Irrational Exuberance

In a lovely talk to the Concept Exchange Society, economist Daniel Friedman told us about financial markets. He said that a financial market is a “marketplace where promises are bought and sold by strangers”. I like that image. A bond is such a promise; a promise to pay interest at fixed intervals and to repay its principal, the loan amount. A mortgage, or a package of them, is also such a promise.

Dan discussed the history of recurrent fluctuations in market prices. They undergo inflation then deflation and back again. He mentioned such a balloon event that culminated in 1720 England; the escapade of the South-Sea Company and its scheme to buy the National Debt. Here is my understanding of the scheme. It may be flawed.

In economics parlance when you ‘buy debt‘ you don’t acquire the debt itself – the owing of money – but rather you acquire the right to collect the debt. You buy from the creditor his ownership of the promissory note. If the note stipulates periodic interest payments, you are buying yourself an income stream.

The debt involved in the South-Sea Company scheme was the British Government’s promissory notes. They paid regular interest and were held by a large number of the public. Held, say, by people who had put their life’s savings into something that would pay them a modest income on which to live. An income stream from Government secured notes.

The notes had been issued by various Departments of the British Government. At that time each Deparment of Government made its own financial arrangements. Each had its own accounting section which issued and managed these debt accounts. With such a system in place it was easy to argue for consolidation of the debt; all loans into one grand account. And to be issued by one single agency of Government; the Treasury.

The promoters of the scheme had members of Parliament make speeches exactly to this effect. And these promoters offered a solution. They would acquire every note-holder’s note. The Government could make the entirety of its regular interest payments to a single recipient, the South-Sea Company. The South-Sea Company would acquire the notes by ‘buying‘ them; exchanging shares in the Company for the notes at the rate of £115/share. If your note was worth £1,150 you got 10 shares of South-Sea Company stock in exchange for it. In the parlance of the cogniscenti, “debt was exchanged for equity”.

Why would a note-holder want to do this? Because the value of South-Sea Company stock had been steadily rising and continued to rise on rumors of impending good fortune. You could double your money! Or better! The share value topped £800 at one point. There arose a mass hysteria to acquire South-Sea Company shares. The buying hysteria spread to shares in any company at all. So all financial market share prices rose stimulating even more of a stock buying frenzy. To capitalize on the moment new companies formed and offered stock.

In his book, “Extraordinary Popular Delusions and the Madness of Crowds” (1841), Charles Mackay writes “Every body came to purchase stock. Every fool aspired to be a knave.” “But the most … preposterous of all (stock companies) and which shewed … the utter madness of the people, was … entitled ‘A company for carrying on an undertaking of great advantage, but nobody to know what it is’.”

In fact the South-Sea Company was a sham. It had no prospects. It paid some dividends to stock holders at the beginning using the pool of interest payment money coming to it from the Government. These dividends helped the Company’s image and increased its share value. But the Company never had a significant source of income other than from the Government. So it collapsed bringing the market down with it.

Now consider the U.S. mortgage bubble of 2008. Here is my overview of events – revised from the original flawed post:

Insurance companies, banks, pension funds, investment fund managers, investment banks and hedge funds hold capital that they must invest. They can’t just store it in a vault. Money is expected to earn money. The very safest investment is in Treasuries; bonds issued by the U.S. Treasury. But the returns from these are low. Safe investments with higher returns are always in demand. And, for an investor, safety is quantifiable; a matter of, say, an AAA rating by the ratings agency, Standard & Poors; an organization specifically devoted to assessing risk.

Intelligent and very imaginative people at a major financial institution introduced the idea of packaging home mortgages into securities salable in financial markets. They are called Mortgage Backed Securities (MBS). The purpose was to invent something attractive to buy for the people holding capital. The digital age, in which we live, allows the complex accounting tasks involved to be assigned to a computer.

The governing rationale to the scheme was this: that mortgages, when pooled together by thousands in a package, hold less risk than their average individual risk. The assessment of risk is not an exact art. Mathematically astute people persuaded the financial community that financial engineering – smart packaging – produced securities of good return but low risk. The ratings agencies must have been cowed by the arguments (or otherwise influenced) because they certified these securities as, indeed, low risk. So an offer was created that investors couldn’t refuse; a certified safe investment with a good return. That the theory about safeness was wrong became apparent with the financial collapse that ensued; events belied the theory’s predictions. In the case of the 2008 housing bubble we see that even the financial cogniscenti were deceived by others in the tribe.

A demand for mortgages to package into securities arose. It incentivized mortgage-lending banks to produce more mortgages; to court new home buyers in order to replenish and sell their mortgage holdings again. Thus loan eligibility requirements become lax and the mortgages being absorbed into pools were ever more risky. When this became apparent the value of the Mortgage Backed Securities dropped precipitously. The scheme collapsed bringing the market down with it.

See Can Growth be Sustainable?

An essential element of our economic structure – the financial market – depends intimately on gambling! And, among the gamblers, are marvelously clever fellows. Their originality shows itself in the creation of novel financial instruments. Those who game the system see the activity as an art form. They feel a calling to do it. They are probing its limits. Just such probing is respected in many fields of activity – in sport, in art, in science, in dance, in mathematics, in music … Only the most gifted among us probe the limits of a human construct.

After every market collapse there arises a howl of indignation. People are indignant about the perfidy of the perpetrators. How could such chicanery be allowed to happen? Why can’t laws be passed that will stabilize the market and prevent these fluctuations; prevent rogues from manipulating the market?

I suspect that nature will not allow us to rid ourselves of rogues. They are as necessary to us as gambling is. No law can guarantee a clean demarcation between productive and unproductive speculation. The reform of banking, say, by resurrection of the Glass-Steagall Act of 1933, repealed in 1999, will be a deterrent to some schemes. But nature evolves, as will financial institutions evolve, and new mischief will be created to upset them – perhaps, next time, by an emancipated woman instead of a man. Society must perpetually re-adjust its legal stance, each time proscribing the last blow it received. Future originality, by the meaning of the concept, is not predictable. So human institutions will always be under attack. The price of well-being is eternal vigilance.

Of course, a life devoted only to vigilance is a meagre one. Playful irreverence is needed for fullness. And that is what motivates the attackers.





4 responses to “Bubbles”

  1. James Carpenter

    in answer to your question ‘Michael Milken’ the junk bond king first packaged junk bonds into CDOs and implied because of packaging CDOs were a much safer investment than buying junk bonds directly as CDOs were diversified collections of junk bonds. After the year 2000 CDOs were rarely diversified and made up of lesser quality mortgage debt. Hank Greenburg then created and sold derivative based insurance on an assortment of low quality real estate backed CDO’s which resulted in our financial crisis. Basically a small bank ECO was told if he signed up for the insurance he could get a 2 percent above market return for his bank however the bank was on the hook should the seemingly high quality mortgage backed securities default…

  2. JD Prouty

    A good read, Marvin, even though I’m easily bored by economics. :p

    Wikipedia tells me that subprime mortgages were only one type of asset packaged into CDOs (which had been around since 1987) in 2005. “Early CDOs were diversified, and might include everything from aircraft lease-equipment debt, manufactured housing loans, to student loans and credit card debt.”



  3. Dan Friedman

    What Marvin says about bubbles is right in essence, tho there are some technical quibbles (e.g., CDOs are not equity).

    The main point I’d like to mention is that the recent financial bubble, like many before it, was not originally a scam. It was founded on a legitimate innovation, related to Milken’s. The thing is, once some good ideas get rolling, they attract scams in their wake, and the scams can eventually take over. Here is how I put it in my 2013 book, Morals and Markets.

    Working with an investment bank, like Lehman Brothers or Goldman-Sachs, the brokers would securitize your mortgage: pool your monthly payments with those from a couple of thousand other mortgages, and sell shares in the pool, called a mortgage backed security. Buy one and you were essentially buying a fraction of monthly payments from all over the place.

    Some securitized pools structured payments into several tiers. The top tier of shares (the “senior tranche”) would pay off first every month, then the second tier, while the bottom tier (the “junior tranche”) would absorb any shortfall. So if a homeowner missed her payment that month, each of the junior tranche investors would get a little bit less. The middle tranche investors would get paid in full unless a very unusually large segment of homeowners missed their payments. Rating agencies (like Moody’s and Standard and Poor’s) almost always gave the senior tranche their highest grade for safety: AAA.

    Such products proliferated under various names, such as CDOs (“collateralized debt obligations”). Why were they so popular? Because mortgage interest rates paid by homeowners are normally 2-3 percentage points higher than traditional bond yields. Financial engineering transformed illiquid and somewhat risky assets into much safer and more liquid assets, greatly increasing their value to investors. It might seem like magic, but the underlying principles were (and are) quite sound.

    The problem with securitization in the early 21st century is not that it didn’t work, but that it worked too well. Lured by high yields and top safety ratings, investors around the world clamored for products like CDOs. So mortgage brokers and investment banks shouted for more raw material for securitization—home loans. But how could supply meet demand? How could you increase the number of home loans?

    It turned out that there were several innovative ways. One was lending to “subprime” borrowers who would not have qualified before. Another was reducing down payments from 20% to 10% and eventually essentially to zero. Yet another was not bothering to verify borrowers’ stated income. These became the famous “liar loans,” and they enabled almost anyone with a decent overall credit rating to get a large sum of money and buy a house. Aggressive innovators, companies like Countrywide Financial, shot to the top. They paid their loan officers on commission and hired almost anyone.

    The federal lawsuit filed against Countrywide in 2012 makes for an interesting study. According to prosecutors, the company launched a program called Hustle (a sort-of acronym for “High-Speed Swim Lane”)….

  4. marvin chester

    for Dan

    “Working with an investment bank, like Lehman Brothers or Goldman-Sachs, the brokers would securitize your mortgage: pool your monthly payments with those from a couple of thousand other mortgages, and sell shares in the pool, called a mortgage backed security.” ← It is just this mechanism that I’d like to understand.

    How were the mortgage holders – banks, S&Ls – persuaded to give up their mortgages to be put in a package? What did they receive? Presumably a salable ownership in a security whose value could rise on the market. i.e. an asset – “the pool” – whose value was open to market speculation.

    Bank B pays money to a seller to aid the home buyers in their purchase. In return Bank B acquires the mortgage from those buyers – a revenue stream. Bank B gives this mortgage up so that it can be packaged; receiving what for it? Presumably not cash, but rather a document certifying ownership of something of value? What ownership?

    “Financial engineering transformed illiquid and somewhat risky assets into much safer and more liquid assets, greatly increasing their value to investors. It might seem like magic, but the underlying principles were (and are) quite sound.”

    It is precisely this virtue – transforming “illiquid and somewhat risky assets into much safer and more liquid assets” – that is the evil. Is it not?