Bubbles, Bankers, Booms, and Busts

The investment banking profession as we came to know it these last 20 years died last Sunday--or so they say.  Of course, 'they' have been predicting the demise of the print media business for a while now, and, while there is a lot of painful sorting out underway, we're still here.  So, who can tell?

I won't miss the investment banks.  My admiration and concern for classmates and friends who chose that career path (myself, almost included, once upon a time) and succeeded---sometimes brilliantly--is offset by doubts about a system like ours where thousands could make gazillions by moving the money around without adding much of real value for workers and our international competitive position.  

If you follow my blog, you know that I have become, sadly, obsessed with The Catastrophe. Perhaps under the rubric of 'tout comprendre, c'est tout pardonner', I have immersed myself in newspaper and online articles and online lectures on the subject---I want to understand how so many smart people got this all wrong and nearly took the rest of us down with them.  

Laissez-faire regulation and a Congressional/Executive/Lobbyist trifecta that let the good times roll in the housing market started us down the path to The Catastrophe.

Aside from the failure of the regulators to stay on top or ahead of the financial engineering that made the housing bubble possible, my research led me to the work of Ivo Welch, an economist at Brown who described a phenomenon in game theory he called information cascades, in which investors' decisions are based in part on their own experience, but driven by the behavior of individual investors who preceded them and collectively appeared to act in tandem.  This is the fuel that drives a speculative bubble.  

Hikers in the woods tend to follow what other hikers do at a crossroad, even though there is a significant probability that each hiker may be wrong some significant percentage of the time. This part is common sense, but what is amazing about the theory is that it predicts that, even in a perfectly rational market, cumulative hiker/investor decisions will be completely wrong 10-30+% of the time! (Hence, The Catastrophe.)

With credit default swaps and CDO's designed to redistribute the risk of sub-prime mortgages, the bankers created financial instruments that were never publicly traded and therefore exacerbated the potential for them to have erred in their valuations, as a group, even though individual decision makers were making rational business decisions within the framework of what they knew.  Fascinating stuff.  

If the theory holds, an understanding of how this came to pass should make us all less judgmental about what happened, given that we are all hikers in the woods from time to time. And it points to a clearer path forward for the regulatory tasks we now face.