Fourth, there is no way to know whether the risk aversion of those who buy S&P 500 stock options tracks the risk aversion of bankers making fraudulent real estate loans or investment bankers purchasing such fraudulent loans in the secondary market. They are different people purchasing radically different assets. The stock option purchasers are passive investors -- they do not expect to run the corporation or determine its policies. The CEOs that lead accounting control frauds run the business. They care about their wealth -- not the wealth of shareholders. They loot the shareholders and use the shareholders' capital to suborn and the lobbyists who maximize the three "de's" (deregulation, desupervision, and de facto deregulation) that allow the CEO the ability to loot with impunity.
The CEOs' abuse of their power to optimize looting produces corporate investments in high risk assets with underwriting practices so pathetic that they create intense adverse selection and a negative expected value to the lending without competently underwriting. Neo-classical economists erroneously interpret the combination of the lenders' asset choices and the destruction of underwriting as evidence of falling risk averseness, but the reality is that the CEO is risk averse and uses his power and the fraud "recipe" to loot with impunity. I discuss this in more detail immediately below when I return to explaining the specific differences between causation and correlation in the context of risk aversion in the home mortgage context. The ECB authors do not even attempt to explain why the purchasers of S&P 500 options would share the same risk averseness as the CEOs of the mortgage lenders and purchasers that led the looting.
The VIX index, the authors' key variable, cannot be used reliably to study even correlation, much less causality, much less causality in the mortgage industry fraud context. Microeconomic variables that the ECB authors did not study can drive the VIX index. Consider Panels A & B of their paper. They claim that the decomposed VIX data demonstrate that the period 2004-2007 represents a period in which investors exhibited "low uncertainty" and "high risk appetite." The first claim is true of the CEOs leading the fraud epidemics, but the second is false for the most important sector that drove the crisis -- the housing mortgage markets.
The ECB authors do not cite George Akerlof and Paul Romer's famous 1993 article -- "Looting: The Economic Underworld of Bankruptcy for Profit." They do not cite the criminology literature on accounting control fraud. They do not discuss the fact that epidemics of accounting control fraud drove the second phase of the S&L debacle and the Enron-era scandals. They do not discuss the three fraud epidemics that drove the current financial crisis. The twin mortgage origination fraud epidemics were inflated appraisals and endemically fraudulent liar's loans. Fraudulently originated loans can only be sold through fraudulent "reps and warranties," so the twin origination fraud epidemics led to the epidemic of fraudulent sales of the fraudulently originated mortgages to the secondary market. Individually, each of these epidemics of accounting control fraud would have constituted the most destructive financial frauds in world history. Collectively, they hyper-inflated the financial bubble and caused the catastrophic losses that drove the financial crisis and the Great Recession.
Akerlof and Romer emphasized the key analytical points that the ECB authors missed when thy implicitly assumed accounting control fraud out of existence.
"[M]any economists still [do] not understand that a combination of circumstances in the 1980s made it very easy to loot a [bank] with little risk of prosecution. Once this is clear, it becomes obvious that high-risk strategies that would pay off only in some states of the world were only for the timid. Why abuse the system to pursue a gamble that might pay off when you can exploit a sure thing with little risk of prosecution?"
[S]omeone who is gambling that his thrift might actually make a profit would never operate the way many thrifts did, with total disregard for even the most basic principles of lending: maintaining reasonable documentation about loans, protecting against external fraud and abuse, verifying information on loan applications, even bothering to have borrowers fill out loan applications" (Akerlof & Romer 1993: 4-5).
As I have explained, Akerlof and Romer also warned about the perverse incentives of loan brokers and sellers of mortgages to the secondary market and the capacity of epidemics of control fraud to hyper-inflate financial bubbles. Akerlof and Romer provided the key that would have allowed any "scientific" economist to unlock the crisis. They anticipated in uncanny ways the key drivers of the current crisis. Akerlof was awarded the Riksbank Prize in Economics in 2001 (economics' version of the Nobel Prize). No "scientific" economist could fail to discuss Akerlof and Romer and "looting" as a possible cause of a financial crisis. In particular, no scientific economist trying to explain the origination and purchase of seemingly ultra-high-risk mortgages and mortgage derivatives could fail to discuss looting as a potential cause. The ECB economists and Taylor, however, are the overwhelming norm among economists. They implicitly exclude the existence of accounting control fraud. They do not cite the relevant economics or criminology literature.
Accounting control fraud epidemics produce a "sure thing" so "uncertainty" is minimized. Accounting control fraud fools economists when it comes to risk and risk aversion. The assets that the frauds invest in are higher risk in order to obtain an (apparent) premium yield, but the "sure thing" remains so, from the prospective of the officers running the fraud, "risk" is minimal. The officers are risk averse -- the purpose of the fraud scheme is to produce huge wealth for the officers with certainty. The officers leading the mortgage origination and secondary market frauds took enormous steps to make the fraudulent mortgage assets appear exceptionally low risk. Liar's loans dramatically inflated the borrowers' income while endemic appraisal fraud grossly understated the loan-to-value (LTV) ratio. The CEOs leading the frauds created the Gresham's dynamics that suborned purported "independent" "professional" "controls" into opinions that aided the fraud, including faux due diligence by entities like Clayton, "clean opinions" from top tier audit firms, grossly inflated appraisals, and "AAA" ratings by the three top rating agencies.
Recall Chetty's claim that economists are scientists analogous to epidemiologists. As a criminologist, I love the metaphor. It is one we use to great effect in our field. We borrowed the concept of a pathogenic environment that can produce epidemics. We search for and warn against criminogenic environment that can produce fraud epidemics. We look for "vectors" that spread fraud epidemics. We study how fraud transmits and how frauds seek to suborn the analog of the body's immune system. We "autopsy" failures to learn these facts and develop our theories and the "natural experiments" we study empirically. With the exceptions of economists like Akerlof and Romer, however, economists overwhelmingly do not act like epidemiologists when it comes to control fraud epidemics. Economists "know" that financial markets "self-correct" and promptly eliminate fraud. Fraud epidemics do not and cannot exist. In preparing to study this crisis, an epidemiologist would have known that we had suffered two modern financial driven by fraud epidemics. No one questions that fact that the Enron-era scandals were accounting control frauds. The national commission to investigate the causes of the S&L debacle reported.
"The typical large failure [grew] at an extremely rapid rate, achieving high concentrations of assets in risky ventures". [E]very accounting trick available was used". Evidence of fraud was invariably present as was the ability of the operators to "milk' the organization" (NCFIRRE 1993).
An epidemiologist would have been particularly interested in the non-crisis in this era. This was the 1990-1991surge in lending that we now call liar's loans that we drove out of the S&L industry. Recall Akerlof and Romer's warnings about loans made without underwriting being strong evidence of accounting control fraud.
Given the dominant role of accounting control fraud in the S&L debacle, the 1990-1991 genesis of liar's loans, and the Enron-era scandals an epidemiologist would have known where to start looking if she were asked to study this crisis. She would have begun by looking for evidence of accounting control fraud.
Economists act like epidemiologists would act in response to an epidemic if epidemiologists were members of a religion that had a taboo about discussing or studying disease and believed that the body self-corrects if left alone by physicians. Epidemiologists who believed that epidemics do not and cannot exist would never look for the presence of bacteria or viruses, never look for pathogenic environments, and never study the autopsy results. What would we call an epidemiologist who did not believe that epidemics can exist, did not study what made environments pathogenic, did not study bacteria or viruses, and did not study autopsy results? We could call them a theoclassical economist. They would, implicitly, ignore fraud. They would propose anti-regulatory policies that were intensely criminogenic.
Similarly, what would we call an engineer who designed homes that had an average life expectancy of three years before they collapsed and caused enormous losses? I'd call them a "financial engineer." Bad economists are very good at appropriating these favorable professional labels to try to pretend to science. Anyone familiar with how a real engineer is trained and their professional ethos of safety and care for protecting others from injury knows that Wall Street "financial engineers" are the opposite of real engineers. Wall Street "financial engineers" are selected on the basis of their ethos of making themselves wealthy at the expense of their clients and then mocking the clients when they suffer losses. Financial engineers view customers as sheep to be sheared (the actual Wall Street verb for what should be done to customers are too vulgar for publication).
Only a theoclassical economist like John Taylor would proclaim, without ever studying or discussing the three most destructive fraud epidemics in world history, would issue a dogmatic statement that this is the first virgin crisis, conceived without sin the corporate "C" suites.