41 seeforexampleambroseetal2005 42

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Unformatted text preview: . The agency paradigm is self‐contained in that it carries the seeds of its own demise. Once participants have taken the plunge, they have little or nothing more to lose by taking on additional risk. A dynamic could be thus unleashed that pushed bets higher and higher as less risky investment opportunities became gradually exhausted. Indeed, there is good evidence that risk taking by mortgage originators mushroomed over the cycle as less and less creditworthy borrowers were gradually let in.37 Such dynamics should be naturally unstable and eventually collapse on their own weight.38 Once the crisis hit, the liberal unfolding of the safety net under the gun of systemic contagion (lender‐of‐ last‐resort by the Fed and bail outs by the Treasury) clearly validated any moral hazard incentives that might have led to the crisis. In particular, it facilitated the early exit of at least some of the well‐informed large investors, rewarding those who had lent imprudently (and allegedly knowingly). Another moral 33 Ashcraft and Schuerman (2008) analyze the “seven deadly frictions of asymmetric information” that unfolded with a vengeance in the originate‐to‐distribute world. 34 The managers masquerading their excessive tail‐risk taking as clever investment moves are dubbed by Rajan (2008a) as “fake‐alphas”. The perfect excuse for the bad times is defined by Calomiris (2008) as “plausible deniability”. Reflecting their greater concern for the short‐term bottom line than for the potential longer term risks (perhaps reflecting mostly backward looking compensation schemes), operational managers seem to have paid insufficient attention to the concerns of risk managers. On issues of managerial compensation and the scope for managerial “abuse”, see also Dewatripont and Tirole (1994), Brunnermeier (2008), and Gorton and Winston (2008). 35 Fannie Mae and Freddie Mac—the giant mortgage government‐sponsored enterprises—could meet their mandated social housing goals by buying eligible subprime mortgages. For a summary of public policy actions to promote housing finance see Calomiris (2008). 36 For good narratives along these lines, see Caprio et al. (2008), and Calomiris (2008). 37 On the propensity for increased risk taking, see Dell’ Ariccia et al. (2008), and Keys et al. (2008). Leamer (2008) goes further to argue that there was a gradual shift from hedge finance to speculative finance and then to outright Ponzi finance during the recent housing cycle. 38 In the end, the trigger for the crisis under the pure agency paradigm should still be a stochastic event (moral hazard would cease to operate if there was no longer a possible upside, as unlikely as it might be). That event, however, can be so small that it ceases to be relevant. 31 hazard booster in the ex‐post unfolding of the safety net was that, for the most part, large institutions were not closed and, perhaps more importantly, managers were allowed to stay in charge.39 In sum, the moral hazard tune does ring true in many respects. However, important questions remain. First, for shadow bank...
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