October 20, 2010
Economics Department
The Big Short, and a Modest Proposal
To my co-blogger Ken:
I haven't seen you in a while, so we haven't had time to talk about any of the usual stuff, therefore I'm taking this opportunity to submit a modest proposal for your consideration.
As you know, one of the areas where we disagree about economics issues is the subject of the efficient market hypothesis. I tend to believe those economists who say that the free market is efficient, that is, it makes the best possible use of materials and information.
Obviously, this isn't perfectly true. In fact, it can't be, because the reason for believing there are few inefficiencies is because people will spot them and take advantage of them for profit, which tends to eliminate them. Further, there are all sorts of inefficiencies caused by things like monopolies and asymetric information. Still, I usually believe the efficient market hypothesis explains much of the market.
You, on the other hand, seem to believe there are a number of persistent inefficiencies that aren't being eliminated. In particular, you ascribe a lot of inefficiency to short-term thinking in the capital markets.
My response to this has always been to ask why the long-term players don't just buy the stuff the short-term guys are undervaluing. Or why don't they take a short position on the stuff the short-term guys are overvaluing? If the short-term guys are pressuring a company's management into squeezing the company for short-term gains, why don't some smart traders buy the company and make even more money by holding it for the long term? If short-term thinking is a problem, why aren't the long-term investors picking up the money?
I've just been reading Michael Lewis's The Big Short: Inside the Doomsday Machine
If the subprime mortgage crisis is a representative example, the short answer to why markets are inefficient seems to be that you are right about there being too much short-term thinking. The major subprime investors were enjoying the cashflow from the mortgage payments (or from various derivatives) far too much, and this made it hard for them to see the dismal future ahead.
As to my question of why someone didn't clean up with a little long-term investment, I think The Big Short sheds a bit of light there too. The natural enemy of long-term investment is unpredictability, and this unpredictability arose for three reasons:
- First, there was a lot of fraud going on. Home owners, mortgage originators, rating services, and investment bankers lied like mad to create the subprime bond market. This is essentially a problem of asymmetric information. Who could invest long-term when you're not sure what's really going on?
- Second, large amounts of money were controlled by relatively small numbers of traders, so it only took a few stupid people to invest billions of dollars in a losing proposition. This blew the economic assumption of rationality right out of the water.
- Third, once a few people started making money from subprime loans, traders faced a lopsided incentive system: If they didn't invest in the subprime market and it made money, they'd look like fools to their bosses and investors. But if they did invest in subprime bonds and the market went sour...well, nobody else saw that coming either, right?
In short, the market was inefficient due to fraud, stupidity, and cowardice.
According to Lewis, one surprising outcome of this mess is that most of the traders on either side of the subprime market made out okay. Win or lose, they earned millions in fees and incentives. Even Howie Hubler, who Lewis says lost more money than any other single trader in Wall Street history, took home millions of dollars and apparently landed okay.
Ken, I don't know if Lewis is right, and I don't know if I've correctly understood everything I've read, but if I've got this right, I can see only one inescapable conclusion: You and I need to become traders.
-- Mark
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According to Lewis, one surprising outcome of this mess is that most of the traders on either side of the subprime market made out okay. Win or lose, they earned millions in fees and incentives.
That, IMO, is the main cause the all our current economic problems, along with similar observations like "Executives of failing companies still make millions in fees and incentives, win or lose." How can any system, economic or otherwise, work well and healthily when those running it have no incentive whatsofuckingever to see to it?
But they ARE seeing to their small part of the system, optimizing their profits which depend upon lots of short term gains rather than any long term gains. Optimization of their own little corner of the system at the expense of sub-optimizing the larger system.
In the long run, those people made much more money through a string of short term gains than they would have through any long term investment. It's just not good for the corporations nor for anyone who is a long term investor.
real estate, for example, used to be a long term market. then investors found they could make more money by not hanging on to the real estate, but by re-selling their investment over and over in different ways.
Last investor standing when the music ends loses. Everyone else who was trading constantly wins.
"How can any system, economic or otherwise, work well and healthily when those running it have no incentive whatsofuckingever to see to it?"
It can't. This is called the owner/agent problem, and it is also a source of inefficiency. However, the question then becomes one of why so many people are willing to put their financial well-being in the hands of people who lack the proper incentives. Or, alternatively, why aren't there a lot more bankers, brokers, and fund managers available who have the right incentives? And how do we fix that?
Looks like I was wrong about what is considered "long term" in the financial markets. I thought one year or even one day was the new (too short) long term investment. Seems like I should have been thinking closer to one minute:
70% Of All Stock Market Trades Are Held for An Average of 11 SECONDS