"I think risk misallocation due to market failures, i.e. the failure of regulation, was more important in generating the crisis than moral hazard "

Here's a post which disagrees with me from Mark Thoma:

"Was Risk Misperceived, Misrepresented, or Misallocated?

We know that excessive risk taking was a factor in the financial crisis, but why people were willing to take on excessive risk?

There are several explanations for this. In one class of models, misperception of risk generates excessive demand for risky assets, housing and financial assets in particular. There are a variety of stories about why risk is misperceived, ratings agencies failed to do their jobs, risk assessment models turned out to be wrong, people believed that housing prices would continue to go up, and so on. The key is that in this class of models the misperception of risk gives people a false sense of security, and induces them to take on more risk than they can handle. ( I DON'T AGREE. I'VE ALREADY SHOWN THAT, IN TWO HOURS ON A COMPUTER IN 2005, THE RISK OF THE VARIOUS INVESTMENTS IN THIS CRISIS COULD BE DISCOVERED. TWO HOURS. THERE WAS SOME WISHFUL THINKING, BUT IT'S BIGGEST CONTRIBUTION IS REALLY IN MAKING FRAUD, ETC., SO MUCH EASIER.)

In another class of models, risk is misrepresented. Here, there is out and out fraud or other practices where, essentially, people know that the house is made of cards, but advertise it as being made of bricks anyway, and assure people that it is perfectly safe. Fraud could cause the victim to misperceive risk, so this is related to the first class of models, but I am trying to separate excessive risk taking brought about by intentional misrepresentation from excessive risk taking brought about by errors in judgment (or, perhaps more accurately in some cases, from negligence). ( BY NOW, EVERYONE SHOULD BE BEGINNING TO UNDERSTAND HOW WIDESPREAD THIS IS. IT IS THE SECOND MOST IMPORTANT CAUSE OF THIS CRISIS )

In a third class of models risk is misallocated, and there are two strands of risk misallocation models. In one, the mechanism that causes people to take excessive risk is knowledge that the government will step in and cover any potential catastrophic losses (risk is reallocated from the private to the public sector). This is the moral hazard problem, and the claim that government intervention led to excessive risk taking has been leveled pretty much wherever government has played a role in housing and financial markets, even when the role has not been very large.( THIS IS, IN FACT, THE MAIN CAUSE )

In the second strand of risk misallocation models, the cause of excessive risk taking is market failure due to principal agent problems (e.g. when mortgage brokers are paid according to the number of loans that pass through their hands rather than according to the quality of the loans, and hence have no incentive to monitor risk). Market failures of this type can cause excessive risk taking because the person taking the risks does not face the full consequences of their decisions when the risky decisions turn out to be wrong. Why not take a big risk if you win on the upside, but you don't have to pay the full cost (or any of the costs) on the downside? However, unlike the first strand of risk misallocation models where there is too much government intervention, here the problem can arise when government fails to regulate markets properly( THIS HAPPENED HERE, BUT IT WAS MORE LIKE COLLUSION. THE IDEA THAT REGULATORS COULD HAVE PREVENTED ALL LEVERAGE INNOVATION BEGGARS BELIEF ), so the problem is often the result of too little government intervention( THE GOVERNMENT NOT INTERVENING IN LEHMAN FITS THIS DESCRIPTION ) rather than too much. ( THIS IS IMPORTANT AS WELL, ALTHOUGH I WOULD CALL THIS NEGLIGENCE, SO THAT IT IS MY SECOND MOST IMPORTANT CAUSE )

In a final class of models government is also blamed, but this time government is a bully that forces banks - through regulation or moral suasion - to make loans that are overly risky( THIS IS FALSE ). The very thoroughly discredited models blaming the Community Reinvestment Act for the financial crisis fit into this class, and the models blaming the CRA are the most prominent member of this category. For that reason, I'll call these models "misguided" and set them aside.

So which was it, misperception, misrepresentation, or misallocation? In the following, Tyler Cowen focuses on the misallocation of risk due to government induced moral hazard. My own view is that misallocation of risk did play a role, but I think risk misallocation due to market failures, i.e. the failure of regulation( IN WHAT WAY ? ), was more important in generating the crisis than moral hazard brought about by implicit or explicit government guarantees. I also think the misperception of risk was important( COME ON ), perhaps even more important than the misallocation of risk (though these are sometimes hard to separate):

Here's Tyler Cowen:

Bailout of Long-Term Capital: A Bad Precedent?, by Tyler Cowen, Commentary, NY Times: The financial crisis is a result of many bad decisions, but one of them hasn’t received enough attention: the 1998 bailout of the Long-Term Capital Management hedge fund. If regulators had been less concerned with protecting the fund’s creditors, our current problems might not be quite so bad. ...

At the time, it may have seemed that regulators did the right thing. The bailout did not require upfront money from the government, and the world avoided an even bigger financial crisis. Today, however, that ad hoc intervention by the government no longer looks so wise. With the Long-Term Capital bailout as a precedent, creditors came to believe that their loans to unsound financial institutions would be made good by the Fed — as long as the collapse of those institutions would threaten the global credit system. Bolstered by this sense of security, bad loans mushroomed. ...

The Long-Term Capital episode ... was important precisely because the fund was not a major firm. At the time of its near demise, it was not even a major money center bank, but a hedge fund with about 200 employees. Such funds hadn’t previously been brought under regulatory protection this way. After the episode, financial markets knew that even relatively obscure institutions — through government intervention — might be able to pay back bad loans.

The major creditors of the fund included Bear Stearns, Merrill Lynch and Lehman Brothers, all of which went on to lend and invest recklessly and, to one degree or another, pay the consequences. But 1998 should have been the time to send a credible warning that bad loans to overleveraged institutions would mean losses, and that neither the Fed nor the Treasury would make these losses good.

What would have happened without a Fed-organized bailout of Long-Term Capital? ... Fed inaction might have had grave ... economic consequences,... and the economy would have probably plunged into recession. That sounds bad, but it might have been better to have experienced a milder version of a downturn in 1998 than the more severe version of 10 years later.

In 1998, there was no collapsed housing bubble, the government’s budget was in surplus rather than deficit, bank leverage was much lower, and derivatives markets were smaller and less far-reaching. A financial crisis related to Long-Term Capital, however painful, probably would have been easier to handle than the perfect storm of recent months.

The ad hoc aspect of the bailout created a precedent for what has come to be called “regulation by deal” — now the government’s modus operandi. Rather than publicizing definite standards and expectations for bailouts in advance, the Fed and the Treasury confront each particular crisis anew. ... So far, every deal — or lack thereof, in the case of Lehman Brothers — has been different.

While there are some advantages to leaving discretion in regulators’ hands, this hasn’t worked out very well. It has become increasingly apparent that the market doesn’t know what to expect and that many financial institutions are sitting on the sidelines, waiting to see what regulators will do next. Regulatory uncertainty is stifling the ability of financial markets to engineer at least a partial recovery. ...

I should add that I agree with Tyler that government action, or in some cases inaction, and in still other cases poorly though out action, particularly by the Treasury, has left far too much uncertainty in markets."

Thoma has no way of explaining the market's reaction to Lehman. None. Did Lehman's not being bailed out have anything to do with regulation? Thoma's analysis would assume Regulators or Regulations that do what? Does he have any way of knowing that, barring CDSs, CDOs, or any other investment in the news, the banks and investors couldn't have found other ways to increase their leverage? These investors are always far ahead of regulators and regulations. If nothing else, they might simply have gone offshore.

More important that regulation would be the poor prosecution of actual crime in the S & L Crisis. Now that's important. The regulators were a problem in this crisis, but more in the sense of Collusion, with allowing Regulator Shopping and Cronyism. In that sense, it falls into my 2nd most important cause.

But going back to Lehman, what is Thoma's explanation of the market's reaction? He doesn't seem to understand that what occurred was a Calling Run. Without the calling run, Brad DeLong's point about the money involved in poor investments being so much less than has been lost would mean that we could have much more easily deleveraged out of this situation over time. The reaction to Lehman was clearly about Government Guarantees. When the government's guarantees were seen to be less than total and impossible to predict, that's when the Calling Run began. There was nothing inevitable about this crisis working out this way. Actual policy mistakes were made. The biggest mistake that the government made was in not understanding that the investors and markets were expecting a total and clear government intervention. It is the people who were actually controlling the big money in this crisis who spoke after Lehman, and their message was loud and clear. To those of us who believe that this the system we have, these investor's reaction was no surprise.