based on these risky positions, while the decision makers responsible for this situation keep their fat bonuses. As long as the risks are born by the firm and not equally by the decision makers, the ensuing moral hazard will not disappear. It is rational and will therefore remain a major root of future financial crises.
Second, herding effects amplify this moral hazard factor. Indeed, performance is commonly assessed on the basis of comparisons with the average industry performance. Therefore, each manager cannot afford to neglect any high yield investment opportunity that other competitors seem to embrace, even if she believes that, on the long run, it could turn out badly. In addition, herding is often rationalized by the introduction of new concepts, e.g. "the new economy" and new "real option" valuation during the Internet bubble. And, herding provides a sense of safety in the numbers: how could everybody be so wrong? Evolutionary psychology and neuro-economics inform us that herding is one of the unavoidable consequences of our strongest cognitive ability, that is, imitation.
Third, while the circumstances that catalyze each particular crisis are specific, they contribute generically to focus the investors' attention on the high level of expected return, making them forget or ignore the fundamental economic principle that returns are just the fair compensation of systematic risks. Concerning the sub-prime crisis, it is hard to believe that the major institutional investors were not aware that sub-prime RMBS were rotten. But the sheer complexity of the investment vehicles (RMBS, CDO, CDO2Š), whose risk assessments were in the hands of quant wizards, may have played a role in lulling managers.
The intrinsic nature of these three elements and the strong positive feedbacks between them suggest that financial crises are bound to repeat and worsen, as the world integration increases and financial complexity blossoms. Is there a remedy?
The ingrained reaction to a crisis is to update and upscale regulations and supervisions. This is a necessary step to restore investors' confidence over the short term - the Sarbanes-Oxley act is a characteristic illustration thereof - but has failed repeatedly to ensure even medium-term stability in the past. It would be hubris to believe that legislations enforced today would be more efficient. The reason is simple and again rational: it is the essence of striving businesses to innovate and exploit all potential initiatives allowed within the law, that is, to function at the borders of legality. Reinforcing legislation would probably be counter-productive on the long-run and create inefficiencies in the market.
Some have proposed to mitigate moral hazard, for instance, by devising deferred compensation funds that would reward multi-period performance to make managers accountable for maximizing the long-run benefits of their companies. Making the position of managers less asymmetric compared to their companies is a positive step. However, deferred compensations run against the problem of defining the metrics to use and of what is meant by "long-run." Indeed, historical bubbles and modern theory informed by behavioral finance and complex system theory show that bubbles can outlast the most tenacious fundamental arbitrager. Should therefore compensations and bonus be even more delayed than existing option-like compensation plans? How would this feed back on the risk appetite of bankers and investment houses, and finally on the overall level of liquidity and diversification provided by the financial universe?
Another concept, inspired by recent advances in neuro-economics, is to design mechanisms by which trust and cooperation is encouraged, so that "immoral" behavior is repressed by the cultural norm. Some success have already been obtained in certain market set-up, such as between brokers and funds specializing in trading small-cap firms, in which the liquidity constraint led to the development of a trust system selecting preferred sellers and buyers on the basis of their past trustful behavior. How could this be implemented at large scale and be sustainable to various sources of flaws and frauds, not to speak of the complexity leading to potential new avenues for opportunistic behavior?
These are hard questions that should be put at the center of the debate if the financial system is to deliver its expected benefits to society. There is absolutely no doubt that other extreme crises will repeat if we do not collectively address the central problem of asymmetric incentives leading to moral hazard, aided by herding and the myopic focus on returns. These questions require brand new approaches and out-of-the-box thinking, strong courage and determination.