January 30, 2011 5 Comments
It’s become clear that I should share my thoughts on what caused The Financial Crisis (tm/2008). I make fun of so many other peoples’ stupid ideas of what caused it, that I may as well put forth my own. Besides, well…the people clamor for my opinions, and I listen.
So, without further ado, here’s my brilliant diagnosis of what caused The Financial Crisis: our pyramid scheme finally collapsed. Oops! Didn’t know they could do that!
Speaking of The Financial Crisis as some sort of event that befell us, which had exogenous ’causes’ (causes that, it’s implied, could have been averted), strikes me as a mistake. When you strap feathers on a fat man’s back and shoot him out of a cannon up into the sky, you don’t later scratch your head at the resulting flattened corpse and ask ‘Golly, what made him come down? Next time we gotta figure out how to make him not come down.’ Sorry. He was gonna come down, the question is, and should be: how the heck did he even get up there in the first place?
Because you put him in a cannon and lit the fuse, numbskull. Did you really think the fat man could fly? No, of course not. You were just pretending.
Due to many factors, our economy, our financial system, has turned itself into the most sophisticated pyramid scheme in human history. So, therefore, the bubble burst. To paraphrase Keanu Reeves to
Joaquin Leaf Phoenix in Parenthood, “That’s what little pyramid-scheme dudes do.” Given that we had a pyramid scheme, the collapse wasn’t avoidable, it didn’t have some mysterious ’cause’, it wasn’t avertable with just the right clever genius Smart People regulations, generally speaking it just wasn’t not going to happen. Not-happening wasn’t something that was in the cards. On the contrary, it was going to happen and the only question was when. Why not summer ’07? You got a better ‘when’? When then?
To cite the most notorious pyramid scheme, everyone has heard of Madoff and everyone has heard of CDOs but few seem to have made the link. So, let me. What Madoff is accused of having done involves taking money (from ‘investors’), giving the investors a Thing, and printing up paper statements showing that the Thing they bought increased in value, which attracted new investors. He did this for a while, and for a while it was fine because new investors kept showing up (so, in particular, he could cash out the old ones who wanted out), but then he couldn’t, as the fiction was unsustainable, and the pyramid scheme collapsed. That’s what pyramid-schemes do.
The tragedy of CDOs actually involves a precisely-analogous story arc. When analyzed responsibly, there’s nothing magical or mysterious about a CDO that makes it different from any other debt instrument. It’s far more levered, and it’s the debt of a synthetic company instead of a real one, but if you take the leverage, the hedging costs, and the uncertainty into account correctly, you can price a CDO appropriately like any other bond, and everything will be fine. CDOs valued appropriately would never have contributed to The Financial Crisis, because no one (including rating agencies) would have pretended their value was much higher in the first place.
The problem though is that CDOs are complex things whose value is calculated with formulas and simulations, and while there are formulas that in responsible hands are basically fine, ultimately it seems they can also be manipulated/tuned to make them come out however you want, and due to the complexity, this is hard to stop or catch. And so, this is what (some) people did. Thus, just as the Madoff crime intimately involved the pretense of value, so did the creation and issuance of CDOs. The mechanisms were different (all Madoff needed, it seems, was some word processing software and a printer, whereas CDO sellers needed a team of quants, a library of algorithms, and a cozy relationship with a rating agency) but the end result was the same: make up some numbers showing the Thing has more value than it really has, sell it, keep marking it there (or higher), sell some more, repeat.
The commonality here is making up value out of thin air – or, to put it more neutrally, inflating value.
This takes me to my real diagnosis. The crisis was the popping of a pyramid scheme. Any discussion of the crisis is therefore incomplete without addressing and diagnosing the pyramid scheme. The real question, in essence, is: what caused the pyramid scheme?
To cut an already-boringly-long story short, we may as well just go straight to the source: housing. Our government poured money into housing and artificially propped up the housing market with easy-money it didn’t have and market-distorting regulations and incentives. Basically, loans were given to people who weren’t good for them. The loans were guaranteed by ‘government-sponsored entities’ that weren’t actually solvent on their own. And that’s how houses were given to people who couldn’t afford them. Lo and behold, at the root of this we see the same factor present as in Madoff’s scheme, and as in banks’ CDOs: the pretense of value. Let’s all pretend that this two-bedroom house on the outskirts of a Phoenix suburb is worth $900k. Let’s all pretend that this modest-salaried person can and will pay back the loan. On these pretenses, a flimsy pyramid was indeed built. And then it collapsed. Duh. That’s what pyramid schemes do.
The motives for the housing make-believe varied a bit (in the Clinton years the handwringing over ‘redlining’ was probably ideological, a sop to ‘diversity’ and race equality; in the Bush years it was, I suspect, more of an approval-rating/electoral strategy) but the result was the same: borrowing money from future
levels of the pyramid sceme generations in order to artificially-boost everyone’s home values and make them feel in-the-money. To create the illusion of wealth, of value. And for a while, it worked, and then the bubble burst, so it didn’t.
But this is the arc of every single pyramid scheme. All perfectly normal and natural. None of it unexplainable or mysterious. What is there to talk about that won’t just be depressing? Any further questions or can we all just end class early and head down to the Rathskeller for a pint, and talk about something else, like cars, and girls? In fact, can we just pretend I never even brought it up…please?