Michael Lewis and the idiots
Larry Summers famously wrote -- but sadly, did not publish -- a paper that began with a timeless bit of wisdom: "THERE ARE IDIOTS," Summers said. "Look around." That paper was written decades ago. Maybe it's time to finally publish it. Particularly that second line.
Michael Lewis's latest book, “The Big Short,” is an attempt to explain the financial crisis, and in doing, it goes through correlation errors and collateralized debt obligations and mortgage fraud and all the other financial arcana the meltdown forced onto the front pages of our newspapers. But in the end, Lewis's explanation is simpler than all that: There were idiots. And no one was looking around.
The worst of the idiots were the ratings agencies: By slapping that "AAA" seal of approval on packages of bonds made from packages of subprime loans, they said those bonds were no riskier than treasury securities, which are considered virtually risk-free. In retrospect, their analytical mistake was almost comically ridiculous: They figured that each subprime mortgage was a unique little snowflake unto itself, and that what happened to one was irrelevant to what happened to others. Nice thought. In reality, when the teaser rates vanished and the loans revealed their true nature, they all went belly-up at the same time, for the same reason. The rating agencies' idiocy was the idiocy that made everyone else's idiocy possible, because it was what they all pointed to in justification.
But why were they justifying it? The downside risk turned out to be tremendous. And yet the big banks were full of idiots who were selling bonds based on mortgages they knew nothing about. They were run by idiots who were rolling in profits coming from underlings selling bonds based on mortgages they knew nothing about. As things began to go south, they started aggressively selling those packages of bonds to smaller investors who were also dumb to the nature of the underlying asset.
And you could drill down further. There were consumers buying into mortgages they didn't understand at prices that were too good to be true. There were regulators who refused to see the very excesses they were supposed to stop. There was a media that occasionally mentioned the odd divergence of housing prices from their historical norms but didn't see the enormity of the problem.
In this case, it's not that there's plenty of blame to go around. It's that there's too much blame to go around. There is not one single piece of the system that worked the way it was supposed to. Consumers did not make smart decisions, nor did banks or ratings agencies or institutional investors or regulators. Everything failed. And that caught us unprepared, because in the run-up to the crisis, we'd looked at these people and pronounced them geniuses. Alan Greenspan, who we'd nicknamed "the Oracle." The titans of Wall Street, who had so much more money than we did that it seemed obvious they knew something we didn't. The banks, which were staffed with the best of the Ivy Leagues.
That said, not everyone failed. Lewis follows a couple of rogue investors who saw what was happening and bet aggressively against it. The gleefully acerbic hedge fund manager Steve Eisman, for instance ("which Wall Street big shots Eisman had insulted was a matter of which Wall Street big shots' presence Eisman was allowed into"). The one-eyed, autistic money-manager Mike Burry. Lewis is a good storyteller, and he has found good characters to help him tell his story.
But the existence of seemingly endless idiots at every level of the financial system is much more important than the frustration of a small handful of clear-eyed doomsayers. Like the poor, idiots will always be with us. In fact, we'll frequently be among them. The seductions of group-think, the tendency to trust experts, the incentives for employees to go along with their bosses rather than contradict them and the need to deliver short-term profits even at the cost of long-term risk are more powerful than any regulation and will exist long after the visceral lessons of the subprime meltdown are gone.
So we're left where Summers started: There are idiots. And if you look around, it turns out that they're everywhere: In the banks, at the Federal Reserve, running the rating agencies, and selling mortgages. You can't idiot-proof a system run by idiots.
But you can limit the damage they're able to do. Think about it this way: Individuals can purchase guns in this country, but it's rather more difficult to get your hands on a rocket launcher or a tank or a tactical nuclear weapon. In this telling, the task for financial regulation isn't making the financial system idiot-proof so much as making everything else financial-system proof -- or if you can't do that, at least making it less vulnerable. Reigning in the size and leverage and complexity of the financial sector such that its mistakes don't pose a survival-level threat to the entire economy would be the obvious way to go.
The other possibility -- and this is what you see embodied in the Dodd bill -- is to make it easier and more straightforward to clean up the mess left by the occasional outbreak of idiocy. That means making it easier for regulators (and everyone else) to know what banks own and how much of it they hold and who their counterparties are. And then, if it all goes bad, making it easier to break the banks apart without paralyzing every other market player.
Either way, the proper interpretation of Summers' comment is not that the world is full of idiots, but that it's full of human beings. Relying on perfect regulators or more responsible bankers will eventually fail. The work of financial regulation is to create a system that anticipates that inevitable failure and limits the damage it can do.
April 7, 2010; 9:34 AM ET
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