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Michael Lewis and the idiots

41rWIVW06yL.jpgLarry 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.

By Ezra Klein  |  April 7, 2010; 9:34 AM ET
Categories:  Books  
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Comments

not only were there idiots, there were lots of idiots; there were mostly idiots even. Otherwise the big shorters would not have been able to pull in such a big fish.

Posted by: bdballard | April 7, 2010 9:40 AM | Report abuse

The issue here is similar to the global warming debate - both involve coping with complex and unpredictable systems, and battling bias and uncertainty. The scientific method is the best way to handle such complexity, as it is self-correcting and cumulative, so we need financial regulation based on similar principles, such as transparency and "peer review" of data and assumptions. But, ironically, we listen to the financial experts, yet refuse to listen to the scientific experts. I guess there are no idealogical biases surrounding CDOs.

Posted by: jduptonma | April 7, 2010 9:46 AM | Report abuse

There are always idiots in hindsight.

Ever read "Smartest Guys in the Room"? Those Enron execs all looked like geniuses from the outside, for a long time, and tended to believe their own press just a little too much.

The problem is, the folks who see the systemic problems when things are going great are always going to be in the minority. Even folks who see the problems--and I expect there were some at all levels--can exhibit a perfectly human tendency to shrug and say to themselves, "Well, this seems doomed to fail, but, gosh, it all seems to be working somehow right now". The fact that everything is "going great"--and, for a while, it was--tends to mask the fact that, at some point, it all has to blow up. And, heck, even the market is going to collapse, maybe it won't do it for another ten years! That's another ten years of high living. And I'm just one investor/banker/ratings agency/regulator. Who am I to stand athwart all the money being made?

It's easy to point fingers after everything comes crashing down. When everything is flying high, it's extremely difficult.

Posted by: Kevin_Willis | April 7, 2010 10:15 AM | Report abuse

I remind you of all the Democrats saying Fannie Mae and Freddie Mac were awesomely solvent, and attacking the guy charged with oversight of Freddie and Fannie--trying to say things were going to start going south--as a heretic.

http://memetrics.wordpress.com/2008/09/30/burning-down-the-house-them-crazy-democratics/

Everyone's a Monday morning quarterback. And all the idiots are probably smart people who understand that giving people ARMs and balloon mortgages on houses that have gone up in value 500% in two years, folks with poor credit who can barely pay the mortgage payment before it triples in 18 months . . . they understood that that was kind of crazy. But then you bundle those mortgages and rate them and then sell them and through the power of derivatives and credit default swaps and the magic of leprechauns, it somehow all just worked out. Who were they to criticize success?

When Andrew Cuomo was pitching endorsing changes to Fair Housing Act under Clinton (essentially endorsing Fannie Mae and Freddie Mac underwriting the subprime market), he acknowledged (if memory serves) that it would lead to more foreclosures and defaults and would be, in effect, putting lots of poor people in houses they couldn't afford--but that it was the right thing to do, it would work out somehow, Fannie and Freddie would underwrite it, and they had a moral obligation to do it. He essentially predicted what would happen (though not the extent), but said, "Eh, it won't be that bad." And implied the Federal Government would make it all right.

Go back and listen to that speech now, and he sounds like an idiot. Go back and listen to Barney Frank and Greg Meeks defend Fannie Mae and Freddie Mac pre-meltdown. They both sound like total idiots . . . and their attacks on the one guy trying to stop the trainwreck are really shameful. In hindsight.

And that's kind of the point. Anytime things don't work out, everybody who thought it would look like idiots. But almost 80% of investors (or more) thought the Dot.com boom was a magical fountain of perpetual wealth, until it came crashing down. In retrospect, they don't look that smart. Most of the failed dot.com companies look like morons (I worked for a company that bought kozmo.com after it went bankrupt, and saw the kinds of things kozmo has spent money on, and boy, did they look like idiots in retrospect). After.

Hindsight does not equal foresight, and thinking you can just make the idiots look around, or get rid of the idiots somehow, ignores the fundamental problems that lead to otherwise smart people being lulled into thinking obvious systemic flaws that are going to lead to disaster can be ignored because "everything seems to be working right now".

Posted by: Kevin_Willis | April 7, 2010 10:16 AM | Report abuse

I disagree. The problem is not that these people were idiots. The problem is that they were careerists. That is, no one loses their job on Wall Street by making a mistake, as long as "everybody else" does it, too.

Since it wasn't their money and their careers that was at risk if the particular investment they were selling was a bad one, and since they were well-paid regardless, there was (and still is) no downside *for* *them*. It is only when you look at the investors or the country as a whole that these were bad deals.

To repeat, the Wall Street guys weren't idiots. After all, how many of them are broke because they put all of *their* money into CDOs or whatever toxic investments they were selling?

Posted by: adonsig | April 7, 2010 10:24 AM | Report abuse

There were idiots, and there were people that were provided incentives to do idiotic things. Don't mistake the two.

The rating agencies knew where their bread was buttered from... blowing the whistle wasn't really an option for them. The investment bankers advanced their careers and scored some big bonuses -- you can't call them idiots. AIG, on the other hand, was acting against their interests -- by underpricing the risk they increased their exposure and sold themselves short on the upside too.

Posted by: wagster | April 7, 2010 10:37 AM | Report abuse

But Kevin, isn't the point of the post that we can't pick the idiots from the crowd before they do damage, perhaps because most of the crowd are idiots, but we can and should limit the damage they can do to the system as a whole?

We can't count on these people to all be smart, savvy, and on top of their game, so we make it so that they can't cause a world-wide financial meltdown when their mistakes catch up with them.

Posted by: MosBen | April 7, 2010 10:38 AM | Report abuse

It was greed and hubris more than idiocy. Nobody really believed the bubble would last forever, despite whatever they were saying. They just couldn't resist participating, and they assumed that they would get out before the bubble popped. Just jack up taxes to something like 95% on all forms of income above $1 million and the problem is solved.

Posted by: AuthorEditor | April 7, 2010 10:50 AM | Report abuse

@MosBen: "We can't count on these people to all be smart, savvy, and on top of their game, so we make it so that they can't cause a world-wide financial meltdown when their mistakes catch up with them."

That would be great, I just think it's going to be difficult when we're using the lens of hindsight to call everybody idiots.

But, yes, in complex system everybody points to somebody else to justify profitable but destructive behaviors. Consumers say, "Well, the bank wouldn't be offering me this crazy loan if it wasn't a good idea?" and "The rating agency wouldn't rate these crazy assets AAA if they weren't all right" and so on.

But, yes, we have to recognize there are simple systemic issues that can be addressed--allowable leverage rates being the primary one. I'm also a big fan of bringing back Glass-Steagall (the repeal--the deregulation, if you will--of which has been credited with help minimizing the financial meltdown by some). But, yes, there are systemic things that should be in place. One example: ARMs and balloon mortgages and zero-down mortgages are little more than loanshark loans, and should be illegal. Frankly, there should only be fixed interest loans for housing. The end. And credit cards should be legally mandated to reduce interest rates on cards inversely proportional to the amount of credit they extend. So, if they extend 5,000 in credit, they can charge 24% interest, but if they extend 10,000, they can only charge 18%, and at 20,000 they can only charge 12%, and so on.

While no doubt imperfect, and certain to be attacked politically, I think FinReg is important. And should be pursued, preferably in digestible chunks, rather than trying to bundle in everything at the same time (Chris Dodd's tell-us-how-your-going-to-go-out-of-business-rule and rules to allow the government to step in and takeover any bank at the sole discretion of the Secretary of the Treasury being examples of controversial regulations that will arguably do much less good than fixed rates of leverage for banks or fixed levels of risk exposure for insurers like AIG, or independent oversight for ratings agencies, etc.

Posted by: Kevin_Willis | April 7, 2010 11:01 AM | Report abuse

Seriously, why was there ever a sub-prime market to begin with? We should only have fixed-interest home mortgages, and any Fair Housing programs should be about subsidies (especially regarding the down payment), not getting them into ARMs or balloon mortgages or whatever.

Posted by: Kevin_Willis | April 7, 2010 11:04 AM | Report abuse

"Seriously, why was there ever a sub-prime market to begin with? We should only have fixed-interest home mortgages, and any Fair Housing programs should be about subsidies (especially regarding the down payment), not getting them into ARMs or balloon mortgages or whatever."

I completely agree. ARM's have a nasty track record of showing up in a big way in every super-heated real estate market, and they inevitably lead to trouble.

Posted by: Patrick_M | April 7, 2010 11:11 AM | Report abuse

And yet the big banks were full of idiots who were selling (bonds) bombs based on mortgages they knew nothing about.

fixed

Posted by: kellgo | April 7, 2010 11:22 AM | Report abuse

adonsig writes above (and is worth repeating): "The problem is not that these people were idiots. The problem is that they were careerists. That is, no one loses their job [...] by making a mistake, as long as 'everybody else' does it, too."

The "bandwagon" effect is powerful but is easily overlooked. Using a recent and controversial example, everyone saw the footnotes in the CBO reports, the warnings from ethicists, the reports from Massachusetts, etc. yet jumped onto the HCR bandwagon as quickly as Enron execs and staffers jumped onto the energy trading scam. I agree that there are idiots... and that too frequently no-one looks around to see them; however, it seems as if the step of looking around is pointless unless the looking results in both identification and resolution of the underlying problem. That is, what mechanism exists to enable those who are NOT driving the band-wagon to prevent the wagon-driver from running it over a cliff? Isn't the argument reinforcing the value of strong, vocal, and meaningfully powerful opposition?

Posted by: rmgregory | April 7, 2010 11:22 AM | Report abuse

"Otherwise the big shorters would not have been able to pull in such a big fish."

Well... not exactly. The problem with shorting the house of cards is that you need *massive* capital. As that noted socialist hippie freedom-denier, Keynes once said, "The market can stay irrational longer than you can stay solvent."

Posted by: antontuffnell | April 7, 2010 11:25 AM | Report abuse

"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." That's it.

The heads of institutions weren't idiots; they were wilfully blind to the sources of their immense profits. They didn't want to know how all these instruments worked.

The ratings agencies weren't idiots, they were venal. They knew that if they didn't uprate the bonds the business would go elsewhere.

The subprime guys weren't idiots; they were crooks. Lewis makes that crystal clear.

The idiots were the people who were seduced into buying products they didn't understand with the promise of a quick buck. This includes the unsophisticated homebuyers on whom the mportgage brokers preyed and the cities, pension funds etc who were seduced by the bond syndicators. And the people who bought into stocks and funds they didn't understand.

What set apart the people who were right was that they were all lone wolves who were for diifferent reasons much less susceptible to group think--in no small partly because they weren't in those groups. This latter trait, plus their immense powers of focus, show who to listen to next time.

Posted by: Mimikatz | April 7, 2010 11:28 AM | Report abuse

And Alan Greenspan is an idiot. He still says low interest rates and subprime weren't causes of the meltdown. He's blaming Fannie and Freddie. He ought to read Lewis' book on subprinme and the syndication of and derivatives based on subprime loans.

Posted by: Mimikatz | April 7, 2010 11:31 AM | Report abuse

"The problem with shorting the house of cards is that you need *massive* capital."

Usually (e.g., shorting stocks) yes; in this case, no. As Michael Lewis pointed out in his NPR interview (and presumably the book also), the glorious thing about shorting RMBSs was you could buy a credit default swap for a very nominal cost (2% or less of the face value), and then sit back and wait, with no possibility of any further loss.

Whether this is a good thing or not, I leave to people who understand it better than I do.

Posted by: retr2327 | April 7, 2010 11:51 AM | Report abuse

Is Michael Lewis an idiot? He called the naysayers "Wimps, Ninnies, and Pointless Skeptics" on January 30, 2007.

http://www.bloomberg.com/apps/news?pid=20601039&sid=aaagOLYMd4yg&refer=home

Posted by: tim37 | April 7, 2010 12:14 PM | Report abuse

Is Michael Lewis one of the idiots? He called the naysayers "Wimps, Ninnies, and Pointless Skeptics" on January 30, 2007.

http://www.bloomberg.com/apps/news?pid=20601039&sid=aaagOLYMd4yg&refer=home

Posted by: tim37 | April 7, 2010 12:16 PM | Report abuse

Is Michael Lewis one of the idiots? He called the naysayers "Wimps, Ninnies, and Pointless Skeptics" on January 30, 2007.

http://www.bloomberg.com/apps/news?pid=20601039&sid=aaagOLYMd4yg&refer=home

Posted by: tim37 | April 7, 2010 12:17 PM | Report abuse

Is Michael Lewis one of the idiots? He called the naysayers "Wimps, Ninnies, and Pointless Skeptics" on January 30, 2007.

http://www.bloomberg.com/apps/news?pid=20601039&sid=aaagOLYMd4yg&refer=home

Posted by: tim37 | April 7, 2010 12:18 PM | Report abuse

Agree with AuthorEditor:

"Idiocy" was not the issue in the lead up to the crisis. It was greed, pure and simple. Greed at every level, every juncture. Blind greed. With one probable exception: home-buyers who were gullible and easy prey to predatory lenders.

Posted by: onewing1 | April 7, 2010 1:07 PM | Report abuse

@onewing1: "With one probable exception: home-buyers who were gullible and easy prey to predatory lenders."

Wanting something for nothing, or a diamond for the price of a cubic zirconia, is greed. A (greedy) fool and his money are soon parted. The lenders are culpable, of course, and should have know better. But an individual smart enough to buy a house and get a mortgage should be able to look at his or her income and understand what sort of house they can reasonably afford.

The subprime mortgage crash didn't consist of $50,000 single-person houses in not-so-great areas of town, after all.

Posted by: Kevin_Willis | April 7, 2010 1:50 PM | Report abuse

Kevin, I don't disagree that borrowers need to take some of the blame, but like with credit cards, most people trust their lender when they tell them that this complex financial arrangement will allow them to get a bigger house than they thought and that it'll be affordable for them. Plus, if they need to get out, the house will have appreciated enough in a few years for them to come out ahead.

Of course, then the lender that told this to the person's face sold the mortgage to some huge, faceless company that the person has no relationship with and the person is screwed.

My point is just that many more people buy houses than there are people who are skilled at reading contracts and/or understand how that ARM really works. Should they get into something that they don't understand? Probably not, but they're going on trust here and being taken advantage of.

That doesn't eliminate blame, but I think it does reduce it somewhat.

Posted by: MosBen | April 7, 2010 2:58 PM | Report abuse

@Kevin_Willis:

"A (greedy) fool and his money are soon parted".

By this, are you saying that you believe all fools are greedy?

If so, this is where we disagree. I think many, though certainly not all, of the home-buyers during the *bubble* were just plain gullible -- defined as:

fleeceable, naive and easily deceived or tricked because of being too trusting

Posted by: onewing1 | April 7, 2010 3:15 PM | Report abuse

@Keven_Willis:

MosBen gives better explanation of what I tried to say.

Posted by: onewing1 | April 7, 2010 3:21 PM | Report abuse

I don't believe the financial crisis happened because of idiots. Whether it was those employed selling the mortgages or those buying the mortgages, the motivator was making a lot of money. And with both the buyers and sellers, that money would be made as long as housing prices kept going up. Most everybody saw the chance of housing prices falling as very small. Thus, there was a great chance of making tons of cash vs. a very small chance of losing cash. And if that small chance of disaster did come, bankers knew they could walk away from their banks and homeowners knew they could walk away from their houses. Importantly, none of the actors took into account what would happen to the whole financial system in the event of falling housing prices. The only saw as far as their own bank or house. They thought, "If the price of my house falls, the worst that could happen is I lose my house." They did not think, "If my housing price falls, the world economic system will be on the brink of total collapse."

To chalk up the financial crisis to idiots misses the point that actors in this crisis were acting in a rational way -- looking at a situation of almost certain big gains vs. a small risk of loss and acting accordingly.

Especially look at those in upper management positions in the banks. Yeah, everybody's calling them idiots, but they got away with millions. I'm sure they laugh at being called idiots, look and their financial worth, and think, "Yeah. Who's the idiot?"

My worry about saying the financial crisis was due to idiocy is it implies that the system works as long as people act rationally. People did act rationally. This was a failure of the system.

Posted by: jeff01 | April 8, 2010 3:03 AM | Report abuse

"I disagree. The problem is not that these people were idiots. The problem is that they were careerists."

"My worry about saying the financial crisis was due to idiocy is it implies that the system works as long as people act rationally. People did act rationally. This was a failure of the system."

I agree with these points. At the end of the day, all the guys with the power to stop this instead crashed the economy...and then walked away from the wreckage as millionaires and billionaires.

Why in the world would we expect it to be different next time?

Posted by: theorajones1 | April 8, 2010 10:07 AM | Report abuse

There were historical analogies to the willful idiocy of our Great Recession.

One was the Gold Rush, greed made moral with a gilt veneer that drove men almost mad each time gold was discovered. But those who profited most were the men who supplied and urged them on, men like the Big Four of California: Huntington, Hopkins, Stanford and Crocker. They knew the secret that made others' greed pay: they mined the miners.

Another example was in the Roaring Twenties when Wall Street exploded with cheap money from the new Federal Reserve. The idiocy arose when barbers were peddling sure-fire tips on stocks, and scullery maids invested their meager savings in Ponzi schemes. Those who made the most money were those who quietly got out of the market early but didn't warn anyone of what they saw coming.

When idiotic sums of money seem easy to make, it will attract plenty of idiots to try.

Posted by: tomcammarata | April 8, 2010 1:25 PM | Report abuse

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