Risk

| Fri May 29, 2009 12:55 PM EDT

Economist Gary Gorton has written a 20,000 word paper on the subject of "informationally-insensitive debt" — i.e., ultra-safe investments like federally insured bank deposits.  Ezra Klein boils this down to a thousand words.  I boldly push the boundaries even further:

The morons who inhabit Wall Street thought they had removed all risk from inherently risky investments.  They were wrong.

There!  Twenty words.  That's a compression ratio even greater than Ezra's.  Felix Salmon comments:

Gorton's solution to this problem is to involve the government in all manner of regulation — and insurance — of the securitization market, thereby making [asset back commerical paper] behave much like federally-insured bank deposits. I don't like this solution at all, since it would send the contingent liabilities of the government into the stratosphere, and more importantly would ratify the demand for informationally-insensitive assets by creating trillions of dollars of new ones.

In my view of the crisis, it's precisely the demand for informationally-insensitive assets which is the problem. And we need to get individuals, companies, and institutional investors out of the mindset that they can do an elegant little two-step around the inescapable fact that anybody with money to invest perforce must take a certain amount of risk. If you have a world where people are all looking for risk-free assets, you end up shunting all that risk into the tails. And the way to reduce tail risk is to get everybody to accept a small amount of risk on an everyday basis. We don't need more informationally-insensitive assets, we need less of them.

I agree.  There's a common view that investors in the period up until 2006 were practically drunk on risk, pricing it nearly at zero — but now, after the crash, they've become more risk averse than your grandmother.  They're almost completely unwilling to accept any risk at any price.

I think this view is fundamentally wrong.  What really happened is that in the early part of the decade investors became convinced that they could avoid risk entirely via financial engineering.  They were, in fact, immensely risk averse, but this wasn't obvious because they were buying up every security in sight.  The post-crash flight to quality, it turns out, wasn't really a flight at all.  Modern investors have been afraid of risk all along.

So Felix is right.  The last thing we need is for the government to perpetuate the delusion that financial markets are risk free.  For small retail bank depositors, that's fine.  For the big boys it's not.  They need to relearn the art of genuinely analyzing risk and taking it on knowingly, rather than pretending they can hedge it away under all circumstances.  After all, accurate analysis of risk is essential to the efficient allocation of capital, and efficient allocation of capital is one of the keys to economic growth.  It's time for Wall Street to get back to basics.

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