Academic

Why Did Banks Keep Risky Assets?

By Gordon Smith, Christine, Hurt, Vic Fleischer, Fred Tung, Lisa Fairfax, David Zaring

Financial intermediaries usually put investors together with opportunities.  But one reason why they fared so badly in the crisis was that they retained so many risky assets on their books, rather than selling them on to sleepy pension funds and insurance companies who tend to be super long only, and very long term, investors.  This is something that can be shown, and it is a basic insight about the cause of the crisis; capital adequacy collapsed, and intermediaries could no longer roll their obligations by posting the bad assets as collateral.  Without repo or commercial paper, the intermediaries went insolvent quickly, because they borrow short and lend long.  Why did they keep these bad assets?

I haven't heard a great story, whether it was to chase alpha, because they thought they had a government guarantee, or because they were running doomed insurance schemes, picking up nickels in front of steam rollers, on the assumption that they (or the employees making the asset purchase decisions) would get out before the collapse and retire to the Vineyard or whatever. 

Or maybe intermediaries were just dumb, though economists don't like the "dumb" explanation much, especially since intermediaries are supposed to be smarter than most market participants, and have always transferred risk to dumb people who don't mind holding it, rather than keep it on their own balance sheets.

There's lots to unpack here.  Jimmy Cayne, the Bear Stearns CEO, had almost all of his net worth tied up in company stock.  Why didn't he do something about "securitize and hold"?  The corporate governance of financials, btw, couldn't be better, loads of outside directors, plenty of M&A, and few poison pills, etc.

Whatever the case, it was a widely shared strategy that didn't work. 

Full post as published by Conglomerate on September 02, 2009 (boomark / email).