Toxic Assets and Toxic Oil

In some ways the Gulf of Mexico oil spill seems like a replay of the subprime lending disaster. Clever technological innovations blew up in a mess that nobody knew how to control, wreaking devastation on those innocently standing by. The actors and the scenes have changed, but you can’t shake the feeling you’ve been through this nightmare before.

Ken Rogoff sees the parallels this way:

The accelerating speed of innovation seems to be outstripping government regulators’ capacity to deal with risks, much less anticipate them.

The parallels between the oil spill and the recent financial crisis are all too painful: the promise of innovation, unfathomable complexity, and lack of transparency (scientists estimate that we know only a very small fraction of what goes on at the oceans’ depths.) Wealthy and politically powerful lobbies put enormous pressure on even the most robust governance structures….

The oil technology story, like the one for exotic financial instruments, was very compelling and seductive. Oil executives bragged that they could drill a couple of kilometers down, then a kilometer across, and hit their target within a few meters.

This rings true to me. New financial instruments and new technologies for extracting oil require changes in regulatory oversight. And this is the kind of adaptation that established bureaucracies often find impossible to implement.

Ed Dolan thinks the common element is gambling with other people’s money:

Executive compensation plans that emphasize short-term bonuses, include golden parachutes, and lack clawback provisions are one example. Not only top executives face such incentives– mid-level traders, engineers, and analysts may also take risks in the hope of bonuses or promotions, with the expectation that the worst that can happen in case of catastrophe is that they lose their jobs. Stockholders may condone such risk taking because they are protected by limited liability.

Both the Gulf oil spill and the financial crisis had their origins in negatively skewed risks. Investigators in the Gulf disaster are looking at whether BP and its contractors underplayed downside risks when they made technical choices, ignored warning signs, and neglected preparations for dealing with a worst-case spill. In the financial crisis, negatively skewed risks involved excessive leverage, manipulation of ratings, design of complex securities, and several other factors.

I agree with Ed that intra-organizational incentives contributed to the problem in both cases, and that government policy allowed the firms that created the problems to pass some of the costs on to others in many details of the financial debacle. But I am less persuaded that limited liability explains BP’s decisions at the corporate level. The company’s market value has declined by over $75 billion since April. Here was an entity with more than just skin in the game and looking more than just flayed at the moment. And yet, the company opted not to invest $500,000 in a secondary acoustic shut-off switch, which is essentially required in Norway and Brazil, and which Royal Dutch Shell (RDS.A) and France’s Total S.A. (TOT) sometimes use even when not required. BP’s (BP) backup plans B, C, and D all seemed to come out of the playbook for dealing with the 1979 Ixtoc disaster— none of them worked that well there, either. So why did the company take such risks?

I think part of the answer, for both toxic assets and toxic oil, has to do with a kind of groupthink that can take over among the smart folks who are supposed to be evaluating these risks. It’s so hard to be the one raising the possibility that real estate prices could decline nationally by 25% when it’s never happened before and all the guys who say it won’t are making money hand over fist. And this interacts with the forces mentioned above. When the probability of spectacular failure appears remote, and moreover it hasn’t happened yet, it’s hard to set up incentives, whether you’re talking about a corporation or a regulatory body, in which the person who makes sure that the risks stay contained is the person who gets rewarded. When everyone around you starts thinking that nothing can go wrong, it’s hard for you not to do the same. It can become awfully lonely in those environments to try to be the voice of prudence.

And yet, prudent judgment is the thing I most desperately wish decision-makers had more of in these times of dazzling new technological capabilities.

Toxic Assets and Toxic Oil

About James D. Hamilton 244 Articles

James D. Hamilton is Professor of Economics at the University of California, San Diego.

Visit: Econbrowser

2 Comments on Toxic Assets and Toxic Oil

  1. Ken Rogoff’s comparison of the oil spill and the financial crisis is very illuminating, but it omits a further parallel. In both cases, the suppliers (of credit and oil) face an inelastic demand curve, so it makes sense for them to carry on increasing output at higher and higher cost (i.e risk – in the form of higher leverage and greater ocean depth). However, the big difference is that the oil firms can be (and will be) made to pay for their errors, whereas the banks rely on taxpayers to pick up the tab

  2. Not all market participants (or observers) drank the kool-aid of ever increasing housing prices and continuing escalation of outrageous money that was generated during the last ten years….it's only that those voices that were trying to get heard were not in the general media mix because they were independent thinkers and that is not allowed in the general version of events.
    I agree with the analogy of the oil spill crisis with the economic one….too much not understood "market" innovations and a reliance on each of the market sectors to self-regulate…that is never a good formula for continued growth or success….the measly $500,000 dollar emergency cut off valve not being used is just like cutbacks at the SEC or other regulatory agencies with the excuse they won't be needed.
    We will suffer from our own greedy folly unless we are well guarded. Who will watch the watchers?????

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