Saturday, March 7, 2009

The reality is that our current problems are more the result of Wall Street’s stupidity and recklessness than its corruption

From the Economist's View:

"links for 2009-03-07
Posted by Mark Thoma on Saturday, March 7, 2009 at 12:06 AM "


"The reality is that our current problems are more the result of Wall Street’s stupidity and recklessness than its corruption (though there was plenty of that). And dealing with that problem is quite a bit more challenging."

I don't buy that, but , even if I did, I'd be more worried about Fraud, etc., because that's a crime and needs to be investigated and prosecuted or it will continue. But let's get to the real point.

No one is saying that Wall Steet types expected Debt-Deflation or even to lose money. Just like Madoff, they probably thought that things would work out, or that it was worth the risk. Saying that they were hopeful that whatever they were doing would work isn't very profound. Of course they did.

The question is what allowed them to take such enormous risks. Surowiecki doesn't believe in moral hazard at all. The fact that the government had been intervening in financial crises since the S & L Crisis doesn't seem relevant to him. To me, that defies belief, especially when you see how the investor class reacted to Lehman. They were betting on the government intervening. In fact, they were demanding it. The major banks believed that their lobbying had bought them an insurance policy for government aid if there was a crisis. They believed that, as in the recent past, the intervention could be costly but would be contained if the government intervened. They did not have to foresee this specific crisis to have been acting on implicit government guarantees. That's silly. They simply expected government aid if they got in trouble. Since we now know that the FDIC had no plans in place in seize a large bank, and we don't let banks go bust in this country, what does Surowiecki think that the plan was if a major bank became insolvent? It was obviously to merge the insolvent large bank with another large bank, at whatever cost to the taxpayer that was needed.

Also, no one is saying that this is all fraud or criminal behavior, many of the problems seem like negligence or fiduciary misconduct. They are civil problems.

As for the risk wasn't known, that's just silly. They were looking for investment vehicles that allowed lower capital requirements. That makes them inherently riskier than other investments. Robert Rubin has a quote saying that he knew exactly that. They knew that these were risky investments.

CDSs and CDOs are not hard to understand as to RISK. It is difficult to do the math that creates tranches and statistical data for prediction, but the risk is easy to explain. They are an attempt to use high leverage, and that's not hard to explain. Just as in the subprime loan business, wall street types misled investors as to the risk.

Here's a paper from 2005 that I found on the web long ago from 2005:

You're telling me that highly educated millionaires couldn't find sources like these on the web or find someone to give them another side to these investments? I don't believe that. Would that have meant that they wouldn't have tried these investments? No. They would have. But they would not have invested the amounts that they have. That's the point. They were consciously overlooking and underplaying risk because the rewards were so great. The Kool Aid, as Surowiecki calls it, was, at the very least, a reckless investment strategy that's now being fobbed off as stupidity, just as in the S & L Crisis. Fortunately, although not at the time, we now have a lot of resources that have shown us that much of the so-called stupidity was actual fraud.

Finally, I sold my house early last year because there was a housing bubble. If I could see that, then I have to believe that some of these Wall Street types could as well but ignored it.

A couple more points about Surowiecki. Note this quote:

"To see this, consider a bank that hypothetically holds two perfectly negatively correlated BBB-rated
assets. If it were to hold the assets directly on its books, it would face a high capital charge. On the other
hand, if it were to bundle both assets in a structured investment vehicle, the structured investment
vehicle could issue essentially risk-free AAA-rated assets that the bank can hold on its books at near zero
capital charge."

I could be reading this wrong, but this helps understand why banks held onto some of these tranches.

Finally, could anything be more helpful to selling risky crap than having someone say that it's AAA and they're investing their own money. One could imagine Mr.Surowiecki helping to sell Madoff or Stanford by saying, "Look! Look! They're investing their own money! How could it be a Ponzi Scheme?"

Perhaps that was part of the pitch.

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