Stupid versus Evil: The Big Short and the Localisation of Risk

I just saw Politico magazine's article about What The Big Short gets wrong, by Michael Grunwald.  I agree mostly with Grunwald's first point:  what went wrong with the markets most recently was pretty simple; it wasn't really the complexity of the derivatives.  And I think his third point is also likely true; that there has been some substantial fixes since.  Certainly both UK and US employment have recovered spectacularly, though I don't know as much as Grunwald does about the new regulatory measures.  But despite Grunwald's good evidence that many banks and bankers hurt themselves as well so must have been stupid, not evil, I'm not entirely convinced on this point.

First let me correct or at least supplement Grunwald on what went wrong with the housing market.  The root problem stemmed from that fact that historically, local US banks who gave mortgages to people were the same people who had to get money back from them.  Because it was their own employer's money, mortgage lenders were motivated not only by the initial fees and long-term interest returns (which both go up if you give more or bigger mortgages), but also the probability of repayment (which basically goes up when you give fewer and smaller mortgages).   When the government legalised selling that risk off to other banks, they were only motivated by the initial fees and size of the mortgages.  So they gave too many, too large mortgages.  The  financial institutions who made derivative products out of these mortgages radically underestimated how much this increased risk.  If you don't want to just take my word on this, my 2008 blogpost money, england links to Bill Moyer and George Soros discussing this, and the post how the credit crisis works links to a short animation that is nearly right, and very clear.  Warning: at that point my blog was basically letters home to my family, so the posts meander a bit.

Biology teaches us that good (pro-social) behaviour only makes sense when you are more likely to work and live with others who are likely to behave as pro-socially as you do.  That principle is known as viscosity and was discovered by William Hamilton in the 1960s. Here's a very recent special issue about the consequences for explaining cooperation in nature.  Trying to make the risk involved in mortgages international instead of local is a pretty good (though not perfect) example of what Hamilton proved would result in the collapse of cooperative behaviour.

But the reason I don't like the claim that people were just stupid was a lot of us knew something was up well before October 2008.  My March 2009 blogpost who knew what when documents specific conversations that I'd had in March 2008 and November 2007 showing that lots of people knew what was happening to the banks.  It also documents journalists who had noticed this (Jon Stewart and Nicole Hollander).  So it is just false to say that there was no evil (or at least culpability) involved in the claims that no one could have seen the crisis coming.

While I'm at it, I also posted in March 2009 about my own experiences in the financial industry during the 1987 meltdown, after my dad asked me about AIG & bonuses.  I link to it here just in case you wonder why I know as much as I do about the financial industry.  But on re-reading it now, I realise that my experience of that crash and its aftermath is also a neat case study in my current working hypothesis about how technology mediates income inequality.  But I won't blog about that until the papers are ready to come out.