Regarding the movie The Big Short, Tyler Cowen wrote,
There is no central villain, none whatsoever. The filmmakers succeed in showing how the collective actions of many, operating together, can give rise to structural problems and systemic risk. And yet the story remains suspenseful.
People prefer stories with villains.
I think that the story of the financial crisis has to include leverage. Individual home buyers did not put up much of their own capital. The lenders did not put up much of their own capital. The mortgage securities were structured and rated so that banks could hold them with minimal capital.
However, some of this leverage was opaque. People did not understand the way that AIG was contractually obligated to put up billions in collateral if prices moved against them. People did not understand that while Fannie Mae and Freddie Mac were reporting that their sub-prime exposure was less than 2 percent, their exposure to risky loans was closer to 30 percent. People did not understand that mortgage securities rated AAA were not really comparable to AAA-rated bonds. People did not understand that banks had created “structured investment vehicles” and other dodges that made them much more levered than they appeared to be. And by “people,” in all cases I mean regulators and investors.
But finally, the opaque leverage was less intentional bad behavior on the part of financial executives than it was self-deception. Suppose that you had asked executives in 2007 to answer honestly, “Relative to what people outside the firm think, how exposed are you to a decline in house prices and problems in the mortgage market?” My guess is that almost all of them would have said, “We are less exposed than other people think.” And they would have been telling the truth from their point of view.
That is what made the speculators in The Big Short so special. They managed to dig through to reality.
And don’t forget that I coined the term, “Suits vs. Geeks Divide.”
If, first there were defaults, then home prices fell a few percentage points, then the mortgage securities broke down, you could say this. But that didn’t happen.
Nationally, home prices went down something like 25%. That’s insane. It’s multiple standard deviations of change. It’s insane that we let it happen, because we have some power to create stability, which we collectively chose not to implement. No model was predicated on surviving a 25%. Model makers may have said we’d never have a 25% decline, but I doubt they would have said a 25% decline could happen without there being problems.
At some point, you can’t blame the models. It’s like watching a guy die after he gets shot, and complaining that you saw this coming because for years he never ate his vegetables.
If you say that we had to let it happen because continuing the “bubble” would only make it worse later, then you are imposing yourself on the outcome.
At the time I was shouting from the rooftops, by which I mean commenting on one relatively obscure blog, that houses could be refinanced to 40 or 50 year mortgages and government has a legitimate role in that because the toxic assets had unclear paper trails…and they run The Fed and control credit and lending standards and customs, not to mention they are supposedly the lenders of last resort and time was of the essence, and there isn’t really anything wrong with increasing mortgage duration.
This was based on the assumption that defaults capitulated on a combination of being underwater plus cash flow problems precipitated by job loss, rates adjusting upward, etc. Increasing the duration of toxic assets along with easing (rather, cycle-smoothing) mark-to-market addresses both of those problems.
Interesting.
It’s funny how perceptions in housing are based on a lot of conventions that have always sort of worked, but don’t really make any sense. For instance, your idea about longer durations would actually make the liability-asset duration match better, because homes have a very long duration, if we think of them as financial securities. But, your proposal will inevitably get a backlash because it will be seen as a way to expand lending, and everyone just knows that those rubes out there buying homes will just suck up everything they can finance if we give them the chance.
The whole issue of matching a nominal, fixed rate loan with a real asset, itself, is a little weird. And the idea that paying down that mortgage is some sort of moral demand is so arbitrary. It basically creates a savings plan for the homeowner based on the level of expected inflation at the time of their purchase. No financial advisor would ever sit down with a client and specifically say, “OK, I think you should save 5% of your income each year, into a real estate REIT, because monetary policy is expected to run at 5% inflation for the life of your mortgage.” Yet, this is what they are saying, and everyone goes bonkers if they think people are deviating from this.
Yeah, I should have said “and there isn’t really anything wrong with increasing mortgage duration…DURING A CREDIT CRASH.”
And people are living longer, so although these plastic houses might even fall apart faster, the effective asset duration may be getting longer, but I don’t know.
“But finally, the opaque leverage was less intentional bad behavior on the part of financial executives than it was self-deception.”
What’s the difference? Almost all evil men also deceive themselves. Nobody admits their evil. Even histories greatest villains always have some rationalization, and if you accept their premises there is usually an internal logic to it all.
IMO, most evil comes in the form of conscious of unconscious “desired ignorance”. This is not an excuse, and these people are still evil and need to be punished for their misdeeds.
Liberals want to coddle people when times are good, conservatives want to punish people when times are bad. Some times they find common ground and we get the business cycle.
Structured investment vehicles were off balance sheet.
High leverage is not necessarily a problem if assets and liabilities are matched by risk and duration. The real financial problem is maturity and risk mismatch (and also of course risk misperception and mismanagement based on faulty statistical models).
A very good point regarding self-deception. In 2007 when things were already starting to unravel, Wachovia paid $25 billion for Golden West Financial (a specialist in sub prime mortgages) and then proceeded to loosen their credit standards! Actions speak louder than words.
Recklessness may not be intentional, but it is still egregious. What were they being paid for? What were they supposed to know? Why does failure have to be rewarded? Is justice so much to ask?
They did get punished. Start with the regulators. Only on government is the failure rewarded and nobody gets fired- unless it’s a scapegoat to protect a more senior failure.
Try to come up with a list of bureaucrats who lost their jobs or lost income or went to prison.
The main reason the bankers weren’t gone after even harder is to protect the bureaucrats.
Not being able to make billions more because the merry go round stops isn’t punishment. Losing your job after collecting billions isn’t. Not materially. Nor do I want punishment, but accountability. Accountability is only for the lowly, like those who wouldn’t play the game and lost out on the way up. All we hear are excuses for accountability from them and their sycophants because they are too high to face any.
Sure it is, relative to bureaucrats only getting more power and budget.
And again, the main reason bankers didn’t get more punishment is because the government doesn’t want the issue looked into.
” less intentional bad behavior on the part of financial executives than it was self-deception” << in the cases of lying about income by home flippers & buyers, and accepting these lies with a wink and nod, the acceptance of the buyers' lies was intentional bad behavior.
The lying buyer assumed house prices would go up. The "lie believing" mortgage provider also, and wrongly, assumed the same. And the executives were intentionally believing the liars, and getting bonuses based on fees and deals, where this dishonesty was being rewarded.
The rich executives knew it was wrong, they were deliberate, they were only deceiving themselves about how hard the market might punish them — they thought, not very much.
They should have all gone bankrupt, but with emergency Fed semi-nationalization power to a) wipe out all equity, b) fire all execs/ offering new "median wage only" jobs to the non-execs, c) force debt to new equity conversions so as to keep the firms operating in a limping along way — and a lot of the most lucrative business goes to lower tier banks that had been less greedy/ risk accepting.
Meltdown at the top of finance, with a loosening of money at the Fed (both lower rates AND more money available for QE or helicopter drops or tax refunds or tax loans), would not have been worse for industry/ Main street than what did happen.
The bailouts kept the rich rich despite their foolish support for dishonesty.
The book is great (haven't seen the movie), and Dr. Michael Burry has a good UCLA speech a few years ago:
http://www.zerohedge.com/news/dr-michael-big-short-burrys-brutal-hangover-inevitable-state-world-ucla-commencement-speech
Also, anybody and everybody who says “nobody predicted it, nor could have predicted it” are wrong, and intellectually dishonest. Probably have NOT read a single CDO or structured finance contract in complete legally binding detail. (They are SO boring, I can’t get thru them).
Especially Greenspan. The rich tax-backed speculators did NOT want to even think about a crash, nor did the bank-captured regulators.
Scott Sumner claims that GNP growth from the 2006 peak of house prices to the 2008 bank crises proves the house price crash was not the key event. I’m certain he’s wrong, but can’t prove it. The house price crash meant some 10-30% of US economic activity was “malinvested”, with slightly to hugely negative rates of return.
Burry’s short selling of the financial products were picked up by newly risk conscious execs around 2007 as the house price increase gravy train turned into a train wreck. It took all of 2007 and half of 2008 for the self-deceived lie believers to realize how much they were about to lose and how few their options were. See 2007 bankruptcies: http://www.mondaq.com/unitedstates/x/58228/Insolvency+Bankruptcy/The+Year+In+Bankruptcy+2007+Part+1
>>Laurels for the largest public bankruptcy filing in 2007 (and the ninth-biggest public bankruptcy filing of all time) went to subprime lender New Century Financial Corp., once the second-largest provider of home loans to high-risk borrowers in the U.S., which filed for chapter 11 protection in Delaware on April 2, 2007, listing more than $26 billion in assets. New Century wrote nearly $51.6 billion in mortgages in 2006 and once employed more than 7,200 people <<