risk_200x200.jpgFelix Salmon's in Dallas today giving a terribly depressing speech to the Regional Bond Dealers Association. A terribly depressing speech which, through the magic of the interwebs, can now depress all of us! In particular, I recommend the beginning, which takes on the prevailing wisdom that Wall Street developed an overly high tolerance for risk. As Salmon argues, the problem was precisely the opposite: Wall Street had managed to convince itself that it wasn't taking on risk.

I believed along with Alan Greenspan that when it comes to debt instruments in general, and credit derivatives in particular, “These instruments enhance the ability to differentiate risk and allocate it to those investor most able and willing to take it.”

But if you look at what happened in practice, the art of securitization always seemed designed to create ever-increasing quantities of risk-free debt. Banks thought they were selling loans and mortgages to people who wanted the risk, but they weren’t: they were carefully packaging those loans and mortgages into bonds carrying a triple-A credit rating. And people buying triple-A risk don’t want any risk at all...triple-A, for those of you who remember as far back as 2006, means “no credit risk at all” – it means “risk free” – it means “you’re only taking interest-rate risk”.[...]

We have a situation where everybody is trying to farm off risk to everybody else, to the point at which everybody thinks that someone else has it. For one thing, virtually nobody ever even stopped to worry about credit risk in the [mortgage-backed securities] market – I know that I didn’t, until it was far too late. I believed what the professionals told me, which was that the only thing a mortgage-bond investor needs to worry about is prepayment risk, and that credit risk is a non-issue.

But even those people who did stop to worry about credit risk were rapidly reassured. Most mortgages were always sold to Fannie and Freddie – and, presto, all that risk magically disappeared. These were hugely profitable corporations, what could possibly go wrong?

When you read it put like that, the level of deception is obvious. But one of the unanswered questions, at least for me, is who, exactly, was being deceived? Was Wall Street perfectly aware that they were playing a game of three securitization monty, and of course financial trickery wasn't making risk vanish into thin air, but it was good for short-term profits to pretend otherwise? Or did Wall Street self-deceive? The latter explanation, of course, is ethically superior. Better they tricked themselves than us. But all things considered, it's actually the explanation that scares me more.