The Best and the Brightest

don’t know what the heck they’re doing.

That’s how this article at the NYT on the bailout of Citigroup struck me. Here’s the snippet in question:

Asked then whether he had made any mistakes during his tenure at Citigroup, [Rubin] offered a tentative response. “I’ve thought a lot about that,” he said. “I honestly don’t know. In hindsight, there are a lot of things we’d do differently. But in the context of the facts as I knew them and my role, I’m inclined to think probably not.” Besides, he said, it was impossible to get a complete handle on Citigroup’s vulnerabilities unless you dealt with the trades daily. “There is no way you would know what was going on with a risk book unless you’re directly involved with the trading arena,” he said. “We had highly experienced, highly qualified people running the operation”…

Just because they’re rich doesn’t mean they’re smart. When they’re not rich any more does that mean they’re not smart any more?

There’s a stock market adage that I think is appropriate here: don’t confuse brilliance with a bull market.

I find the bailout of Citigroup completely baffling. Can someone explain it to me? One place to start might be with the counter-factual: what would happen if Citigroup were allowed to fail? Nationally? Internationally?

Brad DeLong makes a small run at the question and, basically, he finds the move as incomprehensible as I do:

Should Citi’s management have planned for and guarded against this explosion in the risk premium? I certainly did not expect it–I did not think we could see this big a rise in the risk premium outside of a real cousin of the Great Depression, and I thought that modern tools of macroeconomic management would keep such a thing from happening. I never expected to see the unemployment rate hit 15% in my lifetime. I still don’t.

It’s in the nature of a bank to get into trouble and be on (or over) the edge of failure in a financial crisis. Banks exist to provide liquidity and safety: to turn the long-term highly-risky investments in plant, equipment, and infrastructure that are our social capital into the short-term liquid largely-safe assets that savers largely want. This means that banks are–if they are doing there job–long duration and long risk, and their values crater whenever there is a financial crisis because a financial crisis is a sharp fall in the value of long-duration and high-risk assets.

A bank that has not lost massive amounts of value in the past year and a half is either extremely nimble or extremely lucky: even the nimble and lucky JPMorgan Chase has lost 60% of its shareholder value in the past year and a half.

The question of how much duration and risk a bank should assume per dollar of capital is a knotty one–if you match durations and assume no risk, then your stock value never crashes. But shareholders are paying you to be a bank, not to be a not-bank. Rubin has a lot of big wins in his career: as a risk-arbitrage trader, as head of Goldman Sachs, the 1993 budget, the 1995 Mexican rescue, the 1997-98 East Asia crisis–that suggest that his judgment is generally good, and that he takes aggressive but appropriate risks that are in the interests of his principals. You got to know when to hold ’em and know when to fold ’em, but even if you do you may still break even.

If you find any informed people making a stab at this sort of analysis, please leave links in the comments.