Wednesday, November 12, 2008

Michael Lewis: Misses Again

Earlier this year, Michael Lewis blamed the option model Black-Scholes for the current mess. This was a bit like blaming arbitrage, or present value functions for the meltdown. Sure these tools might have been used by some in this process, but it was hardly the distinguishing characteristic of the subprime bubble. He is getting better, as he has new piece in on Steve Eisman, a hedge fund manager who bet correctly on the subprime meltdown. It's a well-written article where, like Malcom Gladwell, he takes you into a story with an arc about staid conventional wisdom shown up by an intellectual maverick.

Alas, it is also profoundly misleading. His thesis is that ignorance and shameless chutzpah is the essence of this crisis and finance in general. While I agree that there is a considerable amount of ignorance and deception in finance, these are not particular to this industry, nor it's main characteristic.

The initial story is about Eisman, who started his career as an equity analysts looking at mortgage lenders in the 1990's, learned they were mainly liars from the very beginning. The problem is recent work has shown that while credit standards declined since 1990 (cowed by cries of discrimination--see Liebowitz), the bad stuff with extra-normal loss rates was all originated after 2004, so Eisman is a bit of a broken clock here, finally correct. The problem is, every salesman omits much, exaggerates much, something that might be characterized a lie. That's what they all do, but that does not mean every firm, every field, is about to crater. Eisman calculated that
All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.
As luck is when preparation met opportunity, he was prepared to find this better than anyone, and the new CDX default swaps allowed Eisman to put this trade on directly right when the market started to really get bad, a trade he had been predisposed towards for 15 years. In other words, Eisman was correct, but his permabear view on subprime mortgage highlights that subprime's essence is not the problem, but rather, the climax of the bubble was the issue. Lewis notes that in the end, investor demand really created these 'liar loans', because there was so much demand that unethical suppliers who knew better filled the need. This is a much more complicated issue, because if in the end, buyers were not doing due diligence, wasn't their demand, the essence of the problem? Where did this demand come from? In the end, this story is like someone talking about a Robber Baron making a fortune in the panic of 1893--interesting, but not the essence of the Industrial Revolution though some would like you to think so (see Hielbroner's Worldly Philosophers extended portrayal of conspicuous consumption and such).

Lewis is back to his old Liar's Poker thesis: finance is a massive con-job foisted on investing rubes, dominated by aggressive, smart (but ignorant) frat boys. Lewis had lunch with the focus of that book, former Salomon CEO John Gutfreund, and he notes Gutfreund confirms he didn't really understand everything they did at Salomon, and his subordinates were greedy and didn't really understand what they did.

Welcome to the real world! Do you think George Bush really understands education? Stem cells? How about FDR's understanding of the economy (this is the guy that invented destroying output to help the economy via farm programs--note that in the 1980's the US destroyed 1 billion oranges. what a legacy)? What about JFK, who used the mnemonic that the 'M' in Monetary Policy was for then current Fed chief McChesney? The point is, most leaders are ignorant about the processes they putatively lead, so the archetype for a leader is a drum major as opposed to inventors like Bill Gates and Microsoft. But then, salesmen are not the most informed on what they are selling, and market makers are often clueless about what drives the long term value of what they are buying and selling, and even Bill Gates now doesn't understand most Microsoft products. A complex market economy means everyone knows a little bit, and if we all mind our jobs, the system works because it has good incentives. Mistakes are made, but with failure, they are corrected.

Thus, Gutfreund's stupidity, and the rash loans made at the end of the subprime bubble, are different kinds of stupidity, and neither the distinguishing characteristic of finance. The natural stupidity of leaders, which I have blogged about many times before (eg, here), is simply the fact that 'know-it-all's are not the preferred leader in any context, because the powerful masses they lead do not want to be dominated, and so they want someone ingratiating who is merely diplomatic, and good at articulating the practical consensus. The ignorance at the end of a cycle is quite different, the orgasmic phase with impossible business models that with hindsight always seem so stupid. These are different problems, and the theme, that stupidity and fluff underlies all finance, is a profoundly misleading insight, that unfortunately seems to stick with Lewis as his one big idea.

1 comment:

Anonymous said...

"A complex market economy means everyone knows a little bit, and if we all mind our jobs, the system works because it has good incentives."

What Lewis is saying is not that people are stupid, it's that incentive structures are all messed up. The system failed not because of stupidity but because of bad incentives