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Understanding what happened

Posted By Russ Roberts On May 21, 2009 @ 6:05 pm In Financial Markets | Comments Disabled

I am scheduled to interview Riccardo Rebonato tomorrow for EconTalk. His book, Plight of the Fortune Tellers [1] is one of the best things I've read about the crisis. Maybe the best. Written before the crisis, Rebonato warns of the dangers of the techniques being used at the time by both firms and regulators to assess the riskiness of their portfolios. He has a lot to say about probability, risk, and the seductive romance of the ill-suited applications of advanced mathematics. Best of all, it's very well-written and though at times, very ambitious, it is always accessible to the non-practitioner.

He has a fascinating discussion of "economic capital," the amount a firm would hold on its own to avoid the risk of bankruptcy. He argues that firms will hold too little capital because they will rationally ignore the spillover effects a collapse of their firm would have on other insititutions, so-called systemic risk. But a firm doesn't want to go bankrupt. It may take too much risk and end up bankrupt anyway.

Rebonato also points out that bondholders and stockholders have different goals for the firm. Bondholders want enough profitability to get their money back but do not share in any upside risk. Stockholders generally wnat more risk even though there is the risk of bankruptcy. For a naif like myself, this raises the question of why these institutions have both stakeholders with such conflicting goals. And the managers in these publicly traded companies would seem to have different goals as well.

A few semi-random questions, a few of which I hope to ask Rebonato tomorrow.

If it's hard to assess risk, and therefore hard for regulators to specify what is "enough" capital, how would an unregulated firm choose economic capital to reassure bondholders and stockholders that their firm is a good risk?

Why did firms choose such radically different levels of riskiness when they faced similar constraints?

Some people argue that the reason firms took on so much risk was because they were publicly traded. Didn't investors know about the moral hazard problem?

Was "too big to fail" an important, crucial, or irrelevant factor in the risk profiles these firms ended up with?

What role does mark-to-market play in risk assessment?

How did the ratings agencies distort choice if at all? (He seems to think it did.)

How much did Basel II distort choice, if at all? (He seems to think it did.)

Rebonato also observes that the 1990s reduced profit margins because of increased competition, encouraging innovation as a way to achieve yield. That's generally good. But Rebonato implies that firms continued to take bigger and bigger risks as a way to sustain yield. Why didn't self-regulation slow or stop this?

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[1] Plight of the Fortune Tellers: http://www.amazon.com/Plight-Fortune-Tellers-Financial-Differently/dp/0691133611/ref=sr_1_1?ie=UTF8&s=books&qid=1242942477&sr=8-1/invisiblehear-20

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