One of the factors that has never been blamed for the sub-prime fiasco is competition.
That is obvious because competition is considered the foundation of the free-market system, and hence criticizing competition is equal to challenging the market itself.
Competition is thought to lead to better products/services, which is assumed will lead to a better society, or at least a more efficient economy.
Competition is never thought to be a market destroying culprit. This is heretical.
Questioning the utility of a competitive market will naturally lead to calls for more regulation - an absolute anathema to the free-market.
So, market participants have an incentive to avoid the elephant-in-the-room.
Let's take a recent example.
The falling standards of mortgage-approval were a direct result of increasing competition.
As more mortgage-players entered the market, customers became a hot property. And in order to secure more customers, lending-standards were lowered. And they were lowered to such an extant that the ability to repay the debt was forgotten.
The mortgage companies were able to ignore the loan-worthiness of the debtors because they never expected to be paid by them - they expected to be paid by those funds and investors who would buy these packaged loans in the form of Mortgage-Backed-Securities (MBS), Collateralized-Debt-Obligation (CDO), etc.
Once these mortgages were packed into an instrument, all that the manager had to do was get a sufficiently high rating from a rating agency to justify a good return for the company and a good bonus for himself, and everybody could go home happy via a short stop at the bank.
The rating agencies had their own perverse incentive system - but that's another post.
Higher competition (for more customers) led to lower standards - which ultimately led to the blow out in the markets.
Had competitive pressures not been high, it is conceivable that the markets would not have suffered a collapse.
Friday 27 June 2008
Perverse Incentive System - I
Perverse incentive management system created the real-estate/sub-prime fiasco
While a lot of attention has been focussed on the 'system-failure'of the financial system and regulation, not enough attention has been paid to the internal management failure in te companies themselves.
Part of the reason is the belief that companies in a free-market have the right to manage their own incentive system. That is true, but it never hurts to do a little introspection.
Fund and investment managers recieve bonuses when the fund(s) they manage beats a given benchmark. The bonus is directly proportional to the percentage of performance over-and-above the benchmark. These benchmarks can be anything like an index, or a given fund, etc.
The need to beat a benchmark propels managers to take on more risk than they normally would. This is where problems come up.
Statistically, some investment opportunities have what is called a 'fat-tail'. In other words, the investment opportunity has -
1) a large possibility of making a small profit, and
2) a small possibility of making a large loss.
The small possibility of making a large loss is a what is called a 'fat-tail' or 'black-swan' event. Because it is a rare event.
In their zeal to raise their returns, investment managers jump at the possibility of making those small gains, and tend to ignore the chance of loss.
And when the rare event of a large does occur, the managers are left holding the sack.
Now, you might wonder why are the managers not smart enough to avoid the problem area. Three reasons - greed, plain bad luck and follow-the-herd.
GREED
Although some managers may avoid the problem, it is not necessary that all would. For some people, the possuibility of making a profit is enough incentive to ignore the chance of a large loss.
PLAIN BAD LUCK
Suppose that the possibility of the loss occurs once in 10 years, and that 9 years of profit have passed. A company investing in the ninth year has a very probability of loss.
Some people just had bad timing to invest at the top of the market.
FOLLOW-THE-HERD
Imagine a manager avoiding the sub-prime market because he thinks the fundamentals are out of order. Now imagine his superior telling him about the money other managers within the company are making, and making continuously. How long would our level-headed manager be able to hold out as his peers get better reviews.
These factors lead to a permissive situation where it is a crime to hold out against joining a band-wagon.
The need to beat the market led managers to take risk more than that justified by the resulting rewards.
While a lot of attention has been focussed on the 'system-failure'of the financial system and regulation, not enough attention has been paid to the internal management failure in te companies themselves.
Part of the reason is the belief that companies in a free-market have the right to manage their own incentive system. That is true, but it never hurts to do a little introspection.
Fund and investment managers recieve bonuses when the fund(s) they manage beats a given benchmark. The bonus is directly proportional to the percentage of performance over-and-above the benchmark. These benchmarks can be anything like an index, or a given fund, etc.
The need to beat a benchmark propels managers to take on more risk than they normally would. This is where problems come up.
Statistically, some investment opportunities have what is called a 'fat-tail'. In other words, the investment opportunity has -
1) a large possibility of making a small profit, and
2) a small possibility of making a large loss.
The small possibility of making a large loss is a what is called a 'fat-tail' or 'black-swan' event. Because it is a rare event.
In their zeal to raise their returns, investment managers jump at the possibility of making those small gains, and tend to ignore the chance of loss.
And when the rare event of a large does occur, the managers are left holding the sack.
Now, you might wonder why are the managers not smart enough to avoid the problem area. Three reasons - greed, plain bad luck and follow-the-herd.
GREED
Although some managers may avoid the problem, it is not necessary that all would. For some people, the possuibility of making a profit is enough incentive to ignore the chance of a large loss.
PLAIN BAD LUCK
Suppose that the possibility of the loss occurs once in 10 years, and that 9 years of profit have passed. A company investing in the ninth year has a very probability of loss.
Some people just had bad timing to invest at the top of the market.
FOLLOW-THE-HERD
Imagine a manager avoiding the sub-prime market because he thinks the fundamentals are out of order. Now imagine his superior telling him about the money other managers within the company are making, and making continuously. How long would our level-headed manager be able to hold out as his peers get better reviews.
These factors lead to a permissive situation where it is a crime to hold out against joining a band-wagon.
The need to beat the market led managers to take risk more than that justified by the resulting rewards.
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