Sunday, November 30, 2008

People Are Not THAT Stupid

All Financial Matters posted an article yesterday commenting about a Wall Street Journal article in which Robert Rubin, a director in Citi Group essentially shirks responsibility for Citi Group's recent failure. I read the same WSJ article and I generally agree with JLP's sentiment which is that officers and executives are paid to drive their company's success,  and can't just blame the system or outside forces for their company's failure. After all, if the company succeeded, I am guessing no executive would be out saying: "oh, it's the economy", or "the competitors really screwed up" or even "we were just plain lucky".

JLP also makes a comment about the stupidity of thinking that bundling sub-prime mortgages and securitizing them would reduce the overall risk and make such securities a legitimate investment vehicle. There I disagree with him. Kitty, one of JLP's commenters also disagrees and in a detailed and well written comment explains that bundling a large number of risky securities reduces the overall risk through diversification. Sure, some of these sub-primes were bound to fail, but the chance that they would all fail simultaneously was pretty slim.  The real problem was that the risk of failure was highly correlated - in other words, the chance of failure for  each individual sub-prime loan increases as the economy falters or as housing prices start to decline. What makes one loan likely to fail also makes others in the same group more likely to fail.

This strong correlation is what folks were unable to see in advance. It's not that they were stupid - this was not a trivial matter to understand ahead of time. People simply did not realize that real estate prices could be subject to nationwide, large scale declines. In fact, as late as the end of 2006 I heard a lecture from a UCLA economics professor who made the point that real estate is subject to volume cycles rather than price cycles and that real estate prices were unlikely to drop nationwide. Of course, in retrospect it's very easy to understand how risky the whole premise was, however at the time even sophisticated investors were unable to understand the true level of risk. 

Does that excuse management who allowed such investment to made? Not really. Executives are responsible for the success or failures of their enterprises whether or not they understand the true risks they are facing. 

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Mberenis said...
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Greg said...

I am no economist, but I have been looking for the real estate bubble to burst for several years.

While living in Washington, DC until 2005, this is what I observed that led me (and my wife) to this way of thinking:

1) housing prices increasing 30% a year
2) APR's when the prime rate was at an all time low
3) Interest-only loans
4) 40-50 year notes

At some point the market had to correct. How could people NOT see this coming???

plonkee said...

I think the issue is that previously house prices have only corrected locally. So the bottom falls out of the market in Phoenix, but it's still going strong in Chicago (or whatever). Everyone always goes on past performance.