Does Felix have criminal tendencies?

By Felix Salmon
July 8, 2009

Joe Weisenthal asks, provocatively enough, whether I, had I been a banker during the credit boom, might not now be held criminally liable were the crime of bankslaughter on the books:

We wonder if Felix had been a banker whether he’d be guilty of bankslaughter. After all, in his research into the subject, he concluded early on that the issue of mortgage defaults wasn’t likely to be a huge deal. Later he changed his mind and of course, defaults proved to be a gigantic problem.

But if I were a prosecutor, I’d have no problem convincing a jury of 12 that a “reasonable” banker should’ve known that lending money to people of dubious credit risk, with low loan-to-value ratios, in an inflated market would’ve been a recipe for disaster.

Well yes — but that’s kinda the whole point. You don’t want the managers of systemically-important banks being as careless as I was on the subject of default risk. Here’s what I wrote in the piece that Weisenthal links to:

A little knowledge is a dangerous thing: I would have been much better off with a completely naive view than I was with a very basic grounding in mortgage finance.

I did some paddling around in the shallow end of the theory of mortgage bonds, and what I found surprised me: no one seemed to be the slightest bit interested in default rates. The prices of mortgage bonds were entirely a function of prepayment rates, and default rates simply didn’t enter into the equation.

Now I’m a finance blogger who prides himself on being wrong every so often (my slogan is that “if you’re never wrong you’re never interesting”) and who has essentially zero equity in being right. My job is to hold up my end of the conversation, not to be some kind of all-seeing market guru.

The manager of a systemically-important bank, on the other hand, is in a very different position, with vastly more responsibility. If such a manager did no more than do “some paddling around in the shallow end of the theory of mortgage bonds”, and on the basis of that took hundreds of billions of dollars of potentially highly-toxic assets onto his balance sheet, then yes, that’s highly reckless activity. And it’s probably reasonable to assume that if the crime of bankslaughter had been on the books at the time, then maybe such a manager might have thought twice before rushing in to such markets.

The key insight is that “financial innovation” is not the kind of thing you want too much of at too-big-to-fail institutions. Writes John Carney:

Collier doesn’t seem to have given much thought to the costs of over-deterrence. Bank executives faced with the prospect of a criminal investigation and possible conviction would likely be overly cautious. We’d lose a lot of socially beneficially risk taking by criminalizing bank failure.

For me, over-deterrence is a feature, not a bug. We’ve seen where Carney’s “socially beneficially risk taking” has landed us, and frankly I’d rather have rather a lot less of it.

Carney concludes:

Because bankslaughter is backward looking but conducting business is forward looking, it would almost certainly result in wrongful convictions. Lots of activity that looks reckless after the fact can seem perfectly sensible ahead of time. Unless the crime required bankers to know they were being reckless—in which case it would deter almost no-one and result in approximately zero convictions—it would wind up punishing bankers for just being wrong.

In an ideal world, of course, there would be no wrongful convictions simply because there would be no convictions and indeed no prosecutions. And Carney is right that it seems unfair to convict a banker of a crime just because he was heading up a too-big-to-fail institution and made a bad decision.

On the other hand, having the statute on the books would certainly increase incentives not to become too big to fail: it would help keep banks small. A capitalist society works by having private businesses take risks and fail. A capitalist society fails when private businesses are too big and systemically important to be allowed to fail. And so I think there is a case to be made that the managers of those businesses should be held to a significantly higher standard than managers elsewhere.

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Comments
10 comments so far

So you’re arguing in favor of randomly, unpredictably criminalizing being the head of a financial institution? Are you deliberately being “interesting”?

Incidentally, I’ve read that hindsight bias isn’t nearly as prevalent in Chinese culture as in western cultures. For what that’s worth.

“You don’t want the managers of systemically-important banks being as careless as I was on the subject of default risk. ”

Let me see:

“You don’t want the members of systemically-important Houses of Congress being as careless as I was on the subject of default risk.”

There, fixed that.

Posted by ThatSueAgain | Report as abusive

I was an intern in the summer of 06 and what I remember is that everyone was worried about how the risk premium had collapsed in nearly every asset class and there was nothing they could do about it. There were just piles and piles of money chasing yield and you got shockingly little compensation for taking on risk. At the time there were lots of asset classes that reasonably could have blown up and it just so happened to be mortgages (although lots of other stuff did, too). But, people had to invest money somewhere and with everything seemingly expensive, AAA mortgages seemed reasonable. It just seems crazy to hold them criminally liable, although more clawbacks would be a clear improvement.

I’m not saying you couldn’t or shouldn’t have gotten this call right, but I don’t think getting it wrong makes you a criminal. Millions of homeowners got it wrong, too.

Posted by Kyle | Report as abusive

When the terms “NINJA loans” and “liar loans” became prevalent in the business press (i.e. probably a few months before it hits Time & Newsweek), it should have been pretty clear to any professional in the financial sector (not the mainstream) that this was a) not gonna end well for people holding those loans (either banks or sub-prime buyers) and b) not gonna end well pretty soon. i’m an old emerging market equity guy, and I heard them about that in Q1 2006.

Posted by davidA | Report as abusive

I’m going to go with dWj and assume you’re being facetious to increase your readership base.

The one useful thing you say is that “having the statute on the books would certainly increase incentives not to become too big to fail: it would help keep banks small.”

Why not address this point directly? Surely there are better ways to prevent TBTF than capricious, vengeful prosecutions decades later (e.g. special wind-downs / bankruptcy rules, leverage limits, size limits, etc.). “Bankslaughter” seems like the bluntest possible tool, with the most potential downside.

Posted by ab | Report as abusive

Right after we get done with the GSESlaughter trail of Barney Frank and Chris Dodd, amirite?

Posted by horn | Report as abusive

dWj is right on target. The primary issue is hindsight bias. Now the whole problem seems obvious. However, at the time there had never been widespread, highly correlated mortgage defaults. Likewise, there has never been an alien invasion that attempts to wipe out the human race. Should we be prepared for that?

Secondly, bank executives are primarily responsible to their shareholders. Can you imagine a CEO saying: “I’m sorry our earnings were 1% of that of our competitors. We’re not going to participate in that extremely easy and highly profitable CDO business…” He would have been kicked to the curb in 2004.

Posted by 3 | Report as abusive

I think Felix was neither charged with nor compensated for (especially the latter) making the right decisions here.

I also think that he is especially frustrated with (as are many of us) with the responsible (and highly compensated) members of the financial community largely throwing up their hands and saying it was an act of God, and their individual performance was exemplary.

Posted by Curmudgeon | Report as abusive

didn’t the enron bankruptcy charges exceed $1billion? no one seems to be addressing the gatekeepers incentives – does anyone keep track of annual revenue from fines as well?

“…Bankers, accountants and lawyers may reap record judge- approved charges of $906 million by the time Lehman’s bankruptcy ends, estimated Lynn LoPucki, a University of California, Los Angeles professor who has a database to calculate fees… Weil Gotshal’s Miller said. “These are the largest bankruptcy cases in history,”…” http://www.bloomberg.com/apps/news?pid=2 0601208&sid=apzbxu6eOxik

Posted by ac | Report as abusive

Even I think bankslaughter is a silly idea. What happened to clawback? I thought we were on the right track there.

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