Were Mistakes Made?

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"Were Mistakes Made?"

Ezra Klein writes:

I’ve spent part of the day reading about super senior tranches and synthetic bonds and all the rest, and on some level, I think we’re making this too complicated.

I tend to agree with Ezra. Which is to say that though the specifics of how the super-senior tranche is created are very complicated, the underlying bet behind the super-senior tranche is very simple — it was a bet that any future housing price declines would be localized, and that it wasn’t possible for their to be a systematic, nationwide downturn in the housing market. And that was, frankly, stupid. National housing prices were out of line with historical values, and now are returning to historical values. Which is just what people should have expected to happen and, indeed, was exactly what many people expected to happen.

But one thing I wonder about is whether this was really a “mistake” at all. I think back to a friend of mine who spent a summer working for a dot-com startup during the bubble years. The company’s business model didn’t make any sense. And my friend didn’t think it made any sense. He just thought it was an attractive job. And the sense he got was that his employers didn’t really think it made sense either. What they thought made sense was that if investors were willing to fund their startup, then spending some time paying themselves a salary out of the investors’ money and working for their own startup would be a fun thing to do for as long as it lasted. Either it would somehow work out — perhaps because some other group of investors was dumb enough to buy the company — or else it wouldn’t. But either way there was no downside risk for the founders — these were young guys, not people who’d quit stable jobs and put their families at risk. In the end, things didn’t work out. And I think the founders went to law school. Or else they’d recently graduated from law school and after the company went bust they took the bar. Or something like that. But the point is that you could look back and see the flaws in their business model and then wonder how they’d made such a terrible mistake. But that would be missing the real story, namely that they didn’t make a mistake at all. They took some investors for a ride! And they had a good time doing it!

In our current situation, meanwhile, it’s hard for me to avoid asking if one of the reasons the instruments were so complicated was that managers were trying to obscure from investors how simple their underlying bets were. I think if you said to someone “let me invest a bunch of your money based on the premise that there can never be a nationwide decline in real estate prices” a lot of people would say “no, that’s dumb” or at least “no, I can do that myself without paying you fees.” But come up with a lot of hocus pocus and you may be able to convince the guy that you have special insights and investment strategies that he should trust.

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