Yves Smith at Naked Capitalism, riffing on a post by James Hamilton, ponders the question of why some CDO investors might have bought securities that were "losers at the start". Hamilton suggests that investors must not have understood what they were doing. As Yves puts it, "[H]ow could investors be so dumb? The buyers were institutional investors, after all. These guys are supposed to be pros." Yves suggests that underwriters, sometimes believing their own hype, sometimes with adroit porcine cosmetology, did a great job of selling iffy paper. Here's another explanation, on the buy-side.

Do you remember the "greater fool" theory of investing from the late-1990s? For many high-flying internet stocks, the disconnect between stock prices and "fundamental" valuation was so obvious that buyers knew they were purchasing securities which, if held for the long-term, offered negative expected return. But it was quite rational to buy them anyway, so long as it seemed likely that someone else, a "greater fool", would buy them at an even higher price than the one you paid. Most serious players understood there would be a reckoning someday, but that there was lots of money to be made today regardless. The risk-return tradeoff on playing the fool for just a little while was quite favorable. Those willing to take big chances for a short time, and smart enough not to try to play "double-or-nothing" indefinitely, did very, very well for themselves.

At first blush, today's markets look nothing like the heady stockmarkets of the 1990s. After all, many of the securities that seem overvalued now rarely trade: structured credits backed by mortgages, commercial debt, credit cards, etc. Generally an underwriter sells an offering to institutional investors, who may plan to hold the paper to maturity. If secondary markets are thin, if no one is buying or selling, who could be the greater fool?

But, in fact, it is not "institutions" that buy this paper, but managers who are paid for performance. And from a manager's perspective, all these securities do trade, about once a year, when bonuses and performance fees are taken. During bonus season, hypothetical valuations of illiquid securities become converted into liquid nonrefundable cash, just like during an ordinary sale. Institutions effectively purchase securities from themselves, at arbitrarily high prices, and pay their managers a commission for the privilege. Financial innovation truly has been a wonder these last years. Institutions have cut out the middlemen and become their own greater fools, to the benefit of managers and the detriment of other stakeholders.

Many managers would be quite content with short, lucrative careers followed by long, wealthy retirements. They are faced with opportunities to "earn" money on so grand a scale that a rational person, looking at historical norms, would sacrifice a lifetime's wages for a few good years. At extremes, shame and legal risk constrain manager behavior. But, to the degree individual managers can attribute self-interested behavior to evolving norms and standards in their profession, they are protected. A "safe" position, from a manager's perspective, is one in which losses to the portfolio they manage are likely to be accompanied by widespread losses elsewhere, so that blame attaches to vast, vague "systemic" problems, and not to the manager personally, who was, after all, only one person, doing her job like so many others. Surely no liability, and no great ostracism, should attach to that.

Like a polluter earning immediate visible profits but exacting diffuse, hard-to-measure costs, managers at hedge funds, endowments, and pension funds are producing cash and "diffusing" risk whose costs will eventually be borne by someone. Institutions may now be their own greater fools, but the rest of us, apparent bystanders, may turn out to be the greatest fools of all.

Steve Randy Waldman — Saturday June 30, 2007 at 8:29pm permalink
Cassandra (mail) (www):
Nice post. In equities, the "time &sales" records of shenanigans is there for authorities that might desire to look. The problem lies in that once they look, the rot runs deep, and the nation can ill afford the capital dislocation event that would follow the loss of confidence in things as safe as a Fidelity mutual fund or 401k (see Miller Risk Advisors paper on Magellan).

But perhaps nothing has done more to undermine what one traditionally might term "prudence" than persistently negative real interest rates, spawning a regime where the winners and superheroes are those who assume future "risk" will be as benign (or more so) than historical risk, and employ other people's equity and yet others' leverage to realize and amplify that vision. Taxes, fiscal restraint, limited mobility of capital, often historically tempered the ultimate incentives to "shooting the moon" where combustion meant penury, for real. Today, combustion while translating into shame in the eyes of fellow traders, just means a juicey book deal and tour on the lecture circuit.
6.30.2007 10:07pm
Steve Randy Waldman (mail) (www):
In a way, then, the "authorities" are running the same racket as the players, ignoring what they can't afford to acknowledge until circumstances leave them no choice. Maybe by then it'll be someone else's watch.

Somehow when even losing becomes winning, so that nobody thinks they can lose, that's when everybody's gonna lose.

It's kind of ironic, in an era of arguably negative real interest rates, that much of "national investment" (e.g. housing, iffy mortgages and consumer credit) in the United States and elsewhere, looks to perform worse than holding deteriorating cash would have. Ready money at low interest rates might have been a boon rather than a nightmare, had the means by which we collectively make resource allocation choices been up to the task of creating productive real assets. Instead it just brought out the mosquitos.
7.2.2007 12:45am
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