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Wall Street says Washington doesn't understand finance. Well, neither does Wall Street.

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"What do you get when you cross a Godfather with an investment banker? Someone who makes you an offer you can’t understand."

That's from a talk Paul Krugman gave at the Levy Institute's 19th annual Hyman Minsky conference. The Economist's Ryan Avent also attended and walked away shaking his head. "I think that the most important thing to understand about financial reform is that its dynamics are simply too complicated to lend themselves to good policy," he wrote.

I'd take it a step further: Wall Street has gotten a lot of mileage out of the accusation that the political system simply doesn't understand how Wall Street works. And that's, well, correct. The problem is that Wall Street also doesn't understand how Wall Street works.. That was what caused the financial crisis. Bankers didn't understand the tail risk of collateralized debt obligations. Ratings agencies didn't understand the subprime mortgage market. Alan Greenspan didn't understand the risks posed by derivatives. Robert Rubin, the former co-chair of Goldman Sachs and one of Citigroup's directors, told the Financial Crisis Inquiry Commission that "all of us in the industry failed to see the potential for this serious crisis."

As the 10 percent unemployment rate and hundreds of billions in added government debt will tell you, when Wall Street gets too complicated to understand, bad things begin to happen. But complexity is core to the business of Wall Street. There's a lot of money to be had over there. About 40 percent of domestic profits, in fact. And you get more of that money if no one understands what you're doing. You can dictate terms to your customers, stay ahead of your competitors and confuse your regulators. And then, of course, there's the holy grail: a high-return product that's so complicated that people can't tell where its risks are and so it's treated as if it has no risk at all. That was the market for mortgage-backed securities. The stuff that got a AAA seal of approval -- that is to say, it was considered riskless -- before it crashed the global economy.

That doesn't leave us with many good options. Can we pass a law against complexity? Not really. Can we build a Wall Street where traders will stop trying to amp their profits by inventing new products that no one quite understands but that seem to offer an incredible return on investment? Seems unlikely. Can we build a class of regulators who will know more than Wall Street does about Wall Street's products and will be immune to the pressures of bubbles? Definitely not. Do we have the political will to make the banks smaller or to tell them that they can't borrow so much money or to tax the sector such that this behavior is no longer so lucrative? Doesn't seem so.

Avent says he's developed "a sense of resigned cynicism." Kevin Drum seems less resigned, but more cynical. I'm increasingly where Drum is. The best thing we could do, it seems to me, is slap a significant global tax on financial transactions such that the industry becomes a lot less profitable and these behaviors become less lucrative. It's like anything else: If you want less of it, tax it. But there's no chance that that will happen, either.

Photo credit: Jin Lee/Bloomberg News.

By Ezra Klein  |  April 19, 2010; 9:01 AM ET
 
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Comments

""all of us in the industry failed to see the potential for this serious crisis."

I don't think that's really true. They simply had a huge incentive to collectively ignore common sense. Banks generally understood the terms of the loans they were offering, and the risk of default. But there was a lot of money to be made. Fannie Mae and Freddie Mac promised implicit guarantees of bad loans, because it was "getting people into houses". There was a perceived government endorsement of the subprime market.

But to say that none of them had any idea something like this could happen is just . . . well, self-serving. They knew it, just like pack-a-day smokers know what can happen to them. But it hasn't happened yet. And it's not going to happen today. And I'm still young. Bad stuff won't happen until I'm old.

And I think, generally, Wall Street understands how Wall Street works, and certainly better than most in Washington, but understanding does not necessarily impart wisdom (sometimes quite the opposite) or prudence. It also doesn't give them precognition. But who wants to be the whistleblower, or the voice of reason, when everybody is making so much money? And, sure, it seems crazy, but . . . well, it's working. Maybe we don't understand it as well as we think we do.

Then it all crashes and you realize that, yes, what you thought was some sort of collective insanity was actually just that.

And things can be addressed--ratings agencies, for one. Perhaps the risks were too well-hidden (something I doubt), but, even if that was true, simple principles could be enforced. No AAA ratings for financial instruments under 7 years old. Any ratings agency giving AAA ratings to instruments that turn out to be pure junk have to radically demonstrate that they did their due diligence, or they lose certification and are on the hook, to the government, for hefty fines.

But, seriously, the ratings agencies had to be able to see what the securtized subprime mortgage bundles were made up of, and could have gotten some idea of the overall likelihood of default of making hundreds of thousands of loans where the monthly payment was going to skyrocket to people with poor or no credit. It's one thing to say, "well, everybody has twenty-twenty hindsight", but the ratings agencies clearly couldn't have done due diligence. So they were either negligent, or participating in outright fraud (because their primary incentive is to get paid by the investment banks whose instruments they are rating).

Posted by: Kevin_Willis | April 19, 2010 9:29 AM | Report abuse

I think you're still missing a basic point Ezra: it is not a question of understanding it is a question of greed. If employees of Wall Street firms can make money they will. Wall Street Banks don't make decisions, the people who run those banks do and they understood they were personally going to make a lot of money on those deals. You may be right that they didn't understand the financial implications for their companies or the economy but that was not a significant consideration in their decision. When the money starts flowing people only see the money whether they are making loans, buying houses or investing in tulip bulbs. Since the bankers were not putting their personal money on the line there was only upside.

The solution: put the olds rules back in place, (Glass-Steagal, etc) rescind Grahah-Leach-Bliley, outlaw synthetic CDS and other 'pure bet' vehicles, require loan originators to hold all the loans they make, have a real consumer protection agency, etc.

Yes, those rules may reduce some "innovation" but very little good came from those innovations and a great deal of harm was done

Posted by: TomP3 | April 19, 2010 9:47 AM | Report abuse

Is "I didn't understand it either" a defense against a fraud charge, or does that come under the heading of "reckless disregard"?

Posted by: paul314 | April 19, 2010 10:09 AM | Report abuse

Kevin, I agree with you that ratings agencies did a horrible job, and have a big part that they played in the crisis. But it's hard for me to just shrug my shoulders about the industry's own participation in the crisis.

If we accept their own statements about this (which, given information coming out about Magnetar and Goldman, is questionable), they created investments that they thought would provide greater return than T-bills, but with no additional risk.

Now if you're into personal responsibility, how can you not put the majority of the blame on them, rather than the group in charge of rating them?

Posted by: rpy1 | April 19, 2010 10:16 AM | Report abuse

in general terms its a pretty bad idea to try to "dumb things down" so the general public understands them. That being said if they readily admitted at these investment banks that they didn't understand them then this is a big problem that needs to be resolved. So we have one of two options.

1-they're lying and they knew they were riskier than a "AAA" rating (most likely)

or

2-they really didn't know how risky they were-- very very scary if this is the case.

Posted by: visionbrkr | April 19, 2010 10:27 AM | Report abuse

i agree with kevin willis. these people knew exactly what was happening. they chose to turn a blind eye.

everyone understand finance on wall street, and in washington too.
one of the top executives at goldman sachs, before he bailed out, bought a fifty-five million dollar house for himself on nantucket....took a 71 million dollar bonus.
what is complicated about that.
i think everyone understands exactly how wall street and a big part of washington works.

as jim kramer says, if you want to make lots of money with your investments, leave your conscience at the door.
i had an uncle who used to say that if you took money away from everyone, in a few years, the same people who had it, will have it again....and those who didnt have it in the first place, wont have it again.
are any of these people serving any prison time, or did anyone of them give back a dime, except as writeoffs to their favorite charities?


Posted by: jkaren | April 19, 2010 10:48 AM | Report abuse

"...That doesn't leave us with many good options. Can we pass a law against complexity? Not really..."

How about, "every contract longer than 1000 words inclusive MUST be available in a deconstructed form understandable by any literate adult, which shall include costs, earnings, contingencies, etc." This would be helpful for cell phone and credit card contracts too.

No contract which is either equivocal or incomprehensible should be allowed standing in law.

Noni

Posted by: NoniMausa | April 19, 2010 10:49 AM | Report abuse

I thought there were two basic rules of investment: don't buy what you don't understand; and if it sounds too good to be true, it probably is.

Is there any burden of responsibility for those who bought the junk that Wall Street was offering if they didn't understand what they were buying? Maybe there will always be enough patsies willing to take too-good-to-be-true deals that have the potential to tank the economy. But the fewer of those patsies we have, the better off we'll all be.

But maybe you can't regulate stupidity and greed. These two basic rules were broken at just about every level of the economic catastrophe, from those who took out complicated, too-good-to-be-true mortgages to the bankers who created CDOs and other complicated instruments, to supposedly sophisticated investors who bought them.

Posted by: dasimon | April 19, 2010 11:15 AM | Report abuse

"I didn't understand" is the new Enron Defense, "I didn't know."

This requires us to believe that the same men who were smart enough to fabricate these "weapons of mass destruction" (coined by one who did understand) were not smart enough to understand their dangers.

Looked at from another angle, if John Paulson was smart enough to see the upside of shorting CDOs based on junk, why weren't the people putting them together?

It's too much to believe that no one on Wall Street had the intelligence to understand what was being done. Their own massive profits demonstrate they knew exactly what they were doing. Now, as the Goldman Sachs civil suit demonstrates, they've been caught at it.

Their was not a failure of intellect, but of morals, of willful disregard and then manipulation, as is the failure of the House and Senate to rectify the deregulation that led to this mess.

Will Rogers is still right. We have the best Congress money can buy, thanks to the best financial markets money can buy.

Posted by: tomcammarata | April 19, 2010 12:33 PM | Report abuse

Oh, there are plenty of ways of measuring and limiting complexity. It's easy to do, jsut very hard to find the votes to do.

Posted by: paul314 | April 19, 2010 8:51 PM | Report abuse

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