Thursday, November 17, 2011

The Big Short

A friend loaned me Michael Lewis' The Big Short. Really good stuff-- as usual from (what I've read of) Lewis. As a popularized of history, his work is readable and seems accurate. He does a nice job painting portraits of characters and laying out institutional and historical detail. (The one big disappointment-- an omission-- is that Lewis did not address the role of "mark-to-market" regulations as a catalyst for the crash, or at least its timing.) Overall: an easy, good read. 

The primary topics of the book are the burgeoning "subprime" home mortgage market (from $130B in 2000 to $625B in 2005), the subsequent market for investments connected to those mortgages (from $55B to $507B), and the failure of the market and govt regulating authorities.

A number of concepts are in play here, from economics and political economy: 

1.) A "subprime" mortgage is not inherently troubling, as long as the underlying (greater) risks are correlated with higher rates of return. If those risks are not easily understood, then the market will struggle. If those risks are subsidized, then the govt is causing inefficiency and other troubles within markets. Both occurred here. 

2.) Likewise, a subsequent market for mortgage-related investments is not inherently troubling, as long as the nature of the investments is understood and their risk is not subsidized. We see such financial markets arise to act as a form of insurance-- a "hedge" against various future outcomes. The problem in this market is that the investments were very complex AND the ratings agencies (in whom investors placed their faith) were a combination of inept and greedy. (Lewis noted that Warren Buffett had/has a 20% ownership stake in Moody's!) Moreover, the govt regulation of those agencies was insufficient-- whether more regulation was needed or whether existing regs should have been observed more closely. And govt policies proved subsequently to encourage the "moral hazard problem" through bailouts-- that failure would be bailed out will encourage more risky behavior.

3.) The key to the story is "imperfect information"-- in particular, information that was highly imperfect and worse yet, highly asymmetric. In the face of such information asymmetries, markets have some remedies and govt regulation can, at least in theory, provide a defense. Think of buying gasoline. How do you know how much gas you received? The little numbers say 9.3 gallons, but how do you know? The gas station has a reputation to uphold and some investigative journalism from a local TV station could bring down the company. But what sort of defense is this, really? Modest. The govt promises to help and hires inspectors to monitor this and affix stickers to the pumps, certifying their approval. But what does this promise? Do we faith in the sticker-placer and do we ignore the firm's post-sticker incentive to cheat and actually take advantage of our faith in the sticker?

In the case of investments, investors rely on credible/objective ratings agencies to step into this information breach. From Lewis' work, it seems clear that the agencies were mostly confused-- but in some cases, unwilling to pay the price for negative assessments of these instruments. Consider "house inspectors" as a parallel example. What makes for a "good" house inspector? Finding all the significant faults in the quality of a house, right? But that's only from the perspective of the buyer. From the perspective of the seller, a good inspector would turn a blind eye to less obvious faults. And more troubling, a realtor has similar incentives. What makes a good ratings agency? It depends on your perspective. And in this case, they failed to provide accurate, objective information. 

Lewis argues that the ratings agencies failed, in terms of competence (vs. motives), given the complexity of investment vehicle, by mistaking diversity for lower risk. Often, diversity lowers overall risk by spreading risk. But in the case of the mortgage-based securities, there was a bundling of diverse, but still highly risky loans (within the subprime housing market). Moreover, the agencies and the market participants who guessed incorrectly failed because their statistical models, based on historical data, assumed housing prices that would increase forever. 

All of this points to "market failure" (the academic term)-- or "market struggle" (to choose a more accurate term). But as always, market struggle must be contrasted with government failure/struggle. Will govt agents be able to regulate something they cannot understand either? The general public's reflex-- and for Congress as well-- is to seek more regulation. But as in many other cases, the record is that existing regs were not embraced to anything near their full extent. (Lewis discusses these failures in passing-- most notably on p. 166.) It is then an act of faith to believe that govt regs will improve things. Perhaps-- but perhaps not-- especially with the reality of interest group politics.


At November 19, 2011 at 4:55 PM , Blogger Eric Schansberg said...

Review in Reason of an academic but accessible book on the same topic:


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