However, the speech covers a very important aspect of the crisis- Why did so many high profile, well educated investment managers take such huge exposures to the subprime mortgages?
The answer is:
Shareholders in any asset management firm are unlikely to pay the manager much for returns from beta risk – for example, if the shareholder wants exposure to large traded U.S. stocks, she can get the returns associated with that risk simply by investing in the Vanguard S&P 500 index fund, for which she pays a fraction of a percent in fees. What the shareholder will really pay for is if the manager beats the S&P 500 index regularly, that is, generates excess returns while not taking more risk.
Hence, most of these fund managers took the risk in search for higher alpha and the as risk was hidden behind faulty ratings, he managed to get higher rewards for his alpha (which wasn’t really alpha as there was high risk). I liked this para:
I buy the AAA tranche of a CDO, not because I am confused by the rating, but because I am selling a deep, out of the money put option, which will give me a steady return most of the time, but default with serious adverse consequences occasionally. By the time it defaults, I have hopefully made my money and am enjoying my own private beach in the Bahamas. A number of managers including Stan O Neill of Merrill Lynch did generate higher returns for their firms for some time, but alas we now realize it was hidden risk. Of course, his parting compensation did nothing to dissuade the rest of the flock from following his example in the future.
And his suggestion:
The broader point I am making is that we need to think about incentives of financial market participants as an important factor in the current crisis. How to improve those incentives will, no doubt, be an important issue for discussion in the years to come.
The speech was given on December 17, 2007 and Raghu Rajan has since then written a similar and popularly discussed article for FT.
This issue over restructuring incentive system in financial sector is being discussed widely. For instance, read Martin Wolf’s excellent article on the same.