Narratives of Knowledge and Arrogance
By Arnold Kling
Early in the crisis, we were hearing that banks knew that the loans they were making were headed toward foreclosure. That was what the bank executives wanted–to take people’s houses. That narrative is no longer operative.
Now, a popular narrative seems to be that executives knew that they were accumulating toxic assets, but they could hide the truth from shareholders and meanwhile loot their companies with bonuses and golden parachutes. Or that they knew that a government bailout was in the offing, a proposition that I discussed yesterday.
Finally, there is the notion that officials knew that credit default swaps belonged on an organized exchange, but chose instead to let the four-year-olds play with fireworks. If you believe that counterparty risk was the main problem with CDS, then maybe that’s right.
I actually think that there were much larger risks at work in the whole concept of CDS. To have a viable market with an organized exchange, you need natural sellers as well as natural buyers. For example, with oil futures, natural buyers are airlines seeking to hedge the cost of flights that have already been sold. The natural sellers are producers seeking to hedge commitments to incur cost to deliver oil.
With CDS, the natural buyers of protection against a bond default by XYZ corporation are the owners of bonds issued by XYZ. And the natural sellers of protection are…who, exactly?
Instead, you have unnatural sellers, whose only mechanism to back their bets is to go out and short the bonds of XYZ as the probability of default starts to increase. That strategy blows up in the aggregate.
To me, that suggests that an organized exchange in CDS would not solve the problem. The exchange itself probably would blow up due to widespread “fails.” Or else, if its rules were strict enough, the exchange would force an even faster blow-up of the companies on which CDS were traded, as the sellers of CDS rush to short the securities of those companies.
My narrative is focused on arrogance, not knowledge. I don’t tell a story of villains who took advantage of what they knew. I tell a story of executives who thought they knew more than they really did.
The kicker in my narrative of arrogance is that I believe that people in Washington are even more arrogant than people on Wall Street (actually, a lot of them are the same people, working in different offices). If the issue is evil, then transferring power to Washington might help alleviate the problem. But if the issue is arrogance, then transferring power to Washington might serve to exacerbate the problem.