Steve Waldman (H/T Felix Salmon) makes a spot-on observation regarding the conventional wisdom that the current downturn in the financial sector of the global economy is the result of too much risk:
One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on "too much risk" in recent years. I think it is equally accurate to suggest that the financial system took on too little risk. [. . .]
The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up "super-senior AAA" tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed ’em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was "safe", so who cared what it was funding? [. . .]
. . . We’ve trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I’ve nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.
Investors’ childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.
Read the entire piece here. As noted many times on this blog (most recently here), many powerful forces in our society — the government and the mainstream media to name just two — continue to embrace myths that distract from a mature understanding of the nature of risk.
The relative level of risk, in and of itself, is meaningless. The issue is how one prices risk. As an investor, if one properly estimates the level of defaults and then adds on a profit margin, the riskiness of the underlying asset is immaterial. The way Wall Street got screwed was to misprice the level of risk they were assuming. It is a surprise to no one that pricing a 30 year mortgage to a subprime borrower with no down payment at 100 basis points over that of a highly rated borrower with 20% down is silly.
The fact that the federal government is getting involved with the mortgage mess is only going to exacerbate the problem as the market distortion cauased by government intervention will only delay the marketplace from properly pricing the risk of providing credit moving forward.