[quote=CA renter]
Good post, dave, and think you nailed the elusive nature of the truly guilty parties in the financial system.
I would disagree, though, about the lack of knowledge regarding the eventual outcome of these “innovations” in finance. I’m not involved in finance (other than trading), never took an econ or banking class, and wasn’t privy to the inner workings of the mortgage market, but could easily see where things were going back in 2004. If I could see it, surely “the experts” could have seen it. It’s hard to believe that so many people who had that much power were so completely incompetent.[/quote]
Well, let’s be honest here – I’m sure that you saw that it would all “end badly” back in 2004. As many of us here at the Pigg were discussing at this website as the peak neared. But did you realize the extent of what AIG was up to? I doubt it. Did you realize what Paulson and Magnetar were up to? I doubt it. The intricate maze of CDOs? I doubt it. I could go on.
I think plenty of folks – many fellow Piggs – strongly suspected that housing prices were going to drop significantly, we’d have a wicked recession, and that some number of banks were going to fail – and this was an extreme outlier view back in the mid-noughties – but with the exception of a small handful of folks (maybe Taleb and a few others – I would add Paulson and Magnetar but in fact they helped to MANUFACTURE the crisis), very very few folks predicted the extent of the damage. Most folks who identified the bubble and tried to profit from it probably started a few years too early (because the bubble should have been arrested back in, say, 2002) and had their asses handed to them by the time it actually burst. Such is that nature of markets. I’m not excusing anyone here – make no mistake – just pointing out that there’s a very large gulf between saying, “Houston, we have a problem” and saying, “Bernanke, the financial system is about to collapse.”
Anyhow, I think when you’re heavily compensated not to see something, you’re unlikely to see it. You put blinders on and say, “No one else is seeing anything, so everything must be copacetic.” Compensation – especially when it’s enormous – blinds people to alternate scenarios.
And here’s the other major problem with our “financial leaders” from the last several years: most of them arrived at their position as a result of adverse selection. Allow me to explain through use of an example.
A business partner of mine rescued an ailing bank during the mid-90s. Recapitalized it, cleaned it up, ran it extremely well and sold it in 2001. He sat back and said, “Things are getting crazy. Time to hit the eject button.” Everyone made a crappile of money. But the bubble kept inflating. Anyhow, based on his considerable prior success he was asked to run a much larger bank a couple of years later. He thought things were even more crazy but he was bored, took the job and didn’t invest any of his own money. He got there and basically said, “Folks, we gotta slow this train down and tighten up some things because it’s really crazy out there.” He was fired within a year. He didn’t really care because he didn’t need the money. But the larger point is this: most of the cautious bankers (or financiers, if you prefer) had been weeded out by the time the bubble burst. They had either sold, retired or just moved to the sidelines (like my friend). Most of the folks who remained at the top had only known expansion and bubbles and couldn’t really fathom any other condition. And if they could fathom it and tried to slow their companies down, they were pushed out. If you saw that the emperor had no clothes, you were long gone by 2006. So, the length of the previous expansion engendered a LOT of adverse selection in the top ranks of banks, investment banks, etc.
So, combining adverse selection with blindness-via-compensation, I find it very easy “to believe that so many people who had that much power were so completely incompetent.” In fact, in hindsight, it looks fairly predictable.
