Michael Lewis is a best selling author of non-fiction books. I just got a copy of "Flashboys" today, which is about how high frequency trading is a vehicle for many unfair practices in financial markets. In promoting the book as well as his ideas, he's been making the rounds on TV and the internet.
He is surprisingly willing to call the stock market rigged against retail investors. He is also very good at fielding criticism. I am impressed with how good he is at not letting the interviewers change the topic.
Here's a long Charlie Rose interview.
He also has an hour-long interview with Conan O'Brien for Serious Jibber Jabber
http://teamcoco.com/video/serious-jibber-jabber-michael-lewis
And he lives in Berkeley!
Showing posts with label financial crisis. Show all posts
Showing posts with label financial crisis. Show all posts
Sunday, July 27, 2014
Wednesday, February 29, 2012
Reforming the Financial Sector
another paper I wrote for the International Financial Crisis class.
Up until 2008, Wall Street, regulators, and economists thought that the US financial system had entered a new era, and that there would no longer be bubbles or depressions. The Great Recession made it clear that on the contrary, the price of risk was extremely distorted, leading to a bubble in the real estate market and a subsequent crash. To prevent future crashes, the financial system needs to be reformed so that risk is properly priced. The most important goals for reforms include reducing incentives for excessive risk taking and dispelling the expectation that the government will back private institutions.
Internal governance of banks should be improved by reforming compensation to reduce bankers’, managers’, and board members’ incentives for seeking tail risk. In his book, Fault Lines, Rajan recommends against doing away with performance pay. Instead, he recommends withholding the majority of a bonus for a banker, subjecting it to claw backs contingent on the performance of assets in future years. There could also be targeted penalties for mistakes. In the case of managers, subjecting pay to claw backs contingent on the performance of the firm in future years. However, it seems that this would not have prevented the 2008 financial crisis since the performance of mortgage-backed securities was very good for a very long time. Even so, linking pay with future performance would be a step in the right direction.
While performance pay provides incentives for bankers and management to innovate and allocate capital as efficiently as possible, reducing pay through regulations may still lead to social benefits. Labor differs from other economic inputs to production in that people have emotional needs. A person’s level of compensation becomes tied to one’s self-worth and increases one’s credibility, especially when it is high. Social psychology research by Paul Piff shows that high pay might impact the psychological mentality such that they are more likely to lie in negotiations. When pay is high, a banker not only has more incentive to manipulate his or her performance metric but is also more motivated psychologically. Reducing payment levels could actually make the job more important to the self-identity than the pay. Then assessing risk to allocate capital efficiently would become comparatively more important. At the same time, I am not sure how this can be implemented effectively and ethically.
Preventing institutions from becoming too systemic to fail is crucial to reducing price distortions of risk. Rajan makes a very persuasive argument that the size of the firm is not what makes a firm systemic. Instead, he argues that regulators should collect data and monitor interinstitution exposures and risk concentration. This data should then be made publically available to be vetted by a wider swath of people. In addition to better information about risks, regulations should require financial institutions to hold more capital and finance activities with equity rather than debt. Financial firms also need to be easier to resolve so that the government won’t have to rescue a firm simply because it is too complicated for it to fail.
Up until 2008, Wall Street, regulators, and economists thought that the US financial system had entered a new era, and that there would no longer be bubbles or depressions. The Great Recession made it clear that on the contrary, the price of risk was extremely distorted, leading to a bubble in the real estate market and a subsequent crash. To prevent future crashes, the financial system needs to be reformed so that risk is properly priced. The most important goals for reforms include reducing incentives for excessive risk taking and dispelling the expectation that the government will back private institutions.
Internal governance of banks should be improved by reforming compensation to reduce bankers’, managers’, and board members’ incentives for seeking tail risk. In his book, Fault Lines, Rajan recommends against doing away with performance pay. Instead, he recommends withholding the majority of a bonus for a banker, subjecting it to claw backs contingent on the performance of assets in future years. There could also be targeted penalties for mistakes. In the case of managers, subjecting pay to claw backs contingent on the performance of the firm in future years. However, it seems that this would not have prevented the 2008 financial crisis since the performance of mortgage-backed securities was very good for a very long time. Even so, linking pay with future performance would be a step in the right direction.
While performance pay provides incentives for bankers and management to innovate and allocate capital as efficiently as possible, reducing pay through regulations may still lead to social benefits. Labor differs from other economic inputs to production in that people have emotional needs. A person’s level of compensation becomes tied to one’s self-worth and increases one’s credibility, especially when it is high. Social psychology research by Paul Piff shows that high pay might impact the psychological mentality such that they are more likely to lie in negotiations. When pay is high, a banker not only has more incentive to manipulate his or her performance metric but is also more motivated psychologically. Reducing payment levels could actually make the job more important to the self-identity than the pay. Then assessing risk to allocate capital efficiently would become comparatively more important. At the same time, I am not sure how this can be implemented effectively and ethically.
Preventing institutions from becoming too systemic to fail is crucial to reducing price distortions of risk. Rajan makes a very persuasive argument that the size of the firm is not what makes a firm systemic. Instead, he argues that regulators should collect data and monitor interinstitution exposures and risk concentration. This data should then be made publically available to be vetted by a wider swath of people. In addition to better information about risks, regulations should require financial institutions to hold more capital and finance activities with equity rather than debt. Financial firms also need to be easier to resolve so that the government won’t have to rescue a firm simply because it is too complicated for it to fail.
Wednesday, January 25, 2012
Holding on to Great Expectations
This is a paper I just wrote for the International Financial Crisis class. Much of it is based on the book Fault Lines, but some of it is also my own analysis.
The incentives of US financial firms and political pressures on the US government were based on expectations for the US economy that may be outdated. These expectations about the American dream have led to a smaller safety net compared to European countries and also resistance against redistributive taxes. In response to jobless recoveries, Americans came to favor expanding credit over strengthening the safety net. At the same time, high expectations for the digital information age have led to a false sense of security while competition for growth intensified in the financial industry. Popular unrest in the form of the Tea Party and the Occupy movements show that Americans are reevaluating their expectations as the recovery inches along.
The US economy developed over years of slow growth with relatively low amounts of government intervention. Because of this, there is a strong faith in the efficiency of markets, individual incentive, and competition. A small safety net for the unemployed is appropriate for a competitive economy that quickly reallocates labor to more productive uses. At the same time, Americans began to take this to an extreme, recategorizing public education and progressive taxes (such as the estate tax) as welfare services. They became reluctant to properly fund schools or redistribute wealth, leading to growing wealth inequality and skills disparity among the labor force.
Until 1991, post-war recessions were short and jobs were quickly recovered since workers were strongly motivated to find work to regain health insurance and other benefits. However, the recession in 1991, 2001, and 2008 have been increasingly jobless. This could possibly be because of structural changes in the economy, but may also be because underfunding education is finally impacting the labor market. To adjust to this development, it has been more political feasible to lower interest rates to stimulate investment and expand Americans’ access to credit rather than enlarge the safety net.
Meanwhile, as information became digitized, it became easier and quicker to access and analyze information. It is possible that financial firms and the public overestimated the quality of this information. The trustworthiness of a broker is masked by the professional detachment of a database. The digital age gave financial firms the ability to create and distribute more complicated instruments more quickly. Risk models are more sophisticated and complex, but complexity also makes models and underlying data more difficult to scrutinize. Furthermore, these models were proprietary and thus although there is more data available, many institutions including the regulatory agencies do not yet have the capacity or tools to analyze them. Data itself cannot be equated with transparency.
The focus on performance in financial firms and confidence in digital information caused bankers to take on tail-risk to increase returns or be replaced. Tail-risk is a low probability but extremely high cost risk. When tail-risk is systematically ignored, the probability increases significantly. This isn’t exactly because the risk models are wrong, but because the operating point of the risk model has moved to where actions of bankers and investors are correlated rather than independent. The public became accustomed to high levels of growth of their investments without considering whether the disproportionate growth of the financial sector was consistent with the amount of value added.
High expectations for the efficiency of markets leading to expanding credit, high expectations for the quality of information in the digital age, and high expectations for the performance of the financial sector set the stage for the financial crisis. When the crisis hit, almost everyone was extremely surprised. The large disconnect between the public’s view of the economy and the reality is evident in the outcry when the government bailed out Wall Street to prevent a crash on Main Street. At the same time, the American public may be adjusting their expectations. Healthcare reform was signed into law in 2010 and the financial industry is in the process of downsizing. It remains to be seen whether the adjustment will be enough to avoid old patterns of behavior and additional economic strife.
The incentives of US financial firms and political pressures on the US government were based on expectations for the US economy that may be outdated. These expectations about the American dream have led to a smaller safety net compared to European countries and also resistance against redistributive taxes. In response to jobless recoveries, Americans came to favor expanding credit over strengthening the safety net. At the same time, high expectations for the digital information age have led to a false sense of security while competition for growth intensified in the financial industry. Popular unrest in the form of the Tea Party and the Occupy movements show that Americans are reevaluating their expectations as the recovery inches along.
The US economy developed over years of slow growth with relatively low amounts of government intervention. Because of this, there is a strong faith in the efficiency of markets, individual incentive, and competition. A small safety net for the unemployed is appropriate for a competitive economy that quickly reallocates labor to more productive uses. At the same time, Americans began to take this to an extreme, recategorizing public education and progressive taxes (such as the estate tax) as welfare services. They became reluctant to properly fund schools or redistribute wealth, leading to growing wealth inequality and skills disparity among the labor force.
Until 1991, post-war recessions were short and jobs were quickly recovered since workers were strongly motivated to find work to regain health insurance and other benefits. However, the recession in 1991, 2001, and 2008 have been increasingly jobless. This could possibly be because of structural changes in the economy, but may also be because underfunding education is finally impacting the labor market. To adjust to this development, it has been more political feasible to lower interest rates to stimulate investment and expand Americans’ access to credit rather than enlarge the safety net.
Meanwhile, as information became digitized, it became easier and quicker to access and analyze information. It is possible that financial firms and the public overestimated the quality of this information. The trustworthiness of a broker is masked by the professional detachment of a database. The digital age gave financial firms the ability to create and distribute more complicated instruments more quickly. Risk models are more sophisticated and complex, but complexity also makes models and underlying data more difficult to scrutinize. Furthermore, these models were proprietary and thus although there is more data available, many institutions including the regulatory agencies do not yet have the capacity or tools to analyze them. Data itself cannot be equated with transparency.
The focus on performance in financial firms and confidence in digital information caused bankers to take on tail-risk to increase returns or be replaced. Tail-risk is a low probability but extremely high cost risk. When tail-risk is systematically ignored, the probability increases significantly. This isn’t exactly because the risk models are wrong, but because the operating point of the risk model has moved to where actions of bankers and investors are correlated rather than independent. The public became accustomed to high levels of growth of their investments without considering whether the disproportionate growth of the financial sector was consistent with the amount of value added.
High expectations for the efficiency of markets leading to expanding credit, high expectations for the quality of information in the digital age, and high expectations for the performance of the financial sector set the stage for the financial crisis. When the crisis hit, almost everyone was extremely surprised. The large disconnect between the public’s view of the economy and the reality is evident in the outcry when the government bailed out Wall Street to prevent a crash on Main Street. At the same time, the American public may be adjusting their expectations. Healthcare reform was signed into law in 2010 and the financial industry is in the process of downsizing. It remains to be seen whether the adjustment will be enough to avoid old patterns of behavior and additional economic strife.
Saturday, January 21, 2012
International Financial Crisis Seminar
I'm taking a seminar this semester on the International Financial Crisis with University of Michigan Professor Emeritus Robert Stern. We are reading Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan. Some of his arguments are very persuasive. I like how he presents the problems in the global economy in terms of systemic tensions. Although he doesn't exactly say it this way, my conclusions after reading some of his book is that no country in the world really knows how to shift to an economy where low-skilled labor is no longer really needed. In other words, in a world where you only need a few highly skilled people to produce the majority of goods, how do you still distribute the goods? Maybe finally, this is where communism comes in.
At the same time, perhaps the case is overstated. Clearly we still have plenty of things to do for low-skilled labor on farms and perhaps cleaning the environment. But there is much more money for skilled labor perhaps because there is not enough supply of skilled labor. At the same time, I'm not sure if this is correct because there is plenty of unemployed skilled labor as well as unskilled labor in Europe.
In Fault Lines, Rajan talks about how many financial crisis such as the Great Depression and Great Recession were related to expansions of credit for housing. Because housing itself is a necessity and that the education system in the US is funded by local taxes, housing is particularly important in the US for social mobility and neighborhood stability. It made me think about how many people make money from investments, but because of the transaction costs, it only makes sense if you have a certain amount of income. Perhaps there is a way to lower the entry costs so that there is more of a cushion for lower income households.
Where do we go from here? Unclear. I suppose we continue to muddle through.
At the same time, perhaps the case is overstated. Clearly we still have plenty of things to do for low-skilled labor on farms and perhaps cleaning the environment. But there is much more money for skilled labor perhaps because there is not enough supply of skilled labor. At the same time, I'm not sure if this is correct because there is plenty of unemployed skilled labor as well as unskilled labor in Europe.
In Fault Lines, Rajan talks about how many financial crisis such as the Great Depression and Great Recession were related to expansions of credit for housing. Because housing itself is a necessity and that the education system in the US is funded by local taxes, housing is particularly important in the US for social mobility and neighborhood stability. It made me think about how many people make money from investments, but because of the transaction costs, it only makes sense if you have a certain amount of income. Perhaps there is a way to lower the entry costs so that there is more of a cushion for lower income households.
Where do we go from here? Unclear. I suppose we continue to muddle through.
Sunday, June 12, 2011
The Backstory : Aggressive Accounting
These days I've also been reading The Great Unraveling by Paul Krugman. It is his NYT columns from 2000-2002 mostly about how bad George W. Bush is. Today I was reading his columns about aggressive accounting and corporate governance. There are two things of note.
In 1995, Congress overrode a veto by Bill Clinton to pass the Private Securities Litigation Reform Act, which made lawsuits against companies and auditors "that engaged in sharp accounting practices."
In 1997-2000, after-tax profits stalled, but the S&P 500, the profits reported to investors grew 46%. Krugman attributes this to the changes in management theory and the advent of "principal-agent" theory. What's sad is that it is a well-meaning idea where managers' pay depends strongly on stock prices so that they have more accountability. I can see how before it may have seemed like managers were inefficient, maybe sometimes too generous to employees, and maybe out of touch with the needs of the company since they did not have as much invested in their own companies. Unfortunately, tying their compensation to stock prices gives them a big incentive to artificially boost those prices regardless of actual performance. The problem is that the real performance of a company will always be somewhat qualitative. It will always be some kind of combination of factors. Any quantitative measure can always be manipulated. That is something Deming said, too.
We are still trying to deal with the effects of these issues today. Back in 2001 I was still in high school and I had no idea who Paul Krugman was. All these things were happening, but I didn't really know. I just knew that Reaganomics and tax cuts are irresponsible. It is kind of weird to get the back-story now, especially knowing that I was there, too. It is a different sensation from reading about things that happened longer ago or in different countries. I am glad that I think I will have a better understanding of things happening going forward, but it's also a little strange knowing that millions of other people will continue to be unaware and just minding their own business as I was.
In 1995, Congress overrode a veto by Bill Clinton to pass the Private Securities Litigation Reform Act, which made lawsuits against companies and auditors "that engaged in sharp accounting practices."
In 1997-2000, after-tax profits stalled, but the S&P 500, the profits reported to investors grew 46%. Krugman attributes this to the changes in management theory and the advent of "principal-agent" theory. What's sad is that it is a well-meaning idea where managers' pay depends strongly on stock prices so that they have more accountability. I can see how before it may have seemed like managers were inefficient, maybe sometimes too generous to employees, and maybe out of touch with the needs of the company since they did not have as much invested in their own companies. Unfortunately, tying their compensation to stock prices gives them a big incentive to artificially boost those prices regardless of actual performance. The problem is that the real performance of a company will always be somewhat qualitative. It will always be some kind of combination of factors. Any quantitative measure can always be manipulated. That is something Deming said, too.
We are still trying to deal with the effects of these issues today. Back in 2001 I was still in high school and I had no idea who Paul Krugman was. All these things were happening, but I didn't really know. I just knew that Reaganomics and tax cuts are irresponsible. It is kind of weird to get the back-story now, especially knowing that I was there, too. It is a different sensation from reading about things that happened longer ago or in different countries. I am glad that I think I will have a better understanding of things happening going forward, but it's also a little strange knowing that millions of other people will continue to be unaware and just minding their own business as I was.
Wednesday, June 1, 2011
The Purpose of Banking
Some bankers call for regulating derivatives or at least taxing trading more.
Thursday, December 2, 2010
Thursday, August 12, 2010
In the Line of Fire : Unemployment Benefits
Some good analysis on unemployment from the WSJ. They use a graphic and some analysis about who was laid off during this recession from Professor Autor! The article is about how even though unemployment is very high, companies are having trouble hiring for a variety of reasons. Many people are less able to move during this recession because it was a housing bubble, and people either don't want to or are unable to take a loss selling their house. Some people are choosing to stay on unemployment benefits rather than take a low paying job. The deteriorating education system also seems to have caused the quality of the labor force to be lower, which makes it difficult for companies looking for people with specialized skill, especially since many companies are either unable or unwilling to pay very much. During the recession, it is mainly middle skilled workers who are laid off, who don't necessarily have the skills that companies are currently looking for.
While an obvious solutions seems to be to stop unemployment benefits, it may be a short-sighted thing to do. Stiglitz encouraged extending unemployment benefits because stopping or even reducing them would make reduce consumer spending and increase foreclosures, so even if those people got lower paying jobs, there may not be a net aggregate benefit to the economy. It may arguably help reduce government expenditures, but it may also make things worse by reducing state and local revenues.
Another obvious need is to improve the skill level of the labor force by investing in education. However, this is expensive, and I think part of the problem is also that companies also used to pay more for their workers to go to training classes, but now that financial burden needs to be borne by either the workers or government training programs. Perhaps a more efficient use of the unemployment benefits should be in the form of money for taking classes.
Stiglitz also makes a good argument that since the recession was caused by a bubble in the financial and housing markets, there is no reason that people in other sectors should be taking the hit for it, especially since real wages for the middle class have been stagnant. Income disparity has been growing the United States, implying that some have gotten rich at others' expense. The fact that the financial industry has pretty much recovered since the crash means that those who benefited are likely to keep their gains and will likely gain further since others are being pressured to take lower paying jobs.
While an obvious solutions seems to be to stop unemployment benefits, it may be a short-sighted thing to do. Stiglitz encouraged extending unemployment benefits because stopping or even reducing them would make reduce consumer spending and increase foreclosures, so even if those people got lower paying jobs, there may not be a net aggregate benefit to the economy. It may arguably help reduce government expenditures, but it may also make things worse by reducing state and local revenues.
Another obvious need is to improve the skill level of the labor force by investing in education. However, this is expensive, and I think part of the problem is also that companies also used to pay more for their workers to go to training classes, but now that financial burden needs to be borne by either the workers or government training programs. Perhaps a more efficient use of the unemployment benefits should be in the form of money for taking classes.
Stiglitz also makes a good argument that since the recession was caused by a bubble in the financial and housing markets, there is no reason that people in other sectors should be taking the hit for it, especially since real wages for the middle class have been stagnant. Income disparity has been growing the United States, implying that some have gotten rich at others' expense. The fact that the financial industry has pretty much recovered since the crash means that those who benefited are likely to keep their gains and will likely gain further since others are being pressured to take lower paying jobs.
Saturday, August 7, 2010
Repeal Bush Tax Cuts
Greenspan has come out in support of repealing the Bush tax cuts. Then again, should he still have an credibility left since he was wrong about the 2008 crash? Oh well, maybe he's seen the error in his ways.
In the meantime, the new Republican star Paul Ryanhas a Roadmap for America that Krugman exposes as "flimflam." Maybe people need to use more charts and visuals when discussing things like the budget and tax policy because numbers that don't add up should be easily exposed and thrown out.
In the meantime, the new Republican star Paul Ryanhas a Roadmap for America that Krugman exposes as "flimflam." Maybe people need to use more charts and visuals when discussing things like the budget and tax policy because numbers that don't add up should be easily exposed and thrown out.
Wednesday, July 14, 2010
Volker Admendment in the Financial Reform Bill
Article on Volker and his Rule. Volker was the Fed Chairman under Carter and Reagan before Greenspan. He was ousted by Reagan partly because he wouldn't go along with the deregulation agenda. He now regrets not speaking out more against the deregulation but notes that it's very difficult to be against deregulation while things seem to be going so well, although now we know it was a bubble. Such is the positive feedback nature of bubbles.
Friday, May 21, 2010
Tuesday, April 20, 2010
Derivatives should not be allowed
Except in engineering. Haha
Some good pieces explaining what are CDO's.
Origins of the Financial Crisis
CDO Squared Senior Tranche
Goldman Sachs is getting sued by the SEC for fraud. That's kind of exciting.
Some good pieces explaining what are CDO's.
Origins of the Financial Crisis
CDO Squared Senior Tranche
Goldman Sachs is getting sued by the SEC for fraud. That's kind of exciting.
Friday, December 26, 2008
10 milluyn n unmarkd billz plz
lolFED
Too much text, not enough pictures. Haven't read anything yet, just browsing images, but some pretty funny stuff. The older ones are better on average, I think.
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