Thursday, April 15, 2010

Shocked Sleuths Discover Shorts

ProPublica has a big story on Magnetar, a company that actively shorted mortgage backed securities prior to the collapse, often encouraging the formation of securities they would then short. As this is a major theme in Michael Lewis's The Big Short, and was breathlessly mention by James Kwak, let me explain why this is not interesting. People as a group generally disagree on everything. There will always be someone saying a price is too high, or too low. Over time, as the price moves one way or the other, those correctly calling the price move were either right, or lucky. In any case, the existence of this prescient group does not imply either 1) that it was obvious the prior price was too low/high, or 2) there was a conspiracy.

This is classic hindsight analysis, and James Kwak and Simon Johnson, Michael Lewis, and Propublica may think it was all so obvious, but as prolific authors it would help their cause a lot if they made unambiguous statements prior to the crash that we were in a bubble. Any idiot can say a historical event was obvious (indeed, I find the best history showing how while some event was inevitable, it was not obvious at the time). Further, even if some people were correct they had to have been correct for the right reasons. If, like Nouriel Roubini, you were a permabear predicting a cataclysm for the same reasons as always, the fact of the credit crisis doesn't mean you called it. Or take my Nassim Taleb, who's shtick is that disaster's are always unexpected (don't get me started), but when he points to his correct Fannie Mae call, he notes an earlier criticism of the interest-rate Value-at-Risk methodology, an irrelevancy to their ultimate problems. Peter Schiff, in contrast, singled out the housing insanity, and so he's a better candidate, but even so, it doesn't mean it was obvious, because the voice of those like Schiff was outweighed by those thinking everything was just fine.

It's important to remember that with so many people in the world, just calling a historical event is not sufficient because there are always people predicting massive failure or success to any policy. The key is whether they right for the right reasons, as in Schiff's case, or right for the wrong reasons, as in Roubini or Taleb's cases.

The problem was that given the historical national housing price index, nominal housing price declines over the prior 70 years were rather minor, and suggested little risk. This is why in 2003 Joe Stiglitz wrote Fannie Mae was overcapitalized and was of no concern. The fact that this assumption supported efforts at increasing home ownership, and helping minorities, was a plus in the way that any assumption that supports what we want to do is taken less skeptically than otherwise, that's human nature. There's no conspiracy there, and while there were some general errors of repetition, it was also in many ways singular crisis (the repo bank run accelerator, the historic decline in housing prices).

For about 50 years, the definitive understanding of the depression was John Kenneth Galbraith's The Great Crash. He outlined the delusion of investors, but also highlighted the nefarious insider trading and financial skullduggery by those puppetmasters, the Captains of Industry. Charles E. Mitchell of National City, Andrew Mellon at the Treasury, in the 1930's were in highly public tax evasion trials, and were popular scapegoats, as if the recession was caused by greedy people with top hats.

Alas, this highlights that 'for every problem there is a solution which is simple, clean and wrong.' The 1929 stock market crash did not cause the Great Depression--ten years of weak performance--and while there was much financial skulduggery, no more than usual, and Mellon and Mitchell were hardly symbolic of some essential prime mover in the whole mess. Like most bad theories, this one died a slow, unpublicized death. Economists might seriously reference Galbraith to explain the death of animal spirits prior to the Great Depression in prior generations, but after 1987 the nexus between the stock market and the economy was shown to be not so clean, and the whole narrative became suspect, a classic 'just so' story.

So the current journalists that are now highlighting that various people actually shorted frothy sectors prior to the collapse, is really just another spin on the 'speculators caused the crisis' theory of the Great Depression. Greed, like lust, is pretty much in steady state. Anecdotes of greed do not lend any more evidence that the national greed-o-meter was especially high in 2006, because with 300 million Americans I could read 100 anecdotes a day and not add up to anything significant.

I heard ProPublica's story in a very well produced NPR radio story this weekend. A lot of work went into it, with dramatic narrative, and the kind of suggestion that, like The Matrix, you would at the end find some truth so large and shocking you would leave forever changed. Unfortunately, the fact that there were shorts during a market decline, and all that is associated with such shorts (eg, they wanted to make a lot of money, they encouraged people to buy from them, they got rich), is simply not news.


Anonymous said...

From what I've read, Magnetar was able to influence the selection of securities that went into the CDO's they sponsored, purposely making them riskier so as to profit from the insurance (CDS) they bought on the supposedly "less-risky" tranches.

What's news about this is that there actually were people stupid enough to write the insurance. This is like selling fire insurance to known arsonists. AIG did much the same thing when it sold Goldman Sachs insurance on CDOs that Goldman itself assembled. This kind of underwriting is an open invitation to fraud, and it's hard to believe the CDS sellers didn't know it.

Daniel said...

Finally somebody says it! Exactly what has been on my mind regarding these issues.


RPB said...

The problem is, and was, that this was a basis trade entered into by counterparty that booked it as a profit based upon implied value. This profit was then handed out to the trading/sales team as a bonus just like any other (more liquid) trade. There was some incentive to get this deal done and ignore the risk by both the salesmen and the traders. (especially those moronic salesmen)

Whether or not they were stupid enough to recognize the risk is unimportant. The argument can be made that their motives were to maximize their bonus at the expense of risk management.

Do I believe they purposely ignored the risk to seek a higher bonus? No, that would jeopardize their long term incentives. I feel it is more likely the incentive structure gave them reason to downplay the risk and put on this trade. I mean, this sort of outright risk seems absolutely ridiculous for such a low capitalized entity. Actually, this type of risk seems idiotic to anyone with any real trading experience.

Who was the risk manager in some of these trades, bozo the clown?

CNG Cylinders said...

The great financial analyst Benjamin Graham declared that “the stock market resembles a huge laundry in which institutions take in large blocks of each other’s washing … without rhyme or reason. It is a nice blog.

Michael Meyers said...

Eric... right on! Of course if the sub-prime housing bubble was so obvious to all, it would not have happened in the first place!

DaveinHackensack said...

"Eric... right on! Of course if the sub-prime housing bubble was so obvious to all, it would not have happened in the first place!"

Not necessarily. Participants in bubbles often recognize they are in a bubble -- they just think they'll get out before it pops.