The Financial Abstraction Ladder: The Story of the Global Financial Crisis

It is difficult to get a man to understand something, when his salary depends upon his not understanding it!” — Upton Sinclair

Each rung up the ladder adds complexity

FAL Rung #1: Originate-to-Distribute for Local Mortgages

Let’s start at the bottom of the ladder, with the people responsible for writing the mortgage contracts and assessing the credit quality of borrowers. The incentives placed before local banks originating mortgages offered no positive reinforcement for originating quality loans. In fact, loan originators were paid for just that, origination.

FAL Rung #2: GSEs and Securitization in the Mortgage Market

The securitization of mortgages plays a crucial role in the non-intuitive incentive structures present at each rung of the financial abstraction ladder. Starting in February 1970, the US government began pooling residential mortgages together into a single security called a mortgaged-backed security (MBS).

Source

FAL Rung #3: Originate-to-Distribute of CDOs by Investment Banks

Investment banks are at least partly in the business of issuing creative and complex financial contracts and selling them to buyers. They get paid when they successfully execute a financial agreement between two outside parties. As a result, the same incentive misalignment of originate-to-distribute was at play here that was present at the local origination level.

How Investment Banks used CDOs as a Polishing Agent for Lemons

Rung 3 of the financial abstraction ladder is a critical one because it is here that we first find evidence for the use of financial abstraction as a tool for market distortion. To continue with George Akerlof’s Nobel prize-winning verbiage on information asymmetries, the paint these investment banks used to coat their lemons was the Collateralized Debt Obligation (CDO). CDOs took relatively benign MBSs, divided them up into tranches according to relative default risk and then repackaged them into CDOs.

FAL Rung #4: The Magnetar Trade and CDSs

Before getting into the nitty gritty on rung 4, it’s important to note that while many CDOs were made up of entirely subprime instruments, only a small fraction of the tranches sold out these CDOs were below AAA-investment grade.

What does Magentar tell us about incentives?

In a financial system where extremely complex financial instruments are being bought and sold, information asymmetries will run rampant and the financial incentives of individuals need to be offset by regulation promoting transparency and risk disclosures in the market.

On a final note, everything Magnetar did was totally legal, with no fines or criminal action ever taken against the firm or its employees.

Holding up the FAL: Rating Agencies

A final incentive misalignment is that of the rating agencies responsible for the assessment and classification of securities according to their risk level. In particular S&P and Moody were the two primary ratings agencies responsible for the risk classification of MBS and CDO tranches.

Conclusion

An important question for regulators and social designers is determining the appropriate level of blame to place on the various parties involved in causing the global financial crisis. Are small-time mortgage originators as culpable as the CEOs of investment banks for the role they played in the crisis? Clearly, the importance of the actions of one small mortgage originator pales in comparison to the damage caused by the pedal to the meddle approach to leveraged speculation in the housing market by the CEOs of some major financial institutions.

Stanford B.A. Economics. Former Hedge Fund Manager. Author: God Money (book in progress). Follow me: https://twitter.com/deanofprivacy

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