The Investor Problem


Two quotes from Barney Frank talking to Ezra Klein:

What’s the most important part of financial regulation?

Limiting securitization. I believe the single biggest issue here is that people invented ways to lend money without worrying if they got paid back or not by securitizing the loan. When I was younger, the theory was if you had a high risk tolerance, you went into stocks. If you were safe and stodgy, you bought debt. But debt became the volatile aspect here.


One theory of the crisis is that the problem wasn’t traders and their high tolerance for risk. It was people fooling themselves into thinking this stuff was safe by slapping a triple-A rating on everything.

I agree; the theory has always been that people bought debt because it was safer. The basic problem was that 30 years ago when people lent other people money, they expected to be paid back by the people they lent money to. So they were very careful. Two years ago, most loans were being made by people who were going to sell those loans to other people and didn’t expect to be paid back.

This relates back to what I was saying about executive compensation. It’s true that the compensation schemes prevailing at many financial institutions seemed to involve bad incentives, but the real issue is why didn’t the market sort that out? Why don’t investors demand to be working with firms whose key employees don’t face those incentives? And similarly with securitization. The mysterious thing isn’t that people made bad loans that they were able to package and sell off, the mysterious thing is that they found buyers for the securities.

Ultimately this looks to me to go back to the ratings agencies, an issue Frank sort of dodged. But the ratings agencies are private for-profit companies that also enjoy a kind of government-sponsored monopoly status. In theory their behavior should be subject to market discipline, but in practice it’s not. They screwed up badly. But while lots of companies have gone bankrupt and lots of people have lost their jobs, the ratings agencies are all still in business. And no new competitors are coming to the fore and there’s no real way for anyone to break into the industry.