Managing Risk On Wall Street

Wall Street is in the business of breaking up business financing so that those who have a low tolerance for risk face little risk, while those who have a high tolerance risk take greater risk in exchange for the possibilty of greater returns.

This seems to be working as intended, without new federal regulation or any massive bailouts.

Shareholders of collapsed institutions have generally lost 95% or more of their investment valued at the market peak about a year ago. Subordinated bondholders appear to have taken a beating. Ordinary bondholders may see delayed payments and not receive all promised interest, but are unlikely to lose a large percentage of principal in these collapses. Just one small money market fund appears to have fallen below the 100% return of principal mark, even though many have had subpar returns on investment. No FDIC insured deposit has gone unpaid, and the FDIC has not had to seek additional funding despite a large number of bank failures.

Even in the area of mortgage backed securities, the duty of the originating and underwriting parties to compensate buyers for excessive defaults has largely left sloppy underwriting originators bankrupt. The line of business that created the crisis, subprime lending, no longer exists. The investment banks that played a leading role in securing funds to make bad loans with, and AIG that insured man other investors against default, have collapsed as a result of their bad financial judgment. Whole industries which developed reckless practices are gone, while more prudent industries have managed to stay in business.

Certainly, relatively innocent parties have been hurt, particularly non-executive employees laid off through no fault of their own and investors in prudent business who have seen their investments fall in price due to general market panic. Meanwhile, the executives who were behind some of these schemes seem to have gotten fat bonuses while seeming to escape responsibility for business failures for now. Some of those executives may face later investigations, be forced to forfeit or return some or all of their bonuses, and may have been heavily invested in the now worthless securities of their companies. But, one suspects that many will have swiftly diverified money taken out of their companies in good times and will weather the financial crisis well.

Critics of the WaMu buyout rightly note that there doesn't appear to have been competitive bidding, so the FDIC was permitted to play favorites between the remaining fiscally solvent large national banks that were interesting in buying the assets. But, securing justice between big commercial banks for the benefit of shareholders and subordinated bondholders in an investment known to be high risk seems like a low priority relative to stability and certainty for customers and protecting the federal government from having to bail out the FDIC.

By and large, the most culpable financial institutions have been promptly punished financially, and the highest risk investments have suffered most, while financial institutions with less culpability, and investors that chose safer investments, seem to have fared better. Where there have been bailouts, shareholders seem to have salvaged part of an investment that would otherwise have been wiped out, and subordinated bondholders seem to have come out much better than they otherwise would have, but shareholders and the many investors who sold out in the face of impending collapse have still lost much of their investments.

While some of the failures, like Bear Sterns and Lehman Brothers have been rather sudden, others, like Washington Mutual, have been expected for months allowing diligent risk intolerant investors to bail out and preserve some of their investment.

Yes, the stock market generally has slumped. But, so far, we have seen declines in stock prices not atypical of a bear market, and bear markets have happened regularly over the years.

Even at the individual loan level this seems to be the case. Fixed rate conventional loans have continued to have extremely low default rates throughout the financial crisis. Those loans that have gone bad, particularly subprime adjustable rate loan with small downpayments, were clearly the highest risk loans being made in the mortgage market.

Housing prices have slumped, but only after a couple of years of increasingly stark warnings from some participants in the national economic discussion that the housing market was in a bubble at risk of collapsing in some areas.

In short, while clearly Wall Street's existing institutions were broken, it isn't obvious that the overall system of allocating risk, and the basic regulatory structure is as deeply out of whack as it may seem. There may need to be some tweaks, but any reform should build on the current system's tendency to direct financial consequences to the investors who took foreseeable gambles that went bad.