Conspiracy or Stupidity?

In my previous post (which I must admit was mostly an angry rant to the bailout) I implied that the current disaster is intentional.  In particular, financial entities are profiting (compared to how they would have faired) by extending the US Government's protections that it provides home-owners.  (That is, in its attempt to save home owners, we'll have to bail out a bunch of non-home-owner rich folks as well.)

But - that's not really fair - we can't assume conspiracy where stupidity and luck will explain the situation.  In particular, I think it's more likely that the existing financial morass is an emergent behavior of a very, very poorly designed system, and those who will get bail-outs are getting so by coincidence of where they landed and not by a plan to leverage poorly designed housing policy.

I have heard congressmen argue that Wall Street was duping Main Street out of their home equity by selling them ARMs that would force a refinancing.  Same situation -- an emergent behavior, not an intention.

Fundamentally in the crisis we have two middle-men and a blind buyer.

The first middle-man is the mortgage broker.  His mission is clear: sell more mortgages.  I you make a fee per mortgage and have zero skin in the game as to what happens to that mortgage, what do you do?  You sell as many as you can, no matter how ugly they are.

The second middle-man is the investment bank that turns the mortgages into securities, perhaps even several times.  If you make a percentage of the size of the deal, what do you do? You do as many deals as you can.

Now both middle men can get stuck holding the goods, if the contracts are written such that the middle man has to take the loan back.  But here I fear the whole industry suffers from the same problem as the blind buyers: asymmetric risk/reward.

Buying all of these goods were, well, all sorts of entities....banks, hedge funds, pension funds, the investments end up everywhere.  In particular, they end up anywhere that someone is willing to buy an investment that they don't understand as long as Moody's says it's really safe and it returns a few points better than cash or T-bills.

I believe that in the short term there is no fix.  There is only the necessary steps to keep the patient alive and what we do in the long term.

• The US Government should not buy anything.  We really should not buy mortgages.  I'll blog about that later.
• The Fed needs to continue to enter repo agreements against illiquid (but not insolvent) assets to prevent financial seize-ups.
• In the long term, we need to redesign the financial system to balance risk and reward.  As long as the decision makers reap benefits when they gamble but someone else pays when they lose, they're going to bet the house, the car, and the grandchildren.

Finally, I think it's important to keep an eye on the fuzzy line between liquidity and solvency in the financial debate going on.  If a bank is illiquid, there are short-term band-aids for that.

But if an institution is insolvent, the equity holders (stock holders) and bond holders need to take one for the team.  The customers need not suffer (see WaMu's failure - bank customers are unaffected - only investors in the bank itself are hosed) but we can't let investors get a free ride on a failed investment - doing so encourages bad investment...it's free poker chips to the gamblers.