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It is fuelled by stupidity … That’s not stupidity that’s fraud

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 hometransaction 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.

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    This Post Has 14 Comments
    1. Yes group think is deadly. DSGE theorists and those who thought Banks only loaned out deposits were not concerned because “the economy a;ways tends toward equilibrium” and for every loan there is a pre-existing deposit.”

    2. Bill I highly recommend watching this documentary called “the warning” based on a regulator in the 1990s who was basically personally attacked and ended up being ignored. If she had been listened to then it’s incredibly likely the GFC would never have occurred. The link is on the PBS website:

      There are also other great documentaries on there. There’s one titled “inside the meltdown” about what happened inside the government whilst the financial system was melting. scary but incredibly interesting how bad it got and how we ended up where we are. Some other great non-economics documentaries too if you ever have time in your busy schedule! :-)

      I enjoyed the great short and like your analysis. How can some of the smartest people be so dumb. Groupthink indeed!

    3. Dear Bill

      Didn’t an Englishman once say, “Never attribute to malice what can be sufficiently explained by stupidity”?

      Regards. James

    4. Very few analysts explicitly call what was done on Wall Street by its real name, fraud, and that its perpetrators should go to jail. Other than yourself, there is Bill Black in the UK and Prem Sikka in the UK, selecting the most prominent that I know. Black is probably the most prominent, pointing fraud out consistently and trying to get the Justice department to prosecute.

      I would have thought it obvious that complex derivatives should be banned. They are dangerous and provide no real value to anyone. I have referred to them as Schroedinger Derivatives. Like Schroedinger’s cat in the box, you, the purchaser, do not know what they are worth or what they will cost you until you try to “trade” them. Only their creators know. And invariably, only the creators “win”. And I expect that it is this attribute that banks dearly love and why they are trying so hard to keep them from being either regulated or banned. They don’t seem to realize that they are shooting themselves in the foot, as it were. As you contend, Bill, Groupthink renders you blind or indifferent, leading you to act stupidly or maliciously.

    5. The AEA study that you cite is deeply flawed because it makes ‘rational agent’ assumptions in its methodology. The study compares the portfolios of those who undertook mortgage securitisation against those who did not. If the former lost more on housing than the latter it is concluded that they did not know what was going on. The assumption here is that they should have integrated any knowledge they had about the future of the housing market into their portfolios — that is a ‘rational agent’ assumption.

      This is a very limiting view. In fact there are many reasons why a portfolio manager might ignore clear evidence that they know to be true when building their portfolio. They may not care that much because IBGYBG (“I’ll be gone, you’ll be gone”) as they say in finance. There is plenty of qualitative evidence from the crash that many people knew exactly what was going on as they built toxic portfolios. Example from the NYT in August 2007:

      “Oddly, the credit analysts at brokerage firms now being pummeled were among the Cassandras whose warnings were not heeded. “I’m one guy in a research department, but many people in our mortgage team have been suggesting that there was froth within the market,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “This has really been progressing for quite some time.”… “All of the old-timers knew that subprime mortgages were what we called neutron loans — they killed the people and left the houses,” said Louis S. Barnes, 58, a partner at Boulder West, a mortgage banking firm in Lafayette, Colo.”

      By making rational agent assumptions in their methodology the authors of that study have done enormous damage to their findings. While I agree that Groupthink etc. played some role in the financial crisis that was not all of it. Incentive structures that led people to stuff junk into their portfolios played a much larger role — as Keynes said: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Indeed.

    6. The fact that as Michael Hudson puts it ,” a home is worth what a bank is willing to lend against it,” combined with the corporate imperative to maximize profits, has an outcome which ought to have been reasonably foreseeable to anyone with a normal IQ or who has tried to buy a home in the last few decades; “group-think” notwithstanding.

      Real estate like many other markets has become a manipulated market due to poorly managed fiscal policies and, weak regulation/enforcement, which disconnects the real resource inputs from price and the ability to pay; the buyer must beware!

    7. Yeah okay they were “dummies” and “greedy”

      But what actually broke down in the flow of payments in the economy?

      Did the banking crisis cause the drop in private spending?

      Or did the drop in private spending cause the Banking crisis?

      Why did house/property prices stop rising and start to fall?

      Did the fall in private spending cause house prices the stop rising and go down?

      Or did the fall in house prices cause the fall in private spending?

      Why did foreclosures increase?(why not refinance)

      Did increased Foreclosures cause fall in private spending?

      Or did a fall in Private spending cause an increase of foreclosures?

    8. Jake it sounds like you haven’t watched the movie “The big short” yet. It was a house of cards built on rising house prices. As soon as they stopped rising and the higher subprime interest rates kicked in the game was over. NINJA (no income no job) loans for house people could never afford packaged inside derivatives rated AAA weren’t based on reality.

      I posted earlier but can’t see it. I highly recommend everyone watch “The warning” on the PBS website detailing what happened in the 90s. The GFC very likely would never have happened had the regulator been listened to instead of being shutdown.

    9. I’ve just been reading about a relatively new financial ‘instrument’ called a ‘Contingent Bond’ (CoCo) which seems to pay a high interest (7%) but runs the risk that it can be ‘triggered’ into a share if there is a bank collapse and thus no longer a liability of the bank. Seems like the shenanigans are on going and ever more inventive and polyvalent.

      I think economist Robert Schiller might be the primogenitor of this idea. Anyone know about this?

    10. Dear Phil (at 2016/02/15 at 21:55)

      Yes, there are issues with the paper I cited, as there are with most research papers. The irony in this case is that their results demonstrate how patterned behaviour overrides what a neo-classical economist would consider to be rational behaviour. Self-interest in the Groupthink milieu (desire to be part of the team, conformity etc) leads to quite destructive behaviour and outcomes, which are at odds with those predicted by the mainstream economics approach.

      Some knew what was going on and they off-loaded dodgy positions. But the traders who were caught with their own assets at peril clearly did not have a good idea of what was going on.

      The evidence is that for the shorters to be able to participate on that side of the transaction (and make huge returns) there had to be counterparties on the other side, who had to be adopting the assumption that the housing market would persist as it was. Otherwise the trades would not have been originated in the first place.

      best wishes

    11. Hate to be a pedant again, Bill, but Making a Murderer is set in Wisconsin. Not Michigan.

      It is a compelling documentary. (No spoilers from me).

    12. @Jason
      I did watch the film.

      “It was a house of cards built on rising house prices. As soon as they stopped rising and the higher subprime interest rates kicked in the game was over”
      -Again, why did they stop rising?

      -“higher subprime interest rates kicking in ”
      Is a myth, Defaults rates did not increase at all when interest rates changed.changed. In fact,we saw an increase in defaults/foreclosures when interest rates got lower.Please look at pg 49 of working paper w18082 (NBER).Three simple graphs illustrate this point.
      -Subprime is not even half of the story :The crisis began in the subprime mortgage sector, but twice as many prime borrowers as subprime borrowers lost their homes over the full sample period. go to the short article w21261(NBER).Note this would have been when interest rates were lower too.

      So your point about NINJA loans is moot too.

      I will watch “the warning” later on vimeo.

      but still,I’m failing to find sufficient explanation which ties together the fall in property prices,the increased foreclosure rate,the fall in private spending and the banking crisis.

    13. @jake sorry to make assumptions about the movie but look I’m oversimplifying things as its easiet. NINJA loans of no income, no job and and no assets resulting in unemployed or low paid workers owning not only one bit multiple homes isn’t rocket science to me. As soon as the illusion of wealth that comes from rising house prices even if you don’t own them it’s very real like stock markets rising I guess. As soon as there’s signs iys not based on reality it’s a house of cards or a game of jenga. Much faster to fall than rise.

    14. @Jason,

      Again NINJA loans were not the key part of the forclosures! Prime borrowers defaulted at twice the rate as sub-prime borrowers.w21261(NBER).SO people with GOOD jobs were all of a sudden unable to service their mortage debt.

      REITS Began to fail in 2007 and foreclosures began to increase. Experts said that this wouldn’t spread to the real economy, but then we had the ‘credit crunch’ and a huge drop in private spending and then unemployment.

      This isn’t simple you are just describing the surface phenomena, not the actual causes and the dynamic relationships between these factors.

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