that’s the Rubin trade: it works until it doesn’t

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"Felix Salmon

a good kind of contagious

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May 5th, 2009

Overconfidence and the financial crisis

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Posted by: Felix Salmon

Tags: banking, risk

Malcom Gladwell kicked off this morning’s New Yorker summit with a talk about the causes of the financial crisis in general, and of the collapse of Bear Stearns in particular, and started provocatively, by saying that if his diagnosis of the problem is correct, then really “there aren’t any solutions”.

Gladwell’s diagnosis is simple: massive amounts of overconfidence, as revealed by its two most common symptoms, miscalibration and the illusion of control. Both of which can be seen in spades in the person of Jimmy Cayne, whose interviews with William Cohan for House of Cards show a man who’s really very deluded about what Cohan, and Cohan’s readers, are going to think of him.

More generally, said Gladwell,

What’s going on on Wall Street isn’t the result of experts failing to act as experts: it’s the result of experts acting exactly like experts act. It’s not a result of incompetence, it’s a result of overconfidence.

When we look for evidence of miscalibration in people, he said, we find it overwhelmingly in experts. We find it when people are in conditions of great stress and complexity and competitiveness. And we find it overwhelmingly with older, more experienced people, doing difficult things which they feel very strongly about.

Jimmy Cayne, said Gladwell, is the picture of overconfidence — and he’s quite typical when it comes to heads of Wall Street banks. And so, Gladwell concluded:

Our goal is not to enhance the expertise on Wall Street. Expertise they have in spades. Our goal is to rein in the expertise on Wall Street. Wall Street needs to be slower, less competitive, and a lot more boring.

This is undoubtedly true — the difficult thing, of course, is how to legislate it, in a world where banks are falling over themselves to repay TARP funds and start taking on lots of risk again. Here’s Matthew Richardson and Nouriel Roubini write in the WSJ this morning:

Consider also recent bank risk-taking. The media has recently reported that Citigroup and Bank of America were buying up some of the AAA-tranches of nonprime mortgage-backed securities. Didn’t the government provide insurance on portfolios of $300 billion and $118 billion on the very same stuff for Citi and BofA this past year? These securities are at the heart of the financial crisis and the core of the PPIP. If true, this is egregious behavior — and it’s incredible that there are no restrictions against it.

But if there were restrictions against this behavior in particular, the same banks, or other banks, would find other ways to chase risk, just because they’re so confident that they can make billions of dollars — and get themselves out of their present hole — by doing so. They might even be right: 95% of the time, they probably are right. But that’s the Rubin trade: it works until it doesn’t. And although it’s the easy solution to the problem, it’s also a very worrying solution to the problem, because it just sets up yet another inevitable meltdown at some unknown point in the future."

Me:

First, a quote from my teacher, Paul Feyerabend:

“Modern science, on the other hand, is not at all as difficult and as perfect as scientific propaganda wants us to believe. A subject such as medicine, or physics, or biology appears difficult only because it is taught badly, because the standard instructions are full of redundant material, and because they start too late in life. During the war, when the American Army needed physicians within a very short time, it was suddenly possible to reduce medical instruction to half a year (the corresponding instruction manuals have disappeared long ago, however. Science may be simplified during the war. In peacetime the prestige of science demands greater complication.) And how often does it not happen that the proud and conceited judgement of an expert is put in its proper place by a layman! Numerous inventors built ‘impossible’ machines. Lawyers show again and again that an expert does not know what he is talking about. Scientists, especially physicians, frequently come to different results so that it is up to the relatives of the sick person (or the inhabitants of a certain area) to decide by vote about the procedure to be adopted. How often is science improved, and turned into new directions by non-scientific influences! it is up to us, it is up to the citizens of a free society to either accept the chauvinism of science without contradiction or to overcome it by the counterforce of public action. Public action was used against science by the Communists in China in the fifties, and it was again used,, under very different circumstances, by some opponents of evolution in California in the seventies. Let us follow their example and let us free society from the strangling hold of an ideologically petrified science just as our ancestors freed us from the strangling hold of the One True Religion!”

Possibly because of him, I always ask questions like: Why did you need to use math? What are the assumptions of any theory or thinker? Are they exaggerating, lying, fudging,etc.? Is the expertise a skill, a position in a group, etc.?

One thing is very clear, which is that expertise is no guarantee of the ability to reason, write, explain, intuit, etc. If someone were to take the time to document basic fallacies of logic or misstatements of what certain theories say or what certain thinkers believed in the major press sources, it would be a full time job. Just look at the wonderful blog called Adam Smith’s Lost Legacy. I thought of doing a blog like this on Burke, but almost everything written about him is wrong or misleading.

As to our topic, I find these claims of complexity laughable. The expert should be able to explain to you the risks in very simple language. If he can’t, then say goodbye. When you read some of the explanations given for this risky behavior, they often violate common sense or basic reasoning. If you take a risky product, then divide it up into less risky and more risky within the risky product, it doesn’t magically make the risky product less risky.

I’m for Narrow/Limited Banking precisely because we need a foundation to the free market that everybody can understand.

- Posted by Don the libertarian Democrat

These tall tales — which tend to take the form of how their firms were the “victims” of a “once-in-a-lifetime tsunami” that nothing could have prevent

TO BE NOTED: Another attack on the stupidity defense: From the NY Times:

"Op-Ed Contributor
A Tsunami of Excuses

By WILLIAM D. COHAN

IT’S been a year since Bear Stearns collapsed, kicking off Wall Street’s meltdown, and it’s more than time to debunk the myths that many Wall Street executives have perpetrated about what has happened and why. These tall tales — which tend to take the form of how their firms were the “victims” of a “once-in-a-lifetime tsunami” that nothing could have prevented — not only insult our collective intelligence but also do nothing to restore the confidence in the banking system that these executives’ actions helped to destroy.

Take, for example, the myth that Alan Schwartz, the former chief executive of Bear Stearns, unleashed on the Senate Banking Committee last April after he was asked about what he could have done differently. “I can guarantee you it’s a subject I’ve thought about a lot,” he replied. “Looking backwards and with hindsight, saying, ‘If I’d have known exactly the forces that were coming, what actions could we have taken beforehand to have avoided this situation?’ And I just simply have not been able to come up with anything ... that would have made a difference to the situation that we faced.”

Jimmy Cayne, Mr. Schwartz’s predecessor, never had to testify before Congress. But he told me, with some rare humility, that before he resigned, “there was a period of not seeing the light at the end of the tunnel .... I wasn’t good enough to tell you what was going to happen.”

Yet Dick Fuld, the longtime chief executive of Lehman Brothers, was squarely in the Schwartz camp last October when he told Congress: “I wake up every single night thinking, ‘What could I have done differently?’ What could I have said? What should I have done?’ And I have searched myself every single night. And I come back to this: at the time I made those decisions, I made those decisions with the information I had.”

Harvey Miller, the bankruptcy lawyer who is representing what remains of Lehman, has been working hard to absolve Mr. Fuld. In a brief responding to a motion made by lawyers for the New York State comptroller, who has joined a class-action suit against the company, he wrote, “The comptroller fails to recognize that Lehman was a victim of a financial tsunami that was beyond its control.”

Now, wait just a minute here. Can it possibly be true that veteran Wall Street executives like Messrs. Cayne, Schwartz and Fuld — who were paid an estimated $128 million, $117 million and at least $350 million, respectively, in the five years before their businesses imploded — got all that money but were clueless about the risks they had exposed their firms to in the process?

In fact, although they have not chosen to admit it, many of these top bankers, as well as Stan O’Neal, the former chief executive of Merrill Lynch (who was handed $161.5 million when he “retired” in late 2007) made decision after decision, year after year, that turned their firms into houses of cards.

For instance, even though he had many opportunities to do so, Mr. Cayne never steered Bear Stearns away from an extremely heavy concentration on its hugely profitable fixed-income business. The firm starved its asset management business, its brokerage business and its investment banking business, which were not as profitable as fixed income but would have spread Bear’s risk.

In 2003 Mr. Cayne passed on chances to diversify his firm by buying Pershing, the back office and clearing unit of Credit Suisse First Boston, and Neuberger Berman, a midsize money manager. “Acquisitions were not my forte,” Mr. Cayne told me. As a result, by the end, his top lieutenants stopped even trying to persuade him to diversify.

Mr. Cayne never seriously considered raising the firm’s equity, which we now know was perilously low, nor did he seriously consider selling or merging it. Rather, he deliberately chose to take Bear deeper into the manufacture and sale of all those risky mortgage-backed securities, as well as into the business of doing trades with hedge funds. Why? Simply put, Bear’s board paid him and the other four members of Bear’s executive committee — including Mr. Schwartz and another former chief executive, Alan C. Greenberg — to maximize the firm’s “return on equity” calculation, which is Wall Street lingo for figuring out how much money one can make using as little capital as possible.

This directive encouraged Mr. Cayne to make the firm as profitable as possible — a worthy goal, no doubt — but without raising any more cash or issuing any new stock, as doing either would increase the denominator of the return-on-equity calculation, and thereby lower the bonus pool Mr. Cayne and his executives could split among themselves.

When viewed through this simple prism, it is not the least bit surprising that when Bear Stearns ran into trouble soon after its two hedge funds blew up in June 2007, Mr. Cayne — and later Mr. Schwartz — chose not to raise new equity, even though they could easily have done so back then. So Bear’s balance sheet remained larded with extremely risky assets that the firm had leveraged to the hilt by borrowing cheaply in the overnight financing markets. The lenders of such money have the right to decide each day whether to continue to provide the financing or to cut the borrower off.

At Lehman, the facts and circumstances were somewhat different than those at Bear Stearns — for instance, after Mr. Cayne passed on it, Lehman bought Neuberger Berman, and Lehman had built a bigger investment-banking business over the years than Bear. Yet the outcome was similar.

Like Mr. Cayne, Mr. Fuld had made huge and risky bets on the manufacture and sale of mortgage-backed securities — by underwriting tens of billions of mortgage securities in 2006 alone — and on the acquisition of highly leveraged commercial real estate. Five days before the firm imploded, Mr. Fuld proposed spinning off some $30 billion of these toxic assets still on the firm’s balance sheet into a separate company. But the market hated the idea, and the death spiral began.

Even Goldman Sachs, which appears to have fared better in this crisis than any other large Wall Street firm, was no saint. The firm underwrote some $100 billion of commercial mortgage obligations — putting it among the top 10 underwriters — before it got out of the game in 2006 and then cleaned up by selling these securities short. Basically, Goldman got lucky.

When in the summer of 2007 questions began to be raised about the value of such mortgage-related assets, the overnight lenders began getting increasingly nervous. Eventually, they decided the risks of lending to these firms far outweighed the rewards, and they pulled the plug.

The firms then simply ran out of cash, as everyone lost confidence in them at once and wanted their money back at the same time. Bear Stearns, Lehman and Merrill Lynch all made the classic mistake of borrowing short and lending long and, as one Bear executive told me, that was “game, set, match.”

Could these Wall Street executives have made other, less risky choices? Of course they could have, if they had been motivated by something other than absolute greed. Many smaller firms — including Evercore Partners, Greenhill and Lazard — took one look at those risky securities and decided to steer clear. When I worked at Lazard in the 1990s, people tried to convince the firm’s patriarchs — André Meyer, Michel David-Weill and Felix Rohatyn — that they must expand into riskier lines of business to keep pace with the big boys. The answer was always a firm no.

Even the venerable if obscure Brown Brothers Harriman — the private partnership where Prescott Bush, the father and grandfather of two presidents, made his fortune — has remained consistently profitable since 1818. None of these smaller firms manufactured a single mortgage-backed security — and none has taken a penny of taxpayer money during this crisis.

So enough already with the charade of Wall Street executives pretending not to know what really happened and why. They know precisely why their banks either crashed or are alive only thanks to taxpayer-provided life support. And at least one of them — John Mack, the chief executive of Morgan Stanley — seems willing to admit it. He appears to have undergone a religious conversion of sorts after his firm’s near-death experience.

“The events of the past months have shaken the foundation of our global financial system,” Mr. Mack told Congress in February. “And they’ve made clear the need for profound change to that system. At Morgan Stanley, we’ve dramatically brought down our leverage, increased transparency, reduced our level of risk and made changes to how we pay people.” He continued: “We didn’t do everything right. Far from it. And make no mistake: as the head of this firm, I take responsibility for our performance.”

Well, it’s a start. But there can be no restoration of confidence in the banking system — and therefore no hope for an economic recovery — until Wall Street comes clean. If the executives responsible for what happened won’t step forward on their own, perhaps a subpoena-wielding panel along the lines of the 9/11 commission can be created to administer a little truth serum.

William D. Cohan is the author of “House of Cards: A Tale of Hubris and Wretched Excess on Wall Street.”"