Arrogant people believe what they say

I’m repeating someone else’s idea (again), but I can’t remember who said it, when or where. But it is a good idea so stick with me.

I happen to think the Moral Hazard story of the financial crisis has some serious holes in it. The story goes that banks that were too big to fail knew they were and therefore the people working there took greater risks than were justified because they knew (or suspected) they would be saved by government.

Now a major problem with this story is that the financial services industry is full of arrogant pricks. They’re selected for overconfidence as Chris puts it. So when a person who…

  • graduates from an elite school and university,
  • is paid a fortune,
  • is told they are at the top of the economic pyramid daily,
  • reads the FT’s “How to Spend It”,
  • drinks Laurent-Perrier Rosé,
  • works for one of the most powerful firms in the world,

…offers you a collateralised debt obligation (a AAA rated senior tranche of subprime mortgages, for example) and they tell you it is a fantastic product that will make you money, that person believes it is a fantastic product that will make you money.

I don’t believe that the thought their super-clever financial innovations would decline in value catastrophically (and that failure would be highly correlated with everyone else’s super-clever financial innovation’s decline in value) crossed many of these people’s minds.

Certainly not in the way much of the discussion of Moral Hazard hinges on. These people were clearly reckless, but a lot of them didn’t think they were they thought they were financial whizz kids because that is what they trained as, lived as and were treated as.

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5 thoughts on “Arrogant people believe what they say

  1. “and they tell you it is a fantastic product that will make you money, that person believes it is a fantastic product that will make you money.”

    Quite: which is why the banks held onto such large chunks of the AAA tranches and why the banks went bust when the value of the AAA tranches fell.

    If they had actually believed it was all total shit that they’d better get rid of they would have got rid of it.

    And yes, there is a policy prescription from this. Both the EU and the US are now insisting that any originator must hold 5% of any securitisation they originate. But this is howlingly stupid, for as we’ve seen above, they thought that the stuff before was good stuff. All we’re managing to do is insist that they’ll go bust again.

    1. But preferences and behvaiour are adaptive, as we know. You can beat the market, but only until everyone else finds out how and your advantage vanishes.

      For instance, there’s a new AAA rated (S&P, so that solely refers to default risk) collateralised sub-prime debt obligation.

      48% or so of the revenue from the mortgages is secured for the CDO, 48% of the mortgages heading south is, in fact, relatively unlikely, it is certainly a long way from the 70% or so they used to work on (or so I’m led to believe).

      Now these rating are bullshit, there are a lot of hoops to jump through to get them and their informational content is not significantly different from 0 at times. But they have changed the way they look at these products…somewhat. So they’ve learned a little, but probably not enough.

      After the depression, Galbraith said that no amount of regulation or oversight can explain the financial tranquility that followed the war and the post-war return to prosperity, people just remembered what hubris looked like and didn’t act like arrogant cocks (I paraphrase). It’d be nice if this crisis taught similar lessons, but I’m not sure it will.

  2. Hang on a minute though – weren’t Goldman Sachs shorting their own CDOs at one point, whilst the guys in the next office were telling their customers that they were “a fantastic product that will make you money”? That kinda implies that they (or at least some of them – we probably shouldn’t imagine that these organisations are monolithic) at least suspected things were not entirely hunky-dory.

    Also, I used to play poker with a couple of guys in this line of business (albeit much lower down the pyramid) and they were quite clear that it was all a house of cards just waiting for the first gust of wind – “timebomb” was the exact word used most often.

    Which is not to say that there isn’t a great deal of merit to the idea – just that it’s perhaps not the whole story.

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