Long-Term Investment
FT special insert on long-term investment featuring interviews by John Authers with 3 Nobel Laureates.
Selected excerpts relating to securitisation [ 'tis a british publication]
Joseph Stiglitz on securitisation
JA: A critical issue for fund managers at the moment is the ongoing credit crisis. How do you explain what has happened?
JS: I totally predicted this. Securitisation was pushed because of its advantages in risk diversification. But I emphasised in some of my work on securitisation that you have to offset that advantage with the awareness that you are creating an agency problem. And you are creating a potential for asymmetries of information.
In the old days, it was the banks that originated loans and kept the loans. But once you went to securitisation you created the possibility of the originator having different information from the buyer. Not only is there information asymmetry but in this context there are perverse incentives. The originator has an incentive to provide distorted information. The buyers should have been aware of this, but it’s quite apparent that they weren’t as aware of this as they should have been.
This was partly because they bought into the notion of risk diversification – they thought they didn’t need to worry about it because of the law of large numbers. But the law of large numbers says only that you don’t need to worry about a single one; you do need to worry about systemic risks. And securitisation helped create systemic risks.
Moreover, securitisation made restructuring loans (when the borrower couldn’t repay) difficult, if not impossible. In the old days, when the bank originated the mortgage and kept it, when its customer ran into difficulties, it was a much easier matter to restructure. With mortgages sliced and diced, spread among dozens, perhaps hundreds, of “investors”, restructuring is virtually impossible (and made more difficult by some of the provisions in the loan agreements). That’s why the expectation is that there will be 1.7m foreclosures in the coming year – or more. And this will reinforce the downward spiral in the housing market; forced sales will drive down prices.
JA: So can securitisation continue in its current form? What does it take to sort out this mess?
JS: At a minimum, it requires greater transparency. For American financial markets, this is the third scandal in 20 years. And that should itself be telling a story. They’ve gone from one scandal to the next with booms in between each one, and moving from one market to another. It highlights the need for stronger regulation, the importance of asymmetric information, and the role of greed in financial markets.
In the scandals of the late 1990s and in this scandal, there were elements of informed parties taking advantage of the less informed. In this crisis, there’s a clear issue of predatory lending. That’s an underlying problem and the most important social aspect of this.
Robert Engle on securitisation
JA: Why are people surprised by this? [ volatility, credit crisis ]
RE: I would say there are three reasons. First, the historical data that’s used for risk management is too short to cover any other housing recession we’ve had. If you look at historical data it looks like it couldn’t have happened. Even in the early 1990s, there was very little subprime lending. That’s not going to give you good information. We’ve only seen a good housing market over the last eight years, and that’s how we are estimating defaults.
Second, there were a lot of lax lending procedures. And third, and most interesting, all those loans are securitised and it’s very difficult to know how risky they are. Rating agencies and investors have got them wrong. Analytic models that are used to price the tranches of securitised loans are really not adequate to reveal the risks. And so investors all over the world have taken a large amount of what they think of as sterilised subprime loans. But they aren’t. They would take on the senior tranches and a few extra basis points for what turned out to be fairly large risks.
JA: Does that mean we will see less securitisation in future?
RE: I think the securitised markets serve a very important function. They spread risks. I think they are here to stay. Possibly it will be less important. Certainly, I think everyone from rating agencies to investors are struggling with how they understand what they’ve seen and how they build better models for rating these things.
I don’t think that means that these kinds of securitisation will go away. They serve a very important economic function. But they lulled many people into taking a risk. That’s a little reminiscent of 1987, with portfolio insurance.
JA: Do you think behavioural finance, which looks at ways in which people are systematically irrational, could explain what has happened?
RE: I’m not convinced you need behavioural explanations to understand what’s happening. I think that they are particularly relevant for unsophisticated investors. But I think that within these investment banks, pension funds and so forth, people are making decisions on rational grounds which happen to be wrong. They were inaccurate models. That’s bound to happen.
Vernon Smith on index funds
JA: Could it have consequences for the way fund managers manage money?
VS: I don’t know that we can be sure of what those are. But I can give you some examples. Suppose I want to put money into index funds. An index is computed from the prices of individual stocks. If everyone is putting money into index funds [as would likely be the case in many proposed default options], where do the prices come from? Who’s discovering the prices and determining them?
Index funds just free-ride on the decisions of whoever is buying and selling individual stocks. Suppose this is wildly successful and we have a lot more offerings and then apparently individuals are relying upon others in these programmes to invest for them. So what happens to fund managers’ performance if they’ve got easy money coming in?This could weaken the process for allocating capital. All I’m trying to do is get people to think about potential negative consequences.
JA: Do you have examples of other public policies that have had unintended consequences for individual behaviour?
VS: Yes. Often, we introduce some changes in policy and implement them and then we find out there are some changes in the world as a result of the policy that we didn’t anticipate. My work has to do with looking at markets and how they might be affected by some kinds of policy. In experiments, you get a chance to see how people react.
The big example that we found was that welfare programmes caused people to structure their family differently. Welfare aid to families provided incentives for male heads to separate, creating female heads of existing and new households.
Not to be missed: Universities are at the forefront of the theory and practice of long-term investing in Lessons from academe by John Authers