Yesterday, we saw the movie – The Big Short – which is entertaining to say the least but depressing in its message that widespread corruption in the corporate and public sectors not only goes unpunished, but is handsomely rewarded. I have also been watching the documentary series Making a Murderer – which follows the stunning and mystery-laded treatment of an American man caught up in a corrupt criminal justice system in the US state of Wisconsin. In that series, it appears that the criminals are those on the wrong side of the bars. I thought The Big Short was the macro version of Making a Murderer, which is a microscopic account of a small town and its nefarious police and legal fraternity. But apart from the corrupt and plainly unethical conduct exhibited by Wall Street, the rating agencies and the bank that fed on all the ridiculous products that were created to make complex what, in fact, was a simple strategy – make money of real estate, there was also plain dumbness at the centre of the collapse and the crisis. Dumbness created by a dangerous Groupthink where patterned behaviour was inculcated into the financial system and, ultimately, came back to bite most of us. While the representations of cocky, sharp, bright financial market traders with PhDs in physics or mathematics in a sequence of movies about the GFC and its aftermath lead to the conclusion that these conspirators knew what they were doing and were happy to profit for themselves at the expense of those they considered to be dumber, a recent academic research study has revealed that the traders themselves were oblivious to what they were doing and became entranced themselves by their own image. That is what Groupthink does – it builds an impervious layer for those trapped inside the group – they are insulated from reality, consistent logic, criticism and behave in self-reinforcing ways that may involve enlarged deviations from anything reasonable, smart or evidence based. Groupthink makes people dumb and compliant. The GFC was in no small measure the product of that sort of dumb compliance, which is not to reduce the enormity of the corruption involved. It, however, does reinforce my view that we should ban all these speculative products that provide no beneficial input to the real economy, if only because the sociopaths that are attracted to creating and selling them are too dumb to know what they are doing.
There is a scene where one of the shorters attends the American Securitization Forum at Caesars’ Palace in Las Vegas. I have been to several of these financial market-type forums and the ambiance is always similar. The Las Vegas event was depicted as you would expect.
Loud, self-confident, arrogant and all the rest of it.
But at the heart of this self-promotion there also appears to be a solid foundation of dumbness.
A 2014 paper from US academic researchers – Wall Street and the Housing Bubble – published in the American Economic Review (Vol. 104, Number 9, pp.2797-2829) examines “whether midlevel managers in securitized finance were aware of a large-scale housing bubble and a looming crisis in 2004–2006”.
The authors note that it is important to understand the awareness of those who were making the transactions that ultimately led to the collapse.
They say that:
If Wall Street was aware that the process of securitization was generating a national housing bubble that would lead to a deep financial crisis yet proceeded to securitize mortgage loans of dubious quality, this would reveal far more severe incentive problems on Wall Street than many have recognized — and confirm many of the worst fears underlying outrage from the public and policymakers. On the other hand, if Wall Street employees involved in securitization systematically missed seeing the housing bubble, despite having better information than others, this raises fundamental questions regarding how Wall Street employees process information and form their beliefs.
That appears to be an interesting research question and motivated their subsequent empirical work.
The authors target the mid-level staff in the banks etc who were the front-line players in the securitization growth. They gathered their sample from “a publicly available list of conference attendees of the 2006 American Securitization Forum, the largest industry conference.”
The sample is made up of:
These investors and issuers, to whom we refer collectively as securitization agents, comprise vice presidents, senior vice presidents, managing directors, and other nonexecutives who work at major investment houses and boutique firms.
They justify this selection which excludes the so-called “C-level executives” (the highest-level executives in senior management) because it is the mid-level operators who “made many important business decisions for their firms”.
On January 16, 2013, the final Task Force – Report of JP Morgan Chase & Co. Management Task Force Regarding 2012 CIO Losses – was released.
This was the outcome of the enquiry into the infamous London While episode aka – 2012 JPMorgan Chase trading loss – where a huge volume of ill-considered credit default swaps were used by a JP trader to short a derivative product based on the LIBOR.
$US6.2 billion in losses later the Report tells us that the senior management were less informed of what was going on than they should have been but the fault lay in “ineffective risk management” processes at the firm and poor “judgment, execution and escalation” in the Chief Investment Office, where the “Whale” worked.
The Report listed a number of personnel who should “bear responsibility” and they agreed with the CEO’s assessment:
CIO, particularly the Synthetic Credit Portfolio, should have gotten more scrutiny from both senior management, and I include myself in that, and the Firm-wide Risk control function … These were egregious mistakes. They were self-inflicted, we were accountable and what happened violates our own standards and principles by how we want to operate the company. This is not how we want to run a business.
The Report indicated that the CEO was dependent on the advice he received from the lower management and only found out what was going on after the damage was done.
Thus, the sample for this study was the mid-level managers and traders, who presumably should have known what was going on on a daily basis, given they were the ones making the running.
In The Big Short movie, the Wall Street operators who initially decide to take a counterparty position against one of the first to propose he wanted to short the market thought they were onto a winner. They sniggered among themselves as they agreed to create the derivative instrument indicating their confidence in the one-way direction of the housing market.
The author of book The Big Short (Michael Lewis) wrote that the major players on Wall Street (the traders) did not consider that the housing market could collapse on a nation-wide basis.
If you go back to the second-quarter 2007 and see what the American International Group were saying in their – Q2 2007 Earnings Call Transcript – you will read the Chief Financial Officer Joe Cassano claiming in relation to their exposure to residential mortgage credit default options (CDOs) that:
… it is hard for us … without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 in any of those transactions.
The academic study’s research design was simple but effective:
1. They accessed public information on the “personal home transaction history of these securitization agents”. That is, they examined how these traders and mid-managers fared themselves in the housing market.
They thus compared “how securitization agents fared in housing against control groups who arguably had no private information about housing and securitization markets:
2. They sought to work out whether “securitization agents may have attempted to time their own housing market” – they refer to this as “market timing”.
They would observe this by the “divestment rates” among this sample relative to a control group (two were assembled – the first being “S&P 500 equity analysts who do not cover homebuilding companies” and the second being “a random sample of lawyers who did not specialize in real estate law”).
In other words, they want to “examine whether Wall Street employees anticipated a broad-based housing bubble and crash”. They say that given the “home is typically a signi cant portion of a household’s balance sheet”, then we would expect those who have personal stakes in the housing market to “have maximum incentives to acquire information and make informed buying and selling decisions”.
Their hypotheses were:
(i) (Market timing form) Securitization agents were more likely to divest homes and downsize homes in 2004–2006.
(ii) (Cautious form) Securitization agents were less likely to acquire second homes or move into more expensive homes in 2004–2006.
(iii) (Performance) Overall, securitization agents had better performance after controlling for their initial holdings of homes at the beginning of 2000.
(iv) (Conservative consumption) Relative to their current income, any purchases made by securitization agents during the boom were more conservative.
I will leave it to you to read the paper if you’re interested in the finer points of their data collection and research design.
They examined five types of transactions that a homeowner might engage in:
1. “buy a second home”.
2. “swap up”
3. “swap down”
4. “divest a second home”
5. “divest last home”.
They calculated what they called “the annual intensity of each transaction type — that is, the number of transactions per person per time period”.
Their conclusions were:
1. “Compared to equity analysts, the divestiture intensity for securitization agents is lower every year from 2003–2006, and slightly higher during the bust period, 2007–2009.”
2. “there is little evidence that suggests people in our securitization agent sample sold homes more aggressively prior to the peak of the housing bubble relative to either equity analysts or lawyers.”
3. “… if anything, there are more first home purchases by nonhomeowning securitization agents than equity analysts.”
4. The results show “that securitization agents were aggressively increasing, not decreasing, their exposure to housing during this period.”
5. Even when they match the sample to specific real estate areas “securitization agents were more aggressive with purchases of second homes and swap-ups in 2004–2005 relative to equity analysts”.
6. Further, “the aggressiveness of securitization agents relative to equity analysts is more pronounced in Southern California than in New York. This suggests that securitization agents living in areas which experienced larger boom/bust cycles were potentially even more optimistic about house prices than otherwise.”
7. They “find little evidence of a higher marginal intensity for securitization agents to purchase second homes or swap up into more expensive homes in nonrecourse states than equity analysts”
8. They find that “all groups, including securitization agents, were worse off at the end of 2010 relative to a buy-and-hold strategy that began in 2000:I.”
9. “In fact, the securitization group’s portfolio experienced signi cantly worse gross returns than the equity analyst group”.
10. They found “if fully aware agents were attempting to ride the bubble, they missed the peak, leading not only to sharply negative returns, but also worse performance relative to other groups.”
The authors overall conclusion is that:
We find little systematic evidence that the average securitization agent exhibited awareness through their home transactions of problems in overall house markets and anticipated a broad-based crash earlier than others …
Our evidence that some groups of agents were particularly aggressive in increasing exposure to housing suggests that job environments that foster groupthink, cognitive dissonance, or other sources of overoptimism are of particular concern. Changing the compensation contracts of Wall Street agents alone, for example through increased restricted stock holdings or more shareholder say on pay, may be insufficient to prevent the next financial market crisis
The study is interesting because it sheds some light on whether these traders were so cunning that they were profiting at the expense of the rest of us.
The reality appears to be that they formed the view, reinforced by the patterned behaviour in their workplaces, that they could not lose.
Their aggressiveness then disclosed their unbridled greed.
That puts a different slant on the usual take that these characters were all “fucking crooks” (a line in the movie) and deliberately played the game knowing the government “would bail them out”.
The research suggests the traders were feckless idiots with too much responsibility over too many innocent peoples’ lives (through their control of assets etc) who should have been restricted to much more sobering and poorly paid tasks – perhaps stamping deposit slips in a suburban bank.
As an aside, one of the characters shorting the sub-prime mortgage market in the movie is Mark Baum (aka – in real life – Steve Eisman). In real life, Eisman has also attacked the growing trend for profit-making corporations to move into the higher education sector.
On May 26, 2010, he addressed the Ira Sohn Conference – Subprime goes to College – and made the opening statement:
Until recently, I thought that there would never again be an opportunity to be involved with an industry as socially destructive andmorally bankrupt as the subprime mortgage industry. I was wrong. The For-Profit Education Industry has proven equal to the task.
He went on to document how the sector “hired every lobbyist in Washington D.C.”, which allowed a massive inflow of public money into the sector. In a ten year period, after George W. Bush Administration forced the Department of Education to gut “many of the rules that governed the conduct of this industry”, more than $US21 billion in Federal government funds (a 450 per cent increase) found its way into this sector.
These so-called – Title IV – funds are granted under US federal student financial aid programs.
They “accounted for more than 100% of revenue growth … In fiscal 2009, Apollo, the largest company in the industry, grew total revenues by $833 million. Of that amount, $1.1 billion came from Title IV federally-funded student loans and grants”.
And so it goes.
Eisner went on to explain how the students typically did gained “NOT much, not much at all” from their educational involvement in these institutions, have very large drop out rates (after the company has accessed the federal funds), and are left with “enormous amounts of debt most for-profit students must borrow to attend school”.
The default rates on that debt were rising as he addressed the audience in May 2010. They have since skyrocketed. Stay tuned.
Groupthink was a focus of my current book – Eurozone Dystopia: Groupthink and Denial on a Grand Scale – except in that case it was concentrated on the political classes who have ruined prosperity in Europe.
In the case of this research paper on securitisation traders and the middle-managers selling these weird financial products, the Groupthink relates to their workplaces, the conferences they attend etc, which insulate them from reality. They then respond poorly because they are dumb.
Dumb here relates to the impact of the Groupthink on decision-making rather than absolute intelligence which becomes suppressed by the motivation to conform to the group dynamic. It is an insidious patterning mechanism.
That is enough for today!
(c) Copyright 2016 William Mitchell. All Rights Reserved.