Thoughts on the root of the crisis

Wed, 30 Apr 2008 06:59:59 -0400

There's been a good deal of hand-wringing about how the vaunted credit crunch we're now suffering through could have happened. It still boggles the mind that a firm like Bear Stearns could go belly up so quickly. A recent column in the New York Times discusses some comments by David Einhorn, of Greenlight Capital, at a recent Grant's Interest Rate Observer event.

Obviously, the top dogs running the top investment banks have incentive to jack up earnings. Like any other corporation, they feel a moral obligation to do this, as it will drive the stock price. That they were willing to use so much leverage to buy lots of securities that are a far cry from Treasury securities is the part that should be surprising. (Then again, the costs of such borrowing were really low.) In a sense, they seem to have taken the simple notion of diversity a bit too far.

On the one hand, it would seem absurd for one to consider high-risk debt, hybrid capital securities, and anything illiquid as part of your capital securing your entire portfolio. But if you diversify away the risk, it seems a lot more palatable. The ratings agencies used a similar line of thought when it rated all those lower CDOs tranches AAA. Obviously, the thinking didn't quite hold when the cards fell.

The Trillion Dollar Meltdown by Charles R. Morris lays the blame for the credit collapse at the feet of the Chicago School of economic thought and its near-cousin, the Modern Portfolio theory, both of which tout diversification as a bedrock principle. Wall Street is grounded in these ideas, which venerates the power of unfettered markets, for better or worse. This, in some ways, is an easy point to make, an easy criticism. Much harder would be to come up with an alternative paradigm.

All this is very big-think of course, and some will consider it of little practical import. Fair enough, but it's worthy of thought. - Jim