Were Mistakes Made?
Ezra Klein writes:
I’ve spent part of the day reading about super senior tranches and synthetic bonds and all the rest, and on some level, I think we’re making this too complicated.
I tend to agree with Ezra. Which is to say that though the specifics of how the super-senior tranche is created are very complicated, the underlying bet behind the super-senior tranche is very simple — it was a bet that any future housing price declines would be localized, and that it wasn’t possible for their to be a systematic, nationwide downturn in the housing market. And that was, frankly, stupid. National housing prices were out of line with historical values, and now are returning to historical values. Which is just what people should have expected to happen and, indeed, was exactly what many people expected to happen.
But one thing I wonder about is whether this was really a “mistake” at all. I think back to a friend of mine who spent a summer working for a dot-com startup during the bubble years. The company’s business model didn’t make any sense. And my friend didn’t think it made any sense. He just thought it was an attractive job. And the sense he got was that his employers didn’t really think it made sense either. What they thought made sense was that if investors were willing to fund their startup, then spending some time paying themselves a salary out of the investors’ money and working for their own startup would be a fun thing to do for as long as it lasted. Either it would somehow work out — perhaps because some other group of investors was dumb enough to buy the company — or else it wouldn’t. But either way there was no downside risk for the founders — these were young guys, not people who’d quit stable jobs and put their families at risk. In the end, things didn’t work out. And I think the founders went to law school. Or else they’d recently graduated from law school and after the company went bust they took the bar. Or something like that. But the point is that you could look back and see the flaws in their business model and then wonder how they’d made such a terrible mistake. But that would be missing the real story, namely that they didn’t make a mistake at all. They took some investors for a ride! And they had a good time doing it!
In our current situation, meanwhile, it’s hard for me to avoid asking if one of the reasons the instruments were so complicated was that managers were trying to obscure from investors how simple their underlying bets were. I think if you said to someone “let me invest a bunch of your money based on the premise that there can never be a nationwide decline in real estate prices” a lot of people would say “no, that’s dumb” or at least “no, I can do that myself without paying you fees.” But come up with a lot of hocus pocus and you may be able to convince the guy that you have special insights and investment strategies that he should trust.
66 Responses to “Were Mistakes Made?”
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December 2nd, 2008 at 6:28 pm
Well there was a lot more on the line in the housing bubble than during the dotcoms. Credibility of rating agencies. Wealth of the nation, literally (most of households’ wealth is primarily their… houses). And the entire financial system.
It was hard to resist betting on that particular bubble unless you thought the entire economy was about to crash in a much more painful way than 2001, something that few people could even imagine.
December 2nd, 2008 at 6:32 pm
“But come up with a lot of hocus pocus and you may be able to convince the guy that you have special insights and investment strategies that he should trust.”
Um, isn’t that your own strategy in this piece? You yourself don’t understand the market or investments under discussion (though you’re relatively honest in admitting that). You then do a lot of hocus-pocus (actually, you rely on a semi-anecdotal model of what I guess we might call a combination of gut behavioral agency, agency problems and institutional analysis). Armed with that claimed expertise, you try to convince people in the market you participate in, the punditry market.
But not only isn’t this not any different from ALL potential investment managers, it’s no different from anybody trying to sell expertise to anyone else - one of the most common economic transactions in the world, and one of the most common social transactions as well (think the pundit convincing the public, the parent with the child, the bureaucrat with the politician, the general with his soldiers, the teacher with the student, and so on).
December 2nd, 2008 at 6:34 pm
You can be sure that it was not a mistake in the sense that a lot of people saw the securitization and bets as a way to make money. They did things to make sure that they made the money. If the investment bankers and hedge fund operators had to put the bets in fancy corsets to make them fit into the safety zone of insurance adjusters, bond raters and money manager, well, so be it. What the people holding the securities and bets when the music stopped missed was that a bad bet anywhere would trigger defaults almost everywhere. If you didn’t see that, you made a mistake but anyone could see it if they looked.
December 2nd, 2008 at 6:37 pm
I completely agree.
But I think there was also causality in the other direction - there was so much demand for mortgages to feed into these financial products that it gave lenders an incentive to make bad loans. Without that incentive, the financial products actually might not have become worthless.
Kind of like in quantum mechanics, where by observing something you disturb it.
December 2nd, 2008 at 6:39 pm
i mostly agree with what you’re saying, but i think you miss the point about why they did these complicated transactions. it wasn’t because it papered over how dumb the underlying ideas were or to make it seem complicated and therefore worthy of highly paid advisors.
instead, think of it this way: there were a whole lot of people out there with a lot of money and able to borrow a lot more who were looking for places to invest that moeny. you can’t just invent new companies or new real estate or other new, traditional assets to invest in. those kinds of things are either fixed quantity (as in real estate) or take time (as in companies).
so clever financial people had to come up with SOME way to take that money off those investors’ hands. and since you can’t just snap your fingers and create new real estate to invest in, they were forced to create very complicated, esoteric, poorly understood derivative securities to sell to people. and, of course, there are all kinds of other concerns (taxes, governance, seniority, etc) that have to be hashed out in advance and generally increase complexity.
in part, i think some of these financial types really did earn their money in the sense that it wasn’t easy to do in the first place (even if it was very easy to replicate as often as possible). of course, in retrospect, it turns out we didn’t really want what those financial types were selling.
December 2nd, 2008 at 6:41 pm
“it was a bet that any future housing price declines would be localized, and that it wasn’t possible for their to be a systematic, nationwide downturn in the housing market.”
Rather, the pricing of the instrument would reflect a perceived likelihood of these events (versus possible other scenarios). First, there’s expertise in relating the perceived likelihood with the pricing - something Matthew doesn’t have the ability to do. Second, there’s whether the commonly perceived likelihood itself is correct - and I would challenge whether Matthew’s claim that it was unchallengeably apparent that these two scenarios were clearly wrong.
December 2nd, 2008 at 6:51 pm
A nationwide decline in housing prices has only happened twice in US history. In the 1840s and 1930’s. For all practical purposes in the experience and minds of most people, impossible. Then too was the belief that when a rough patch came and if a bit of systematic deflation loomed then the Fed and the worlds central banks would step in to save the day.
The belief in endless liquidity and endless credit expansion became the foundational belief of the financial world. As if to put an exclaimation point on it Ben Bernanke who spent his life making the case that systematic deflation was impossible if the Fed acted to counter it was named Fed Chaiman, right at the top. Thus history placed the perfect man in front of the freight train.
The structure of the financial markets determines the direction and performance of the underlying economy. That has always been true and has become more true as the decades have passed. The financial world is completely and totally dislocated and like Humpty Dumpty cannot be put together again. They have spent two trillion and promised six more since March and not one single thing in the world has stopped deflating. Not one single thing. Our banking and financial system simply cannot exist without inflation. It is an impossibility.
December 2nd, 2008 at 6:53 pm
I don’t think there’s anything particularly troubling about the complexity of the ways in which these mortgage cash flows were cut up. Different sorts of institutions liked different types of cash flows and risks, and the various tranches and slices aren’t a completely recent thing. The problem was the misrepresentation or misapprehension of the quality of the mortgages underlying these recent MBS, and then all the leveraging that went on around and above them.
There is a great discussion of these details at Calculated Risk, in the MBS segments of Tanta’s Complete Ubernerd pages ( http://calculatedrisk.blogspot.com/2007/07/compleat-ubernerd.html ) Sadly, Tanta passed away last week, aged 47. Reading her detailed discussion of these issues before pronouncing on their value or lack thereof would be an appropriate tribute to her memory.
December 2nd, 2008 at 6:59 pm
I don’t think you can get to your conclusion without delving deeper into securitization. For instance, consider that the super-senior tranche of a “traditional” mortgage-backed security (not a CDO) is presumably doing fine. The whole point of having tranches is to control the risk borne by investors in any particular tranche. Sure, the issuers messed up the math, but it would take unrealistically high default rates for the highest tranche to get burned (this is true of securities backed directly by mortgage payments, not necessarily securities backed by other securities). So investing in the super-senior tranche wasn’t really a bet about the real estate market at all, though the complexity of the securities may have dragged their value down along with the lower tranches.
Then consider that most of the issuers of these securities held on to the lowest (i.e., last to be paid) tranches. In a lot of cases, the banks are in trouble precisely because they ate their own dogfood. This does not seem to be consistent with the idea that they were simply scamming the investors. It’s as though your friends had actually invested their own cash in the venture they were working for.
Of course, you can argue that these people were dishonest, as no doubt many of them were, but I don’t think it’s fair to do so without understanding what you’re accusing them of and dealing with exculpatory evidence.
December 2nd, 2008 at 7:00 pm
But I think there was also causality in the other direction - there was so much demand for mortgages to feed into these financial products that it gave lenders an incentive to make bad loans.
Stop talking crazy. Everyone knows it was Teh Negroez.
December 2nd, 2008 at 7:05 pm
This also has to do with a certain real estate myopia. They say that back in the 1980’s, banks in Japan would approve any loan, for any amount, for any purpose, as long as land was used as collateral. Real estate, being “real”, was considered the gold standard. It was inconceivable that land could ever lose value.
I’m willing to bet that a great many of those involved really belived that those CDO’s were safe - after all they were backed by “real” estate…. you could drive out and see one of the homes that backed your bond. It seemed, at the time, like the model of safety.
December 2nd, 2008 at 7:05 pm
I can explain what happened to a significant part of AIG. I assume it was similar to other situations.
AIG paid bonuses based on the difference between the money received for selling a Credit Default Swap (CDS) and the ‘perceived’ risk of the CDS.
Now, if I have anything to do with it, I will claim the risk is as low as possible so that my bonus is as big as possible. Over time, as few credits default then I can claim the risk was overstated and claim even bigger bonuses. Then, of course, when things go south, I get to keep my bonus and the company dies.
AIG didn’t have a system where the people who judged the risk were removed from the benefits derived from judging the risk.
We need people who can impartially judge the risk. Putting CDS’s into a regulated exchange would be a big first step.
December 2nd, 2008 at 7:33 pm
Can I make a point here that I feel is perpetually glossed over? Until 2007, the buyers of mortgage backed securities, in all their forms, had been making a killing. From the outside it was fairly easy to see how they were headed for disaster, but if you’ve made a lot of money doing something that essentially works like arbitrage even though it isn’t actually arbitrage, it feels different. They could borrow as much as 30 times the value of their assets at a lower rate than these securities paid, and make tons and tons of money off the spread.
This went on for years. It accelerated in 2004, 2005 and 2006. You didn’t need to trick any of the hedge funds or endowments to buy this stuff, because they believed in it. It had made them tons and tons of money for years. They believed in it not for any fundamental reason, but for the most powerful reason of all (at least on wall street) because it had worked. I know there’s a specific term for this type of bias, but I forget what it’s called. So of course they wanted to buy as much of it as they could–on margin of course–and the fact that they did it on margin is another large part of the reason why the brokers got so screwed in the end–because they were forced to take back their own merchandise when the hedge funds lost money–mortgage reflux as my boss calls it.
Another point: brokers could make a lot more money selling these securities than anything else (as long as they were packaged by the brokerage house they worked for) because of various hidden fees. A mediocre salesman could make four million a year selling this stuff, way better than other parts of fixed income or stocks. So there was every incentive in the world for the brokerage houses to create this junk and the brokers to sell it.
December 2nd, 2008 at 7:39 pm
I don’t think you can get to your conclusion without delving deeper into securitization.
There’s no need for that here. MY has already summed up the entire crisis with an anecdote about kids bilking investors with a bogus start-up. The analogy holds perfectly for the mortgage industry, and any explanation that doesn’t place 100% of the blame on willful actions of greedy wall street scammers is clearly wrong.
December 2nd, 2008 at 7:45 pm
I think it’s likely true that the purpose of the more complicated financial instruments was to obscure the reality untenable risk assessments: the “greater fool” could only be found by making the substantive basis of what was being purchased as hard to grasp as possible, refracted and simply obscured by the beauty of the instrument itself.
It’s hard for me to be categorical about this, because I do acknowledge that finance is a genuine realm of knowledge and expertise like neurosurgery or medieval history, but my sense is that there is relatively little genuine genius-at-work (maybe those guys who figured out how to price futures, for instance), and quite a lot of spurious knowledge that’s more in the way of marketing than of real innovation. Of course, that’s a very fine and subjective line, but Matt’s comment casts some light on that line: derivatives that were based on one party accepting the viability of a market prediction that they’d never accept if posed to them in a straightforward manner were clearly a triumph of marketing, rather than of financial innovation.
December 2nd, 2008 at 7:47 pm
Not to be too critical, but how does a Harvard grad so regularly confuse “there” and “their”?
December 2nd, 2008 at 7:50 pm
Re: those kinds of things are either fixed quantity (as in real estate) or take time (as in companies).
The main question I would like to see answered is why people weren’t starting new companies in 2003-2004 so as to soak up that investment money. Normally that’s what happens when a recession ends. The recession clears out a lot of dead wood (rather like a forest fire) and gives room for new start-ups to grow, while the lower interest rates provided by the Fed make capital for such ventures cheap (and of course allow existing business to expand as well). But instead in 2003 and well into 2004 we were reading stories about businesses just sitting on piles of cash not doing anything productive with it. There’s usually a small real estate boomlet at the end of a recession owing to pent-up demand and low interest rates, but then new business activity sops up the spare investment cash so the thing doesn’t get out of control. Why not this last time? Did the 90s somehow exhaust the entrepreneurial energy of the nation?
December 2nd, 2008 at 7:57 pm
First, it’s somewhat misleading to call it a national decline in home prices. It’s really a fairly flat market in much of the country and catastrophic declines in a number of states. The four “sand states” - California, Arizona, Nevada, and Florida — account for half the defaults and likely 70+% of the defaulted dollars, because that’s where the Housing Bubble was. (There was also a dead cat bounce in the Rust Belt centering on Detroit.) California alone accounts for roughly half the unexpected defaulted dollars.
December 2nd, 2008 at 8:05 pm
Matt’s attempts to explain the credit crisis are increasingly sophmoric — and who does he cite as his compatriot in this quest — well none other than good friend Ezra Klein. Talk about the keystone cops!!
MY’s last paragraph would hold except for the inconvenient fact that many of those constructing these instruments and holding them — ie, Goldman, Lehman, Bear, Citi — were one and the same!
Did the bilk themselves?
They tried to make money off the spread between the cheap commercial paper they issued and the higher yielding securitized notes they bought.
And hedge funders were also holding these — not a particularly unsophisticated group.
So MY’s theory holds — if widows and orphans were holding these securities. Except they weren’t.
If you want a more informed view of this, read Michael Lewis’ article in Portfolio mag.
December 2nd, 2008 at 8:05 pm
Second, it’s not an interesting question to ask, “Was Wall Street driven by greed?” Of course Wall Street was driven by greed. That’s why people go to work on Wall Street: greed.
The interesting question is where was Greed’s traditional counterbalance: Fear. The markets are supposed to be driven by both Greed and Fear, but Fear was AWOL for years when it came to the question of whether that $400,000 no money down mortgage made out to a drywaller in Santa Ana was ever going to get paid back.
Why was Fear missing? I think one reason was the assumption that the mortgage business, unlike the dot.com business, would have to be bailed out if something went wrong. Pets.com didn’t get bailed out, but that was equity more than debt. Debt is supposed to be more secure than equity, so it’s more catastrophic when debt fails.
Furthermore, the political pressures for bailing out lenders who are helping ordinary Americans attain the American Dream, yada yada, is much stronger than for Pets.com.
December 2nd, 2008 at 8:19 pm
Finally, let’s look at a big reason there was too little Fear on Wall Street about whether or not Californians would pay off their giant mortgages (which is more or less the root cause of the crisis): political correctness.
Notice how the gorge rises in your throats and your head fills with thoughts of how evil I am as I point out that it should have been obvious that Californians weren’t going to pay back many of these new alf-million dollar mortgages because California is full of Mexicans and not many Mexicans earn enough to afford to pay back half-million dollar mortgages. Furthermore, people who do earn that much don’t want to live next to a whole bunch of Mexicans. So, the whole idea of the median home price in California being worth a half mil was ludicrous. Hence, the whole idea of lending gazillions to Californians, of octupling mortgage dollars going to Hispanics from 1999 to 2006, ever made any sense.
Now, examine those irrational feelings of loathing toward me that you are currently experiencing. Do they get in the way of rational thought? Does the knowledge that other people are also sputteringly hostile toward anyone who speaks heresy about the sacredness of diversity lower the chances that you might ever speak up and utter heresy in public?
Of course. The bottom line is that political correctness makes people stupid. We have a culture that punishes heresy about diversity, so we have very little of it. So, we are suckers for policies like Bush’s 2002 plan to add 5.5 million minority households by attacking down payments.
December 2nd, 2008 at 8:23 pm
Fear was AWOL for years when it came to the question of whether that $400,000 no money down mortgage made out to a drywaller in Santa Ana was ever going to get paid back.
Is he a Mexican drywaller? Because then, no way.
December 2nd, 2008 at 8:33 pm
Steve Sailer says:
Here’s the data. It is striking how much of the bubble was in the “sand states,” but prices have declined by more than 10% in DC, Minneapolis, Chicago, Boston, New York, Cleveland, Seattle, and Atlanta. I wouldn’t call it a “fairly flat market,” in other words.
December 2nd, 2008 at 8:36 pm
Matt is exactly right.
Also, I worked for a couple of those startups too. It was fun!
December 2nd, 2008 at 8:44 pm
Or maybe a Guatemalan dry-waller in Santa Ana.
But, we’ve got a pretty good idea from his living in Santa Ana, a city of about 350,000 that’s 95% Hispanic, of his prospects for repayment.
He almost certainly can’t go to his parents to help him out with repaying his loan. They’re poor. His siblings aren’t likely to have a lot of spare cash either. He’s probably not studying to be a neurosurgeon in his spare time. He’s probably not going to marry a lady doctor who makes lots of money. He’s probably not going to be a better, more productive, higher paid drywaller when he’s 30 years older than he is now (as his mortgage winds down) because his body is going to be breaking down from doing hard, physical labor.
His children are probably not going to become chip designers for Intel and help him pay off his loan. (We have many generations of experience with Latinos in Southern California, and a recent study by the UCLA Chicano Studies Center found that among Mexican-Americans whose grandparents were born in America, only 6% have college degrees).
Nope, this is a bad, bad loan.
That’s how a banker traditionally thinks. But, you aren’t supposed to think like that anymore. Only evil people like me think like that. So, lots of non-evil people bought into the conventional wisdom about how diversity is making us stronger and poured huge amounts of money into working class neighborhoods in California, Nevada, Arizona, and Florida, with catastrophic results.
December 2nd, 2008 at 8:55 pm
Well, we’ve known since Marx that the private sector sucks at allocating capital. The less the wealthy are taxed, and the more the financial markets are deregulated, the more they will chase high yield into a worthless bust. Economists like to talk about public investment crowding out private investment, as if that is always a bad thing. Oftentimes, it is a wonderful thing - since oftentimes public money has to be used to start the R and D projects which take a long time to gain any kind of profitable footing in the private sphere.
This boom is different in kind from the tech boom, which was driven by something increasingly rare in the U.S. - actual manufacturing and innovation. Michael Lewis, in 2002, wrote an excellent piece in the NYT about this. The current boom bust was the reassertion of financial power, which is a blind and piggish force. As this recession keeps going deeper, the idea that we should stop the next one by very high marginal tax rates - making it unprofitable to become, say, a billionaire - the seizure of the OTC market and its institutionalization as a regulated equities market, State intervention in R and D of our crucial industries, like healthcare and transportation, to create more open -ware - and thus breaking up IP monopolies - might actually create a fairer deal and a more equal distribution of wealth, something that is sorely needed at the present time.
December 2nd, 2008 at 8:58 pm
There has been a string of robberies and murders by Latino landscapers (out-of-work landscapers, one presumses) in the wealthier neighborhoods around Washington, D.C., as Matt ought to know if he bothers to read the Metro section of the Post. I don’t want to extrapolate a trend, or cast racist aspersions. A pan-American tragedy, rather — people who were attracted to low-skill jobs in the bubble economy are the first to be cast off when the contraction begins. There’s also a suggestion of Brazil, or of Amy Chua’s World on Fire.
December 2nd, 2008 at 9:09 pm
The markets are supposed to be driven by both Greed and Fear, but Fear was AWOL for years when it came to the question of whether that $400,000 no money down mortgage made out to a drywaller in Santa Ana was ever going to get paid back.
Given Lee Ving’s general right-wing outlook, I think we can assume Fear’s answer would’ve been “no.” I’m not familiar with Greed–didn’t they put out a split 7″ with the Feederz around 1982?
December 2nd, 2008 at 9:18 pm
Oh come on. Insurance has been around for hundreds of years. AIG was a tremendously successful insurance company. You think no one ever thought of this point until now? How do you think insurance gets priced?
December 2nd, 2008 at 9:18 pm
“In our current situation, meanwhile, it’s hard for me to avoid asking if one of the reasons the instruments were so complicated was that managers were trying to obscure from investors how simple their underlying bets were”
I agree with your analysis. This was a huge dumb bet, camouflaged by a whole lot of complex shuffling and sleight-of-hand and magical pixie dust from the ratings agencies. But all the complexity wasn’t just fooling the investors, it was also fooling regulators and the financial institutions’ own internal risk-management systems.
The structure is pretty similar to what Enron did. A trader
makes a bet about the future (in Enron’s case, a long-term contract for energy supplies) and the short-term revenue from the bet goes on the books as immediate profit, while the risk of losing the bet gets grossly underestimated and/or hidden
off the books in a separate SPV corporation.
It didn’t work out so well for Enron. But the banks played the same games anyway. Damn fools.
December 2nd, 2008 at 9:43 pm
Mr. Sailer,
The problem wasn’t that those Mexicans” weren’t earnign enough to pay those mortages, the problem was that lost’s of people of ALL races and national origins weren’t making enough to pay those mortgags.
Well, not “the” problem, that was one of many problems, you evil racist fuck. And the fact that you are a little smarter than the typical racist fuck just makes it worse, not better.
I pray to God every day that someone comes along and slits your throat Mr. Sailer.
December 2nd, 2008 at 9:51 pm
With all that complexity I wonder why did they bother writing mortgages at all? They pulled these investment vehicles 95% out of their asses, why couldn’t they go the extra mile, pull it 100% out of their ass, and leave the real economy out of it? Their phony earnings should be able to evaporate into the thin air from which they were created, without having to tank my property value in the process!
December 2nd, 2008 at 9:55 pm
As my Intro to Marketing prof used to say - “There’s margin in mystery”
December 2nd, 2008 at 10:05 pm
I want to thank Voice of Reason for illustrating my point for me that someone speaking in violation of the conventional wisdom about the wonders of diversity induces feelings of homicidal rage in many nonheretics:
“you evil racist fuck. And the fact that you are a little smarter than the typical racist fuck just makes it worse, not better.
“I pray to God every day that someone comes along and slits your throat Mr. Sailer.”
So, more and more people train themselves not to write the facts, not to speak the facts, not to think the facts, not to even notice the facts. That’s what political correctness is: social-mandated ignorance.
And thus we get the world pouring money into California mortgages that never had a chance in hell of being paid back, with cataclysmic consequences.
December 2nd, 2008 at 10:10 pm
Read the Irvine housing blog. The bubble wasn’t in working-class neighborhoods. It was in middle and upper-class white suburbs.
December 2nd, 2008 at 10:47 pm
I think Matt’s point is a good one. Its happened before. For example, why would the Latin American economies of the 1970s borrow so much of the petrodollars, or why would these be invested in those countries, when the fact was that they had highly unstable economies that would eventually result in debt crises?
December 2nd, 2008 at 10:51 pm
“So, more and more people train themselves not to write the facts, not to speak the facts, not to think the facts, not to even notice the facts. That’s what political correctness is: social-mandated ignorance.”
That’s a little dramatic Steve. I don’t think anyone denies that it’s a good idea, or good social policy, to sell ballooning mortgages to people who can’t afford them, whatever their race.
But you make a stronger claim–namely, that this crises’ origins lie in the PC desire to expand minority home-ownership. Because it’s one thing to claim, correctly, that efforts were made to expand minority home-ownership; it’s another to say that it is this which caused our grand economic/credit crisis. You’ve shown the former, but not the latter, not by a long shot, so far as I have seen (this blog and paper you wrote back in June-ish).
And I don’t know exactly how you would prove it–providing a history of modern lending practices (was it minority driven?); or the actual percentage of minority owned sub-primed loans (is it a decisive share?); or a demonstration of the drastic importance of sub-prime loans in relation to the crisis as a whole (not just the housing bubble), over and against the CDS and insurance market. Whatever the case, you still have a lot of work to do.
December 2nd, 2008 at 10:53 pm
I don’t think anyone denies that it’s a good idea, or good social policy, to sell ballooning mortgages to people who can’t afford them, whatever their race.
ahh, bad idea! bad idea!
December 2nd, 2008 at 11:25 pm
Igloo spot on mate!
I joined a competitive flag football team, and when I showed up for the game the QB (a former arena leaguer) went to great pains to run me (WR) through all the position nomenclature, formations and plays. After he was finished, I said “okay so it sounds like I’ve got three basic routes a slant, hitch-n-go, and down and out” the rest of the guys nearly fell over laughing their tails off.
It seems to me that the self-described purveyors of all things finance have a vested interest in advancing the “it’s not that simple” meme. What is it? They get to be the biggest brains in the room! One thing I learned in b-school and consulting is that supposed big brains hate to have their theses reduced, it hurts their ego to know everyone gets it.
I’ll admit that not everything can be reduced, and there are legitmate needs for big brains, understanding this crisis is not one of those.
k1
December 2nd, 2008 at 11:27 pm
This is exactly (well, almost exactly) the point that Alan Greenspan missed in his much ballyhooed mea culpa. He said his worldview was based on a faith that companies would look after their own self-interest, and he was shocked and dismayed that they did not.
The basic problem with his understanding of the world, though, never came out. The fact is that “companies” do not do anything, only people do things. The people who worked for these companies were all looking out for their own self interest, big time. They made millions of dollars. The companies failed, of course, and the shareholders got screwed. But the people who were running the show were looking out for their self interest, and Mr. Greenspan shouldn’t have been shocked at all that they were doing so.
December 2nd, 2008 at 11:39 pm
J.G.A. Pocock talks about the Country Opposition in England in the 18th C. and its belief that the market was essentially delusional. Very important for our Founders, by the way, this Country tradition.
The books is THE MACHIAVELLIAN MOMENT: FLORENTINE POLITICAL THOUGHT AND THE ATLANTIC REPUBLICAN TRADITION.
December 2nd, 2008 at 11:54 pm
The problem with Matt’s analysis is that the investment banks weren’t dumping the super senior tranches on unsuspecting investors — they were keeping it for themselves, which is why they are almost all nearly defunct now.
They kept it for themselves because it was unsaleable — not because it was too risky, but because it was too boring. The hedge funds snapped up the lower tranches but weren’t interest in safe, AAA rated investments.
So the supposed scam was on themselves? The theory doesn’t hold up.
December 2nd, 2008 at 11:58 pm
So basically no one in finance ever thought about principal-agent problems, and that’s why the crisis happened.
Or is it simply that you never thought of principal-agent problems until now?
Which is more likely?
December 2nd, 2008 at 11:59 pm
It’s certainly fair to say that finance types don’t like to have their models simplified. But that doesn’t make it accurate for Matthew to equate human frailty and misjudgment with malice.
December 3rd, 2008 at 12:18 am
Here is an interesting take.
http://bigpicture.typepad.com/comments/2007/08/cdo-insiders-we.html
It doesn’t sound like they wanted to defraud investors. It was just that they were too busy getting rich to care if the whole thing exploded and took out a lot of investors.
December 3rd, 2008 at 12:41 am
On a similar note, it may have made a certain amount of sense, at least on a short-term basis, for people to live outside their means with a mortgage they couldn’t afford over the long run.
Heads, housing prices rise and things work out. Tails, housing prices fall, but hey, you lived in a nice house while it lasted.
December 3rd, 2008 at 2:00 am
The real failure is people buying these instruments with 20 to 1 leverage. Leverage is high risk. If I have $100 and want to invest it in stock at $10 a share… If I use just my $100 I have 10 shares. But if I borrow an additional $900 then I can buy 100 shares. If the stock goes to $15 a share… In the former example I gain $50, but in the latter I gain $500.
A $500 return on a $100 investment is fantastic.
The problem comes in when the stock price drops instead to $5. Now I’ve lost $500 instead of $50, and considering I only had $100 to start with that is a substantial loss and drives one to bankruptcy.
December 3rd, 2008 at 3:33 am
in part, i think some of these financial types really did earn their money in the sense that it wasn’t easy to do in the first place (even if it was very easy to replicate as often as possible). of course, in retrospect, it turns out we didn’t really want what those financial types were selling but you want to see my home this one : http://makkale.blogcu.com/hertha-cok-iddiali-hertha-berlin-galatasaray-macinin-golleri-hertha-berlin-galatasaray-uefa-kupasi-macinin-golleri_30222711.html
December 3rd, 2008 at 9:21 pm
Many here have made cogent points about the degree to which unmediated greed and self-delusion were key factors in the minds of the persons, not companies, that were making these decisions. this was true on all sides–the borrowers for housing that they couldn’t afford who greedily convinced themselves that whenever they needed to they would sell the house for huge bucks; even more so the lenders, the syndicators, who were professionally trained to know better, everybody.
but only cliff mason and blah have pointed out the very key role that TRANSACTION FEES played in all this. The people who really really made all these deals go–the creators and traders of credit default swaps, mortgage bets, and the rest–earned big fees on good deals and bad deals ABSOLUTELY REGARDLESS OF THE QUALITY OF THE LOAN. It was simply not a factor. whatever deal you did, that’s what generated revenue for your company, and that determined your bonus, the company’s ‘earnings’ and so on. All benefited just beautifully from all deals, no matter how monstrously stupid the underlying bets might have been.
i know some of these investment bankers, and yes, they fucked their own companies as well as the rest of us. this certainly wouldn’t cause them (or me) any lost sleep. and yes a few of the companies fucked themselves right out of business in the mid-run (the long run has yet to run—we’ll see), but by and large the individuals certainly and the companies for the most part made much more money over the last five or ten years than they are losing now. and the others, well they lived like masters of the universe for a very long time, buying a great deal of overpriced condos, champagne and sex for the last decade or so, and probably regret it all only a bit. [they also may have remaining more cash than most of us will earn in a decade. ]
the DEAL and its fees drove everything. the whole investment banking industry was built in order to capture these fees and honed itself over the years into a brilliant instrument for achieving this. and the masters of the universe mastered the system to a fare-the-well.
it will be a hell of a challenge for the regulators to figure out how to prevent or at least inhibit this in the future.
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