The lessons of subprime turmoil
Posted on November 30, 2007 by Richard Beddard
Filed Under Investing |
It’s human nature to push the boundaries of regulation in search of profit - which is why bankers seek to reduce the amount of (expensive) capital they must hold as insurance against a fall in the value of their assets.
It’s also why agents’ interests conflict with investors’:
Think about the manager of a pension fund who is looking for a place to put some cash.
Rules, both governmental and institutional, restrict the choices to high-rated fixed-income securities. The manager finds some AAA-rated bond that has a slightly higher yield than the rest. Because of differences in liquidity risk, for example, one bond might have a yield that is 20 or 30 basis points (0.30 or 0.30 percentage points) higher. Looking at this higher-yielding option, the pension-fund manager notices that there is a very slightly higher probability of a loss. But, on closer examination, he sees that this higher-yielding bond will only start experiencing difficulties if there is a system-wide catastrophe. Knowing that in the event of crisis, he will have bigger problems that just this one bond, the manager buys it; thereby beating the benchmark against which his performance is measured.
Professor Cecchetti says there’s no way to stop this:
Detailed regulations are a guide for how to legally avoid the spirit of the law. And the more detailed the rules, the more ingenious the avoidance. This brand of ingenuity is very highly rewarded, so I am sure these strategies will continue.
He recommends that individuals demand more and better information:
As individuals we should adhere to the same principle that President Ronald Reagan followed in agreements over nuclear weapons with the Soviet Union: Trust, but verify.
But, judging by Professor Cecchetti’s example, verifying your fund manager requires sound financial judgement even once you’ve got the information you need. Assuming you’re capable of that, there is another way to ensure you aren’t investing in some spivvy SIV (Special Investment Vehicle). That is to choose the investments yourself, where you can.
That notion brings to mind another American ‘B’ movie actor, David Duchovny, star of the X-Files. The film’s tag line was Trust No One. But that’s paranoid. Trust yourself is more like it.
Comments
Leave a Reply
