The Bankers and the Producers

Over at Vox-Eu, Thorvaldur Gylafson compares banking scandals with plot of Mel Brooks' The Producers. Like modern day Biayalstock and Blooms the bankers make bad loans and hope to loot the bank before anybody notices how much they have earned:

Not all the CEOs running the fraudulent savings and loans (S&Ls) in California and Texas in the 1980s and 1990s saw The Producers, but all of them could have played Max’s role convincingly. They shared Mr. Brooks’ insight into why the massive frauds use accounting as their “weapon of choice”, structure their efforts to fail, and recruit an accountant as their most valuable fraud ally. The fraudulent CEOs and their accounting allies were the real-life Bialystocks and Blooms. They bankrupted the S&Ls, enriching themselves and their friends along the way, at the expense of stockholders, creditors, and taxpayers.

This explanation is then applied to the recent financial crisis.

During the ongoing subprime mortgage loan crisis, the rating agencies and the top tier audit firms played the real life role equivalent to the critic that Max pretended to try to bribe to make sure that Springtime for Hitler received a terrible review. Unlike the critics, who Max realised he could not succeed in bribing, the rating agencies and the top tier audit firms gave rave reviews to toxic subprime mortgage paper. The rating agencies claimed the toxic waste was pristine “AAA” – the safest of the safe. The elites that we count on to advise us on quality in the real world are more corruptible than the elites in the fictional world that Max and Leo inhabited.

One important element of this crisis was that the big banks kept too much toxic debt on their own books. This is why the banks had such big losses. They did not just sell off the worst debt. They kept it too.

How does this fit with the Biayalstock and Bloom theory? Holding all that toxic waste on the books is kind of like producing a really bad play. But is it credible that Richard Fuld and James Cayne wanted Lehman and Bear Stearns to fail? Did Stanley O'Neal believe he as dooming Merrill Lynch while he earned his big bonuses? This seems unlikely. The CEO's of these companies were more like the old ladies seduced by Max than they were like Max. They did get rich while the play looked like it was a hit, but they were highly compensated because people actually thought they produced hits.

The problem in this crisis was that risks were underpriced. Executives got overly compensated for taking risks because investors believed that markets were inefficient and these guys were brilliant.