Bad Faith Finance, Nash Style.


Ezra Klein responds to the Wilmott piece with this:

I actually agree with that proposal, but it wouldn’t have prevented the current mess. The traders powering these companies did not decide that they were going to invest in a series of risky financial instruments that would net them a big Christmas bonus but force their company to liquidate itself in two years. Rather, they thought what they were doing would work! They really, truly, did. You can come up with all sorts of reasons for the strength of their belief: They overestimated their own intelligence, or they overestimated the intelligence of everyone else making these trades. They overestimated the prudence of bank managers, or they didn’t understand quite what they were getting into. Humans are fallible creatures. We screw up. We have tiny little brains that hold a finite amount of information. We are emotional creatures, susceptible to group pressures and likely to discount future risk.

That’s a big question there, how much did traders think that all these crazy instruments were safe? One thing to remember here, to dig into the Econ 102 toolbag, is that we often don’t just act on our own knowledge, but we have to act conditionally on other’s actions regardless of our knowledge.

Let’s think of this as a simple prisoner’s dilemma. Bank A and Bank B both report their earnings to their cilents. Bank A knows that the CDOs are garbage, and are going to collapse someday. However if Bank B put the CDO’s, with their superior earnings (and they were superior, in 2005) in their portfolio, they can report much better numbers than Bank A – they steal Bank A’s cilents. The CEO of Bank A will fire you for not performing as well as Bank B, even though Bank B is really just leverage up their risk. Especially (not to get too technical), as the CDOs are reported as a safe AAA number, their numbers look really better, especially on their risk-free assets. So Bank A has to take these instruments too to stay competitive, even if they really don’t believe in them. It’s the same mechanism that causes all those prisoners to rat each other out even though they should just stay quiet.

Maybe you don’t like the idea of the economy as two Banks. But we can extend it. Bank A and B can even be in the same Bank – if you have a responsible portfolio, but the people down the hall don’t, you can believe the people down the hall are going to get your bonus. And one can, Coase-style, think instead of the competition as being between short-term and long-term goals within a company. The pension you run has become a slush fund for CEOs, and is grossly underfunded – you need to stay solvent in the short term, even though you know the instruments are bad, they’ll give you some breathing room to survive until the long term. Replace pension with municipality fund, insurance company, etc. etc.

You see this clearly in This American Life’s epsiode of The Giant Pool of Money (which is fantastic, btw, for a primer on what has been going on). You hear mortgage officials, long-time veterans, clearly understand what they are selling to be packaged in the CDOs are crap. However, you keep hear them saying, when it comes to NINJA loans and other escalations of bad mortgages, things like “but everyone else was offering it, and our clients were getting mad that they we weren’t offering it, and our bosses were getting mad we were getting undercut.” The gut reaction are that these are lame excuses; it sounds like it, but it isn’t – this is the Nash Equilibrium at play.

And this is key in markets where the real “quality” comes in a few numbers, sometimes just one number – you look at the Morningstar report, and you see which mutual fund gives you the best returns. They get clearly ranked from most to worst, with no caveats for “shows remarkable long-term judgement.” Ezra works with the idea that behavioral style human imperfections are a driver here. They certainly are, but it’s important to realize that even with perfect information about what would have happened with the CDOs, it’s likely that things would have played out in a similar way….

This entry was posted in Uncategorized. Bookmark the permalink.

One Response to Bad Faith Finance, Nash Style.

  1. Pingback: What is a subprime mortgage? « Rortybomb

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s