I’m reading Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon by Gretchen Morgenson and Joshua Rosner. It’s an account of the collapse of the subprime mortgage market at the beginning of our current economic mess. The book tells the story at an odd level of detail: It doesn’t give a lot of details about the characters and institutions involved, but neither does it present a broad economically-informed description of what was going on.
For example, mortgage originators were making bad loans to unqualified borrowers and then selling bundles of these loans as mortgage-backed securities to Fannie Mae, Freddie Mac, and a host of investment banks. The book emphasizes over and over that these loan originators had a poor incentive to produce high-quality (or at least honestly-described) mortgages because they knew they wouldn’t be holding on to them. This is an obvious agency problem, and I couldn’t understand from the book why the investors weren’t on the lookout for it.
Yet about 2/3 of the way in, the authors mention that under the terms of the securitization agreement, the originators had to buy back all loans that were materially misrepresented and all loans where the borrower defaulted early in the loan’s term. In other words, the purchasers had sought to protect themselves from agency risks by requiring the originators to shoulder substantial default risks. In that case, why didn’t the originators pay more attention to the quality of the loans?
As it happens, according to the book, the loan portfolios were so toxic that the originators would have gone bankrupt if forced to buy them all back, which would have cut off the flow of new loans, so the investment banks didn’t force them to take a loss. But that just raises more questions: Could threatening bankruptcy really have been the originators’ plan for protecting themselves from the consequences of their poor loans? How did the investment banks not see that coming?
So far, when it comes right down to it, I’ve reached two conclusions:
(1) Unscrupulous sociopaths can make a lot of money in the financial markets, especial during the manic phase of an asset bubble.
(2) I’ve got to figure out how to get a piece of that.
Update: Not directly connected, but I’ve just noticed that Charles Mackay’s Extraordinary Popular Delusions and the Madness of Crowds is available as a Kindle download for only $0.99. It’s a classic work about asset price bubbles and other types of craziness. And it was published in 1841. If nothing else, spend the 99 cents (or just get it free here) to read the extraordinary story of the seventeenth century Dutch tulip bulb craze.