- The Subprime Crisis Revisited

A 1972 Ford Pinto is a $#itty car. It was a $#itty car when it rolled off the line and it’s an even $#ittier car today. It’s underpowered, it handles poorly, it gets comparatively lousy gas mileage, it’s horribly ugly, and if you hit it from the rear its doors will lock shut while it bursts into a massive ball of gasoline flames. But if I try to sell you one for $5, am I taking advantage of you? Of course not. You could sell it for scrap and make $45 dollars on it, even if you never sit in it. This is the main point that’s so completely missed by the leftist view of how the mortgage catastrophe came about, and that's the only view presented in the film 'Inside job'.

The Pinto sale above is an example of market making, and it's based on the idea that however poor the product, there is probably a 'fair' price for it. Market making is a voluntary process. No one is either forced to make a market, or forced to participate in it. The dealer will typically offer two prices, one at which they will buy an asset from you, and one at which they will sell it to you. The industry parlance for these is called the bid and offer, or the bid and ask. The bid, the price they will buy the asset from you if you are inclined to sell, is always the lower of the two, and the difference between them is called ‘the spread’. That ‘spread’ is where the dealer expects to make money.

If there is competition between dealers, that is – if there is more than one dealer in the same specific asset, then the bid-offer spread will shrink, making it ‘cheaper’ to do business with one dealer than the other. That has the effect of keeping the pricing very close to what everyone thinks is a 'fair' price.

But no one will ever use force to make someone do business with a market maker. If you buy when you should sell, it isn't because they forced you. and since that's so, if you get what you later think was a bad deal, then it’s really your own fault.

Anyway, the reason I bring all this up, is because of this laughably one sided movie ‘inside job’, which purports to instruct people in the how’s and why’s of the mortgage crisis. The movie is ridiculous. It’s a horrible misrepresentation of the facts where accusations of fraud are presented as evidence that the fraud occurred, and the fact that someone made money is presented as evidence of malfeasance. None of it even remotely passes the reality smell test.

More than anything it seems like a propaganda piece designed to inflame the masses against those evil capitalists, and to encourage them to press for more ‘regulation’. The makers of the film obviously believe that if we had just had more regulation, everything would have been fine. This is nonsense of course. The whole reason for the derivatives market in the first place was to sidestep regulation. And if there were any more of it, it may have changed the look of the industry, but it wouldn’t have prevented a thing.

I could get into the specifics here, but I don’t see the point. I’ve written about it at great length in the past (peruse my stuff from the autumn of 08 or do a search on the word mortgage and you’ll find it) but at this point I don’t think a lot of minds will be changed about it. You will either believe this movie or not. And as someone who’s worked in the derivatives business for twenty years and understands every aspect of the crisis without having participated financially in it, I’d recommend ‘not’.

You’ll get nothing from this movie that you can’t get from 15 minutes reading the Times opinion page. “The rich get richer by taking advantage of the poor, blah, blah, blah.” Blame the winner for winning, and forgive the loser for their greed because they lost. It’s the same old anti-capitalist diatribe that hasn’t changed meaningfully since it’s advocates were at Woodstock. As an argument, it has all the subtlety of a burned draft card, and the intellectual honesty of a Howard Zinn essay. And the film itself has all the thoughtfulness and desire for exposing the real truth as a mob of angry teenagers. In short – it’s crap.

Although for you guys reading this who are also insiders in the industry, I do have a little 20-20 hindsight to offer. Now that time has given me some perspective, I think I can see this clearer than ever. What we had was a vast expansion of balance sheets and credit. We’ve seen that before. And when that happens, it opens up new and more sophisticated markets to a much broader group of people. And what happens to the dynamics of a self selected group when you vastly and rapidly expand it?

I’ll give you a hint – what would happen to the culture at NASA if you tried to hire 250,000 people to work on the space program? Do you imagine you can find 250,000 PhD physicists, Engineers and other scientists that can cut the mustard in such a demanding environment? Probably not. So the only way you could expand that group so rapidly would be to lower the standards. There is no other option.

In the end, the savings and loan crisis was driven by the same sort of thing. It was relatively unsophisticated small bankers getting into a market they didn’t fully understand. They took imprudent risks, and eventually, they took the losses.

So what I think we had in effect during the mortgage crisis was a number of comparatively unsophisticated pension fund managers, insurance company executives, and other money managers trading in a market they didn’t fully understand. Some people understood it. Paulson & Co. did, and most, but certainly not all, of the sell side brokers did. But they were in those positions because they were the best and brightest. And their results have demonstrated that.

So that’s what I think this was. As the size of the pool of ‘mortgage bond’ and ‘mortgage derivatives’ investors grew, it’s mean intelligence fell. Even worse, the gap between the best and the worst became more and more pronounced. And eventually, as is always the case, the less smart ended up losing out to the “more smart”. It’s a pattern that you can see repeated time and again throughout history, every time a market rapidly expands. That may sound harsh – but the truth usually does.

My personal area of expertise is in understanding how markets process new information. And in that light, it might be an oversimplification to say that the investors that lost money were simply ‘less smart’ than the others. I could as easily say that they were operating at a less efficient window for optimal decision making based upon their cost of information, but the truth is, that’s probably a good proxy for general intelligence where financial markets are concerned. It’s like being at a poker table and not knowing who the sucker is, but playing on anyway cause you think it’s fun.

And with all of that said, one group of people who are definitely not smart enough to understand how all this happened is the makers of this atrocious film. It’s an elegantly shot, well lit, piece of $#it, that hides far more of the truth than it reveals. And it was specifically designed to do that very thing. More than that, it wasn’t produced for someone like me who understands what really happened already, but for someone who really won’t have the background or knowledge to get it at all.

In that way the makers of the movie are treating their customers precisely the way that they claim Goldman treated theirs. They believe Goldman executives should go to jail for their efforts. So I suppose it would be fair to say that they should be locked up for this movie as well. The Oscar it won is sort of like Obama’s Nobel peace prize. It says more about the politics than it does about the actual result.