Fundamental drivers of our current economic problems

[patientrenter]

There’s a great article in the Financial Times about one fundamental driver of many of our recent economic problems. It’s a bit subtle, so it’s not as exciting as “it’s all the rich fat bankers’ fault”, or “it’s all the feckless borrowers’ fault”, or “it’s all the fault of the Reublicans/Democrats”, but I think it’s a key driver, and worthy of a lot more attention from us and our economic and political leaders.

http://www.ft.com/cms/s/0/629fe44e-366e-11de-af40-00144feabdc0.html

It may be behind a firewall, so I will excerpt it here. I don’t know the fair use rules, so I will try to compensate for any abuse by saying that the author, John Authers, is consistently excellent in his analysis of the financial markets. I subscribe to the FT partly because I appreciate his insights.

“The heavy cost of the principal-agent divide
By John Authers
Published: May 1 2009 18:47 | Last updated: May 1 2009 18:47

Few of us interact directly with financial markets. We have agents to do it for us – brokers, insurers, pension funds and the rest.

When we invest or borrow, we are at least one remove from the producer. The person who decides to lend you a mortgage will not bear the risk of your failing to repay it. Instead, that risk is securitised and sold in the form of a bond on the securities market.

It makes sense for economic principals to appoint agents to work for them. Most of us have better things to do with our lives than worry about the details of financial products.

But the splitting of principal and agent over the past few decades has exacerbated the financial problems that now bedevil us. Most obviously, this affects mortgage lending. The people who authorised “toxic” subprime mortgages in the US did so knowing that they would not have to bear the risk. They had an incentive to lend as much as possible but not to ensure that as much money as possible came back.

Meanwhile, the people who ultimately bore the risk, such as big banks and insurers, never had the discipline of looking into the eyes of their borrowers. This might have helped. In its origins, the mortgage industry revolved round debt collectors visiting borrowers in person.

Principal-agent problems also apply to investing. For much of stock market history, most shares were held by individuals. Stock brokers, with their own incentives, intruded into buying decisions but there was still a direct connection between shareholders and the companies they owned.

As recently as 1980, three-quarters of shares in the US, the world’s biggest stock market, were held by individuals. But that changed with the growth of big institutions, particularly mutual funds in the US.

Mutual funds had incentives that diverged from those of the ultimate shareholders. These divergences were slight but they had significant effects.

Michael Mauboussin of Legg Mason Investment Management points out that the outperformance of smaller companies in the US, which had persisted for decades, came to an end at about the time that large mutual funds took over as the main investors in the early 1980s. From then until 2000, such institutions roughly doubled their share of the market.

Dealing costs are cheaper for big companies, which can also be researched more cheaply. And they looked undervalued. Big mutual funds could not buy enough shares in small companies to have an impact on their portfolio without amassing controlling stakes. And so, Mr Mauboussin points out, the rise of the mutual fund co-existed with the dramatic outperformance of large-cap stocks seen in the chart.

Once the internet bubble burst in 2000, the baton passed from mutual funds to unregulated hedge funds. They had fewer assets than mutual funds but they could invest using borrowed money. With leverage cheap for much of this decade, this meant that hedge funds wielded far more buying power each day than their regulated counterparts. By 2007, Mr Mauboussin says, they accounted for about 3 per cent of global equity holdings, but between 30 and 40 per cent of daily trading on Wall Street.

Where did they invest? Mostly in smaller stocks. Again, this had much to do with the interests of the hedge funds themselves. They spotted value in small caps and they were small enough to be able to exploit it. And as the chart shows, smaller companies started outperforming once hedge funds took over as the biggest investors.

With leverage no longer plentiful, it is now not clear which institutions have the greatest buying power.

When it comes to funds that are managed passively, merely tracking an index, the principal-agent problem meets a collective action problem. For individuals, it often makes overwhelming sense to buy an index fund. They have much lower costs than actively managed funds and over time this means they are highly likely to outperform them.

But an index fund has no interest in the behaviour of the management of the companies it owns. It will keep holding the company in proportion to its weight in the index regardless of whether managers act in shareholders’ interests.

So the growth of indexation has weakened the control shareholders exert over companies’ managements. That in turn allowed managers to behave more and more as though they owned the companies. Chief executives, maybe even more than most of us, tend to be overconfident.

This is most true of investment banks, which were once partnerships – where bankers making decisions on what risks to take were also owners. By the time the crisis hit, most investment banks were public companies. The bonus system gave managers an incentive to boost short-term profits.

Thus it begins to look, as though the gradual split of principals from agents at all levels of finance has been a big factor in the financial disaster of the past two years. This is among the many problems to be solved as the world’s financial architecture is redesigned.

Meanwhile, there is money to be made by those who can identify the most powerful investors and understand the incentives confronting them.

[email protected]

Copyright The Financial Times Limited”

[davelj]

This is directly related to my post regarding principal-agent incentive issues from March 16:

****************************
I can’t disagree with that. Which reminds me of yet another great quote (this time from Keynes): “Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.”

I think a lot of folks kind of knew in the back of their minds that we COULD be headed for trouble. But, like Chuck Prince – he of “so long as the music’s playing we have to dance” fame – there are too many financial jobs that are evaluated and compensated based on short-term performance measures. In other words, it simply pays too well to fail conventionally as things are currently structured.

I like Jim Grant (of Grant’s Interest Rate Observer), for example, but Jim would have been fired from running a bank back in 1998 for being unwilling to underwrite loans. (He’s unconventional, you see.) This “dancing” issue is a huge problem because (1) everyone presumes they’ll be able find a chair when the music stops, and (2) you get fired if you stop dancing too soon.

Anyhow, on a related issue, we obviously need regulatory overhaul with the banks, etc. But what we REALLY need – and what’s REALLY at the root of our problems – is a system of misaligned incentives, specifically getting paid in the short-term for instruments that are risky and display a long-term payout.

Mortage brokers getting paid today to underwrite mortgages that would explode later. Lenders getting paid today to underwrite construction loans that would explode later. Traders getting paid today to execute strategies that would explode later. Wall Street securitization desks getting paid today to securitize and sell mortgage securities that would blow up later. Insurance underwriters (think AIG Financial Products unit) getting paid today to underwrite risks that would blow up later.

While we need regulatory changes big time, it’s pretty clear to me that these changes will be all for naught if they don’t address incentives. If we’ve learned one thing from this whole debacle it’s that, for better or worse, people respond to incentives.
***************************

You can’t address principal-agent problems without addressing incentives. They are part and parcel of the same issue.

[davelj]

This is directly related to my post regarding principal-agent incentive issues from March 16:

****************************
I can’t disagree with that. Which reminds me of yet another great quote (this time from Keynes): “Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.”

I think a lot of folks kind of knew in the back of their minds that we COULD be headed for trouble. But, like Chuck Prince – he of “so long as the music’s playing we have to dance” fame – there are too many financial jobs that are evaluated and compensated based on short-term performance measures. In other words, it simply pays too well to fail conventionally as things are currently structured.

I like Jim Grant (of Grant’s Interest Rate Observer), for example, but Jim would have been fired from running a bank back in 1998 for being unwilling to underwrite loans. (He’s unconventional, you see.) This “dancing” issue is a huge problem because (1) everyone presumes they’ll be able find a chair when the music stops, and (2) you get fired if you stop dancing too soon.

Anyhow, on a related issue, we obviously need regulatory overhaul with the banks, etc. But what we REALLY need – and what’s REALLY at the root of our problems – is a system of misaligned incentives, specifically getting paid in the short-term for instruments that are risky and display a long-term payout.

Mortage brokers getting paid today to underwrite mortgages that would explode later. Lenders getting paid today to underwrite construction loans that would explode later. Traders getting paid today to execute strategies that would explode later. Wall Street securitization desks getting paid today to securitize and sell mortgage securities that would blow up later. Insurance underwriters (think AIG Financial Products unit) getting paid today to underwrite risks that would blow up later.

While we need regulatory changes big time, it’s pretty clear to me that these changes will be all for naught if they don’t address incentives. If we’ve learned one thing from this whole debacle it’s that, for better or worse, people respond to incentives.
***************************

You can’t address principal-agent problems without addressing incentives. They are part and parcel of the same issue.

[davelj]

This is directly related to my post regarding principal-agent incentive issues from March 16:

****************************
I can’t disagree with that. Which reminds me of yet another great quote (this time from Keynes): “Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.”

I think a lot of folks kind of knew in the back of their minds that we COULD be headed for trouble. But, like Chuck Prince – he of “so long as the music’s playing we have to dance” fame – there are too many financial jobs that are evaluated and compensated based on short-term performance measures. In other words, it simply pays too well to fail conventionally as things are currently structured.

I like Jim Grant (of Grant’s Interest Rate Observer), for example, but Jim would have been fired from running a bank back in 1998 for being unwilling to underwrite loans. (He’s unconventional, you see.) This “dancing” issue is a huge problem because (1) everyone presumes they’ll be able find a chair when the music stops, and (2) you get fired if you stop dancing too soon.

Anyhow, on a related issue, we obviously need regulatory overhaul with the banks, etc. But what we REALLY need – and what’s REALLY at the root of our problems – is a system of misaligned incentives, specifically getting paid in the short-term for instruments that are risky and display a long-term payout.

Mortage brokers getting paid today to underwrite mortgages that would explode later. Lenders getting paid today to underwrite construction loans that would explode later. Traders getting paid today to execute strategies that would explode later. Wall Street securitization desks getting paid today to securitize and sell mortgage securities that would blow up later. Insurance underwriters (think AIG Financial Products unit) getting paid today to underwrite risks that would blow up later.

While we need regulatory changes big time, it’s pretty clear to me that these changes will be all for naught if they don’t address incentives. If we’ve learned one thing from this whole debacle it’s that, for better or worse, people respond to incentives.
***************************

You can’t address principal-agent problems without addressing incentives. They are part and parcel of the same issue.

[davelj]

This is directly related to my post regarding principal-agent incentive issues from March 16:

****************************
I can’t disagree with that. Which reminds me of yet another great quote (this time from Keynes): “Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.”

I think a lot of folks kind of knew in the back of their minds that we COULD be headed for trouble. But, like Chuck Prince – he of “so long as the music’s playing we have to dance” fame – there are too many financial jobs that are evaluated and compensated based on short-term performance measures. In other words, it simply pays too well to fail conventionally as things are currently structured.

I like Jim Grant (of Grant’s Interest Rate Observer), for example, but Jim would have been fired from running a bank back in 1998 for being unwilling to underwrite loans. (He’s unconventional, you see.) This “dancing” issue is a huge problem because (1) everyone presumes they’ll be able find a chair when the music stops, and (2) you get fired if you stop dancing too soon.

Anyhow, on a related issue, we obviously need regulatory overhaul with the banks, etc. But what we REALLY need – and what’s REALLY at the root of our problems – is a system of misaligned incentives, specifically getting paid in the short-term for instruments that are risky and display a long-term payout.

Mortage brokers getting paid today to underwrite mortgages that would explode later. Lenders getting paid today to underwrite construction loans that would explode later. Traders getting paid today to execute strategies that would explode later. Wall Street securitization desks getting paid today to securitize and sell mortgage securities that would blow up later. Insurance underwriters (think AIG Financial Products unit) getting paid today to underwrite risks that would blow up later.

While we need regulatory changes big time, it’s pretty clear to me that these changes will be all for naught if they don’t address incentives. If we’ve learned one thing from this whole debacle it’s that, for better or worse, people respond to incentives.
***************************

You can’t address principal-agent problems without addressing incentives. They are part and parcel of the same issue.

[davelj]

This is directly related to my post regarding principal-agent incentive issues from March 16:

****************************
I can’t disagree with that. Which reminds me of yet another great quote (this time from Keynes): “Worldly wisdom teaches that it is better to fail conventionally than to succeed unconventionally.”

I think a lot of folks kind of knew in the back of their minds that we COULD be headed for trouble. But, like Chuck Prince – he of “so long as the music’s playing we have to dance” fame – there are too many financial jobs that are evaluated and compensated based on short-term performance measures. In other words, it simply pays too well to fail conventionally as things are currently structured.

I like Jim Grant (of Grant’s Interest Rate Observer), for example, but Jim would have been fired from running a bank back in 1998 for being unwilling to underwrite loans. (He’s unconventional, you see.) This “dancing” issue is a huge problem because (1) everyone presumes they’ll be able find a chair when the music stops, and (2) you get fired if you stop dancing too soon.

Anyhow, on a related issue, we obviously need regulatory overhaul with the banks, etc. But what we REALLY need – and what’s REALLY at the root of our problems – is a system of misaligned incentives, specifically getting paid in the short-term for instruments that are risky and display a long-term payout.

Mortage brokers getting paid today to underwrite mortgages that would explode later. Lenders getting paid today to underwrite construction loans that would explode later. Traders getting paid today to execute strategies that would explode later. Wall Street securitization desks getting paid today to securitize and sell mortgage securities that would blow up later. Insurance underwriters (think AIG Financial Products unit) getting paid today to underwrite risks that would blow up later.

While we need regulatory changes big time, it’s pretty clear to me that these changes will be all for naught if they don’t address incentives. If we’ve learned one thing from this whole debacle it’s that, for better or worse, people respond to incentives.
***************************

You can’t address principal-agent problems without addressing incentives. They are part and parcel of the same issue.

[patientrenter]

Incentives were indeed a very important part of the problem, and potentially a part of the solution.

But this article does go beyond incentives. For example, investor principals exert weak control over company management. My favorite recent example of this is BoA and the Countrywide and Merrill acquisitions. I had very carefully chosen BoA as my stock for the “TBTF bank” category, because I thought it was the least tainted by risky home loans. That changed with C’wide and then Merrill, but real BOA investors (not the mutual fund managers supposedly acting in their interest) had no control over those transactions. They should have. Changing the system so that CEOs must get permission from their shareholders for major transactions would help enormously. And there must be a way to get mutual fund managers and other agents to have less influence than ultimate shareholders – real principals.

Institutional money managers have added a certain incremental value to the system, by enabling better diversification for small investors, but they may have subtracted more value in the aggregate by letting public company management become far less answerable to the ultimate investors.

[patientrenter]

Incentives were indeed a very important part of the problem, and potentially a part of the solution.

But this article does go beyond incentives. For example, investor principals exert weak control over company management. My favorite recent example of this is BoA and the Countrywide and Merrill acquisitions. I had very carefully chosen BoA as my stock for the “TBTF bank” category, because I thought it was the least tainted by risky home loans. That changed with C’wide and then Merrill, but real BOA investors (not the mutual fund managers supposedly acting in their interest) had no control over those transactions. They should have. Changing the system so that CEOs must get permission from their shareholders for major transactions would help enormously. And there must be a way to get mutual fund managers and other agents to have less influence than ultimate shareholders – real principals.

Institutional money managers have added a certain incremental value to the system, by enabling better diversification for small investors, but they may have subtracted more value in the aggregate by letting public company management become far less answerable to the ultimate investors.

[patientrenter]

Incentives were indeed a very important part of the problem, and potentially a part of the solution.

But this article does go beyond incentives. For example, investor principals exert weak control over company management. My favorite recent example of this is BoA and the Countrywide and Merrill acquisitions. I had very carefully chosen BoA as my stock for the “TBTF bank” category, because I thought it was the least tainted by risky home loans. That changed with C’wide and then Merrill, but real BOA investors (not the mutual fund managers supposedly acting in their interest) had no control over those transactions. They should have. Changing the system so that CEOs must get permission from their shareholders for major transactions would help enormously. And there must be a way to get mutual fund managers and other agents to have less influence than ultimate shareholders – real principals.

Institutional money managers have added a certain incremental value to the system, by enabling better diversification for small investors, but they may have subtracted more value in the aggregate by letting public company management become far less answerable to the ultimate investors.

[patientrenter]

Incentives were indeed a very important part of the problem, and potentially a part of the solution.

But this article does go beyond incentives. For example, investor principals exert weak control over company management. My favorite recent example of this is BoA and the Countrywide and Merrill acquisitions. I had very carefully chosen BoA as my stock for the “TBTF bank” category, because I thought it was the least tainted by risky home loans. That changed with C’wide and then Merrill, but real BOA investors (not the mutual fund managers supposedly acting in their interest) had no control over those transactions. They should have. Changing the system so that CEOs must get permission from their shareholders for major transactions would help enormously. And there must be a way to get mutual fund managers and other agents to have less influence than ultimate shareholders – real principals.

Institutional money managers have added a certain incremental value to the system, by enabling better diversification for small investors, but they may have subtracted more value in the aggregate by letting public company management become far less answerable to the ultimate investors.

[patientrenter]

Incentives were indeed a very important part of the problem, and potentially a part of the solution.

But this article does go beyond incentives. For example, investor principals exert weak control over company management. My favorite recent example of this is BoA and the Countrywide and Merrill acquisitions. I had very carefully chosen BoA as my stock for the “TBTF bank” category, because I thought it was the least tainted by risky home loans. That changed with C’wide and then Merrill, but real BOA investors (not the mutual fund managers supposedly acting in their interest) had no control over those transactions. They should have. Changing the system so that CEOs must get permission from their shareholders for major transactions would help enormously. And there must be a way to get mutual fund managers and other agents to have less influence than ultimate shareholders – real principals.

Institutional money managers have added a certain incremental value to the system, by enabling better diversification for small investors, but they may have subtracted more value in the aggregate by letting public company management become far less answerable to the ultimate investors.

[CA renter]

Both are excellent posts. Agree 100% with this being the problem.

[CA renter]

Both are excellent posts. Agree 100% with this being the problem.

[CA renter]

Both are excellent posts. Agree 100% with this being the problem.

[CA renter]

Both are excellent posts. Agree 100% with this being the problem.

[Author]

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