Wednesday, December 3, 2008

Sources of the Crisis, Part a Million.

Two good articles emerged recently about the mortgage crisis and Wall Street. First one by Michael Lewis - the author of a Wall Street classic Liar's Poker; the second one by Henry Blodget - one of the co-authors of the internet bubble.  They are both incredible reads, but the one thing they agree on - one which is unlikely to see much change in the fallout from this crisis - is the extent to which the Wall Street banks' insane risk-taking was enabled by their public ownership structure.   

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.
Wall Street never has been—and likely never will be—paid primarily for capital preservation. However, in the days when Wall Street firms were funded primarily by capital contributed by individual partners, preserving that capital in the long run was understandably a higher priority than it is today. Now Wall Street firms are primarily owned not by partners with personal capital at risk but by demanding institutional shareholders examining short-term results.
When it comes to our life or our property, we do not like taking chances, no matter how small.  Would you take a 20% chance of losing everything you have in return for an 80% chance of winning ten million dollars?  It sounds tempting but most of us can't afford to take the risk.  10% chance?  Probably not, still.  Not even 5%.  The likelihood of losing everything is something we cannot accept, no matter how small, when it comes to our own money, even though that bet makes perfect economic sense.  Would you do it with your neighbor's money?  Most probably.  Suddenly the concept of expected return (it is $8 million) feels much less personal and much more relevant; betting the bank, so to speak, is no longer an unacceptable idea; in fact, it is perfectly rational.

God capitalism sucks ass sometimes.

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