Why Do Financial Firms Take Too Much Risk?

Excerpt from John Makin's latest commentary:

The principal/agent problem--where interests of managers of financial intermediaries diverge from those of their shareholders--has been clearly illustrated by the widely publicized cases of Merrill Lynch and Citigroup. Substantial errors in initially reported third-quarter earnings, when revealed, resulted in the "resignation" of the CEOs of both institutions--Stan O'Neal of Merrill Lynch and Charles Prince of Citigroup. For those who review these sad cases, it is tempting, but untrue, to say that financial firms take too much risk because they are managed by foolish people...

The transition from the principal/agent problem, which concerns too much risk at the firm level, to the broader systemic risk problem of moral hazard and the threat of stagflation facing the Federal Reserve is tied to the underlying cause of the problems dogging the CEOs of financial institutions worldwide. The real estate that underlies mortgage-based assets that have been repackaged and releveraged into mortgage-backed securities and distributed worldwide to banks, investment banks, brokerage houses, and even to money market funds is a rotting asset. Its price has fallen in the U.S. market for residential real estate about 5 percent over the past year.

The fundamental problem for the financial sector is twofold. First, the trillions of dollars of subprime mortgages and higher-rated assets tied to real estate were created on the assumption that U.S. home prices do not fall persistently. They had not, until 2007, dropped on a year-over-year basis since the Great Depression. But now they are falling at a 5 percent annual rate. Second, the drop in home prices looks likely to accelerate--probably to a negative 10 percent year-over-year rate or more--meaning that further write-downs will be required on mortgage-based assets...

Answers to the question of why financial firms take too much risk suggest some changes going forward, both at the firm level and at the economy-wide level, to avoid the principal/agent problem and the systemic-risk, moral hazard problem. First, boards of directors of financial firms need to design compensation packages that align the interests of managers closely with those of the shareholders. Second, financial innovation is a good thing, but it needs to be monitored more closely, especially when it leads to a massive magnification of risk attached to aggressive lending that results in a real estate bubble.

Third, lenders who are allowed merely to originate mortgages and then to sell the resulting mortgage contracts into highly complex and highly leveraged packages of securities need to be given incentives to take some of the mortgage risk onto their own books. Fourth, banks should no longer be afforded the luxury of arbitrary model-based valuation of level III assets. Transparency on asset values is essential. ..

Finally, central banks need to reinforce their commitment to stable inflation by refusing to cut interest rates while inflation is rising, even as growth slows sharply.

Comments

[Pj568]

Question as to your "Fourth point" that "banks should no longer be afforded the luxury of arbitrary model-based valuation of level III assets." Just what is the correct way to value assets where there is no market?

[Pj568]

I suspect the PCAOB and SEC have decided there is no single answer to each unique Level 3 asset value or Level 2. They have adopted the "principle's based" accounting methodology that each company has the responsibility to determine that value. The best they can hope for is that appraisal valuation firms and auditors act as adversaries in arriving at stated value. If a company feels like they are being under valued in the market place then their option is to make "fuller disclosures" to convince otherwise.

[Paul Meisel]

Leverage and less than transparent balance sheets have always been issues in properly evaluating the risk and value of companies and assets. The "different" factor here was the combination of overconfidence in the underlying asset -- real estate values -- with the persistence of deterioration, at the same time many intermediaries had become very leveraged in these instruments. Banks and thrifts that tend to own their mortgages do not appear to be experiencing discomfort -- they can tolerate the relatively small, to them, deterioration in collateral.