Charles Calomiris illuminates what really happened in subprime.
To begin with, he notes that the crisis, rather than being a surprise, was the quite expected result of investors’ unrealistic assumptions about risk of loss. Calomiris notes that rating agencies expected 4.5%-6% losses on subprime mortgage-backed securities pools. Independent analysts knew these were way too low. This assumption enabled financing at indefensibly high ratings, and therefore low rates.
These numbers were based on experiences during 2000-05 when there happened to be a dramatic rise in housing prices, which affected both the number of and losses from defaults. Experts could have sharpened their forecasts by looking at business cycles, rather than focusing on a narrow range of dates that could not provide useful guidance about the future. And it stands to reason that if the industry makes drastically more subprime loans, the quality of the borrowers will decline and expected losses will rise, as did, in fact happened.
Of course, the rating agencies and institutional investors were all in on this. But as Calomiris says
they were all investing someone else’s money and earning huge salaries, bonuses, and management fees for being willing to pretend that these were reasonable investments. And furthermore, they knew that other competing asset managers were behaving similarly and that they would be able to blame the collapse (when it inevitably came) on a surprising shock. The script would be clear, and would give “plausible deniability” to all involved. “Who knew? We all thought that 6% was the right loss assumption! That was what experience suggested and what the rating agencies used.”
Calomires also points to various regulatory policies that helped this disaster along, particularly including the great power delegated to the ratings agencies, SEC anti-notching rules that encouraged ratings inflation, rules that discouraged banks from holding junior tranches in their securitizations (by raising minimum capital requirements for banks that did this).
But as Calomires points out, one set of investors did better than all the others – hedge funds. Now why would that be? Because, he says, their managers’ fees based on profits (and, I would add, their own substantial investments in their funds) aligned their interests with those of their investors. They couldn’t afford to simply herd with the others – they had to actually pay attention to reality.
Calomires notes that hedge fund managers are not subject to the regulation that applies to mutual fund managers, who get paid according to how many customers they can suck in rather than their funds' returns. As Calomires says:
Because hedge fund compensation structure is not regulated, and because both investors and managers are typically highly sophisticated people, it is reasonable to expect that the hedge fund financing structure has evolved as an “efficient” financial contract, which may explain the superior performance of hedge funds.. . .
Managers who gain from the size of their portfolios rather than the profitability of their investments will face strong incentives not to inform investors of deteriorating opportunities in the marketplace and not to return funds to investors when the return relative to risk of their asset class deteriorates.
Readers of this blog will already see where I’m headed with this. This story directly supports what I have been saying about the advantages of what I call partnership, or “uncorporate,” governance structures that involve not only high-powered owner-like compensation, as Calomires stresses, but also distributions to owners and limited term of the fund, both of which tend to expose managers to capital market discipline. See my Uncorporating the Large Firm, which discusses the use of these structures in several types of firms, including hedge funds.
I argue that these devices can be superior to the sort of monitoring structures that publicly held corporations and other firms governed on the corporate model typically rely on. So we see that all of the so-called independent directors in the world and the other trappings that are considered so essential to the modern corporation did not stop a huge segment of the investment industry from deliberately ignoring reality, and causing vast dislocations as a result. Yet despite this, as I show in my article, there is still a bias against uncorporate structures in large firms.
The story of the subprime bust is yet another reason why we cannot afford to overlook the importance of governance to the economy, and to remain blind to alternatives to a governance orthodoxy that continues to lead us astray.
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