September 22, 2008
Bad Loans Soured Lehman Brothers' Soup
The collapse of Lehman Brothers and the widespread stock sell-off it engendered is a bit scary. It shows those of us on Main Street that more than a year after the sub-prime mess became daily news, significant and sophisticated financiers still grapple with the effect on their firms. They are now far less significant and sophisticated than they once believed.
I am still uncertain as to how this will end. The US and world economy will emerge stronger, more vibrant and empowered with better risk assessment tools than it is today. Sadly, it is very possible that the road to this ending will include a significantly slowing economy. This will depend upon how many more firms will follow Lehman into financial history.
It is easy, and more than a bit tempting to attribute this crisis to greed. That won’t do. Ignorance is a far better explanation. It requires less coordination between actors and there is far more empirical support for ignorance. Occam’s razor still works. Here’s how we got here.
When the sub-prime mess began I envisioned a smart young mathematician working in a financial engineering department of a Wall Street firm. He’d been engaged in risk analysis using historical data on a variety of loans. These included mortgages (always safe) small business loans and a host of others with straightforward and nearly constant default rates. Imagine that this young mathematician spent hours each day feeding these data into his models, applying statistical tests to the output and carefully ensuring that he could observe the regularity of Brownian motion. (Kinda makes you want to study finance doesn’t it?).
From this data on loan history he carefully blends each to match risk and return. The soup created from this exercise is then sold to other banks to provide a ready stream of income for their investment banking needs.
Then he arises from his labors, heads to the company canteen and chats with his co-workers about the 80/20 mortgage he just got on a nice house in Brooklyn. Oblivious is he to the possibility that his loan style might have a different default rate than the historical mortgage data he uses to manage risk. This isn’t greed, it is ignorance. I won’t be the first to argue that Wall Street will be looking for more polymaths rather than just mathematicians in years to come.
Fast forward to today. From our mathematician’s soup of risk, dozens of ingredients soured. This has caused untold numbers of analysts to carefully pick bad loans from the soup– though most of the soup was tossed, becoming valueless as an exchangeable asset. Lehman Brothers owned much of these. Yet over the past year claimed it didn’t require additional assets. It is just like a restaurant, which has thrown away its soup insisting it would still have a lunch for its patrons.
My biggest fear remains knee-jerk Federal regulation. We cannot control ignorance (or greed) with regulation. Only knowledge born of the pain that Wall Street now feels will fix the soup.
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