Rational Markets

Bee takes a look at seemingly irrational behavior in the financial markets.

It was not that people who were actively involved in building up the problem were completely unconcerned. They just had no way to channel their uncanny feelings. From a transcript of a radio broadcast "This American Life" (audio, pdf transcript, via):

mortgage broker: ...it was unbelievable... my boss was in the business for 25 years. He hated those loans. He hated them and used to rant and say, “It makes me sick to my stomach the kind of loans that we do.”

Wall St. banker: ...No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it.

Italics added. My favourite part though was this

Mike Garner: Yeah, and loan officers would have an accountant they could call up and say “Can you write a statement saying a truck driver can make this much money?” Then the next one, came along, and it was no income, verified assets. So you don't have to tell the people what you do for a living. You don’t have to tell the people what you do for work. All you have to do is state you have a certain amount of money in your bank account. And then, the next one, is just no income, no asset. You don't have to state anything. Just have to have a credit score and a pulse.

Alex Blumberg: Actually that pulse thing. Also optional. Like the case in Ohio where 23 dead people were approved for mortgages.

Here we have examples of the market forcing people to do things that they quite correctly believe to be irrational. What's up with that? Partly, I think, its the "other people's money" effect - the mortgage lenders aren't dependent on the borrower's paying, because they will already have sold the mortgages to some bank to securitize, and the banks are passing them on too. The buyers think that they are safe because they are protected by credit default swaps. Everybody thinks they have offloaded the risk (or certainty) of failure on somebody else, and everybody trusts the "efficient market" and some models they don't understand. The model builders may understand the models, but either they don't understand or haven't been told the facts underlying their statistical data.

Even more important, I suspect, is the focus on short term results. This rewards the bank and the investment officer who take big risks to get good results for the next quarterly earning report, and punishes their counterparts who play it safe. The big investment banks used to be partnerships who were risking their own money - by the time of the crash they were all corporations run by guys who were playing with other peoples' money and getting a big chunk of it when they succeeded. The instinct of the predator is not focussed on next year or the next decade, but on his next meal, and when there is money in the water humans tend to revert to shark like feeding frenzy behaviors.

So what's the cure or treatment. The diehard Chicago ideologues, most of whom have never left their ivory towers, say let the idiots go bankrupt. It will be a lesson for the future. They predict this would result in a short but very sharp recession, but neither history nor systems theory is very supportive of this theory. Most of those who have actually practiced the discipline Chicago pretends to study, and most mainstream economists, think that the resulting collapse of world financial systems would be catastrophic, possibly destroying most world economic activity for a generation or more.

I say, be very suspicious of the true believer who stares lovingly into the abyss.