Dumb Money

The efficient market hypothesis (EMH) is the central tenet of the Chicago economic religion. According to that dogma, the prices of products and capital computed by the market are optimal within the constraints of the information available. This optimization supposedly happens because agents could otherwise profit by taking advantage of mispriced assets. In capital markets this occurs by “shorting” the stock or bond in question, in effect betting that its price will go lower. In the real world, as opposed to the EMH model, information is often in short supply, especially where intent of fraud is in action. In such a circumstance, those who first recognize what’s happening can reap outsize rewards even as a house of cards comes tumbling down.

Michael Lewis’s book, The Big Short: Inside the Doomsday Machine, is, among other things, the story of those who figured out how to take advantage of the inevitable collapse of the giant Ponzi scheme that mortgage backed securities (MBS) had become. Since these guys make a ton of money exactly when most investors are going belly up, they look like suitable villains to a lot of people, but in fact, their function in the market is essential, preventing mispricing from becoming even more absurd. In a truly efficient market, their bets against the mispriced assets would prevent absurd mispricings from happening. In the real world, they often just signal the inevitable collapse.

I haven’t finished the book, so this isn’t yet a review, but I’m a huge fan already. Lewis is a skillful writer, the author of The Blind Side (the basis of the Sandra Bullock movie) and many other books as well as a former Wall Streeter himself, who told his story in his first book Liar’s Poker. Lewis has an intricate story to tell, that of the mortgage backed securities, sub-prime loans, and credit default swaps (CDS), but his exposition is neatly interpolated into the stories of the curious gang of green-eyeshade characters who are his primary characters: a former lawyer and comic book fan, a former accountant, and a one-eyed former neurosurgery resident for three.

These guys are among those who figured out that the MBS had become a giant Ponzi scheme and how to take advantage of that fact. What they had realized was that what were being promoted as safe investments were in fact guaranteed to fail. Once lenders and banks had figured out that they could lend money to anybody and then sell the loans to other people, thereby offloading their own risk – or so they thought – it was devil take the hindmost, and loans on the most absurd terms were shoved out the door.

Perhaps the most egregious has the arcane name interest-only negative-amortizing adjustable-rate subprime mortgage. With this marvel, the homeowner can pay nothing at all, explains Lewis, and just roll the interest owed over into the principal, making it, as Lewis notes, the perfect loan for somebody who has no income. The lender doesn’t care, since he is going to sell the mortgage to a banker who will package it up with a few thousand more into an MBS that everybody will pretend is perfectly safe.

Every Ponzi scheme needs an ultimate sucker, the guy who gets stuck with the losses. I haven’t got to that part of the book yet, but we know that the taxpayers were among them. The original losers, though, were those who bought the MBS, and those who sold the credit default swaps that insured them – dumb money.

In the Chicago fantasy, the ensuing financial disaster was due to a real shock to the economy – the massive reallocation of resources away from the building of houses that no one could afford. I find the Keynesian version more persuasive and richer in explanatory power: dumb money suddenly realized its folly, and was filled with terror of the world it no longer understood.

(by CIP in MT)