QOTD

Christine Hurt at The Conglomerate:

[I]s the 2008 financial crisis going to be a risk story or a fraud story? I think this is important because it is going to drive the regulation that will inevitably follow. The 2001 scandals were fraud stories, and SOX is basically an anti-fraud statute that re-allocates responsibility for fraud and tries to prevent fraud. SOX does not address risk-taking directly, although some make the argument that SOX stifles risk-taking.

I would argue that at least given what we know now, the 2008 financial crisis is a risk story. Different individuals and firms underassessed the risk of certain financial transactions and products. Homebuyers underassessed their ability to refinance mortgages and the potential appreciation of their homes; mortgage lenders underassessed the potential appreciation of collateral and credit risk; mortgage asset-backed security buyers underassessed the risk of those products; financial firms entering into credit default swaps to hedge the risk of those products underassessed counterparty risk; and so on. Although the system was meant to reduce overall risk of mortgage lending, the system could not withstand the shock to its system when housing prices fell. (Think of it as all the nation's insurers selling hurricane insurance, and then several hurricanes hitting at once. And, unfortunately, those insurers weren't regulated and required to maintain reserves.) If this is just a risk story, then regulation just needs to backstop the risk for these "perfect storm" "once in a century" types of shocks. Some risk stories don't even need regulation -- think of the "take or pay" cases from the 1980s between pipelines and producers of natural gas who never envisioned that demand would be less than supply of natural gas.

But of course, risk stories don't sell. They don't sell to the media, the regulators, the investors or the voting public. Surely mispricing of risk couldn't cause this collapse, could it? If we're going to put $700 billion into fixing the system, then the problem has to be as big as the cure. In other words, the bailout only sells if there is a fraud story. Our markets are efficient, and efficient markets price risk well, if not perfectly. If there was mispricing of risk, that must have been because there was fraud in the system.