Blowing Bubbles to Watch ’em Pop

The Jesse Eisinger and Jake Bernstein of  ProPublica’s recently released work on the economic train wreck’s roots is  marvelous.  Listen to it on This American Life!

A quick overview of the story:  First recall that a key link in the supply chain of the subprime mortgage industry was the step where the risky mortgages where bundled and sorted.  The rational was to capture the benefits of diversification, while the sorting’s purpose was to allow investors to select the risk profile they  preferred.  Like all the other stages in the industry’s supply chain this part starts out as a sensible thing and over time it transitions into insane.  The story uncovered by Eisinger and Bernstein outlines a plausible story about how a  predator appeared on the scene and figured out how to enable the insanity to both continue and redouble.  Doing this in a pattern that allowed the  predator  to make huge profits when it all blew up.  Credit default swaps, i.e. bets that paid off when a loan defaults, provided a way for the  predator  play place a bet that would pay off if the house burnt down, and place those bets on houses he had built out of tinder.

An interesting question is then why did the builders willingly create these houses of tinder?  The  explanation  suggested in the piece is that the builder’s incentives caused, or at least encouraged, the shoddy workmanship.  Each time the bankers put together a new meta-toxic CDO built out of toxic mortgage bonds they got paid a fee; a large part of which flows right into their bonus pool.

But it seems to me there is another aspect to the story.  Industries, just like people, have a strong tendency to be consistent.  Behaviors are hard to change.  You have to discard your current expertise and start over creating entirely new skills – a very very  risky  proposition.  So there is strong incentive, largely rational, to attempt to continue to with current practice.  So it became increasingly obvious that the entire subprime mortgage industry supply chain was going insane; all the players in the chain were faced with exactly this puzzle.  Into that landscape arrives the  predator.  What he offers, sells, the existing players is the perfect product.  A solution to their principle pain point.  A way to keep on doing what they are already doing.

I’ve seen that a few times over my life.  Though never seen it with the added trick of piling on an adverse selection insurance fraud angle.

Moore’s law and his friends have regularly displaced existing, but deep pocketed, industries over the last few decades.  Each time the old, deep pocketed, players grow  increasingly uncomfortable.  So they look for ways to continue their current habits and they are willing to pay large sums, acquire foolish startups, and take significant risks to do so.  Sooner or later folks appear on the scene happy to help.  In most of these cases continuing in the old behavior is hopeless; but hope springs eternal eh?  Throw another layer of sandbags on the levee.

But really two things make the Eisinger and Bernstein story orders of magnitude more potent.  The first is the insurance fraud angle.  The second is the bubbling.  If you can play into this game just as the bubble begins to peak; encouraging the bubble to expand while betting on it popping.  That’s when the – ah – fun begins.

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