A Game Played by the Gullible, the Self-Hypnotized and the Cynical
Without question, the history of capitalism is a story of boom and bust cycles. And, quite often, the “boom” turns into a bubble. But if these cycles are an essential feature of capitalism, as Daniel Gross suggests in Pop!, this does not mean that events driven by the most irrational of human emotions—greed and fear—are in any way desirable. This is the dark side of a certain kind of unregulated capitalism—what the French call “le capitalisme sauvage.” It is not the capitalism that has brought us periods of great prosperity. It is the capitalism that has ushered in eras when the gaps between the haves and havenots widen.
Those who celebrate bubbles often quote Joseph Schumpeter’s phrase “creative destruction.” But as Robert Kuttner points out in “Everything For Sale”: "while casual readers (or non-readers) of Schumpeter may remember him as the prophet of creative destruction . . . the usual cartoon of Schumpeter gets his meaning backwards. Schumpeter's concern was how a market system could endure DESPITE its many propensities toward ruinous competition. He was no advocate of 'creative destruction.’”
As Nathan Newman observes below, during the investment mania of the 1990s, billions of dollars that could have been invested in viable projects were instead squandered on massive overinvestment and mal-investment. As he notes, real innovation took place before the market took off. Then “the leadership moved from the tech folks to the money folks and innovation slowed tremendously.”
Now money flowed, not to where it was most needed-- not into the projects with the strongest business plan--but into those with the sexiest "story"--those companies whose backers felt confident that they could take public, at a premium, in a matter of months.
In Bull!: A History of the Boom, I quote Morgan Stanley's Byron Wein who saw the waste of capital. "A company would come to us with this new, new thing and say 'You've got to take it public.' The new thing might be a little better than the technology that everyone was already using," Wein told me, "but not that much better. Still, they would say, 'If you don't underwrite it, we'll take it down the street to Goldman.' And we would say 'where do we sign.?'"
But it wasn’t just fly-by-night IPOs that sucked up capital. By 1995, AOL’s shares were up 2,000 percent in just three years. Meanwhile AOL was gaming its books—and everyone on Wall Street knew it. (Journalists like Alan Sloan were writing about it in the mainstream media). But most were content to ignore “aggressive accounting”—just as later they would be willing to ignore the fact that no one could make heads or tails of Enron’s books.
Short-seller David Tice was one of those who tried to warn investors about AOL, and in the aftermath of the crash, he was asked to testify before Congress. There, he talked about the mal-investment that he had seen: "Do you wonder why our country does not have enough power plants and oil refineries?” he asked. “This is a consequence of keeping stock prices artificially high for extended periods while extending credit recklessly in the midst of a mania . . . As a nation we are about to pay for this crucial misallocation of capital."
Not everyone went along for the ride. If, as Gross suggests, “irrational exuberance . . . greed and risk-taking is embedded in the national character,” someone should tell Warren Buffett. Buffett has avoided the enticements of a bubble not just once, but twice in his career.
At the height of the go-go market of the sixties, Buffet cashed out, selling virtually his entire portfolio and returning the money to investors who were very sorry to get it back (Over the preceding decade those who invested with him earned a stunning 1,156 percent.)
But Buffett wanted no part of that market: “The game is being played by the gullible, the self-hypnotized and the cynical,” he wrote to his investors in 1969. So he got out and sat on his cash--–until the crash of 1973-1974. Then, he knew, it was time to buy.
In the nineties, Buffett once again cast a cold eye on market mania. And he was not alone; there were other honest money managers who understood what was going on. But if they wanted to keep their jobs, they had to keep on buying over-priced stocks. This is what both their bosses and their clients wanted.
Yet, at the end of the nineties, even while individual investors and mutual fund managers followed the crowed, insiders headed for the exits. From September of 1999 through July of 2000, insider selling of big blocks of stock (at least $1 million or 100,000 shares) rose to $43.1 billion—twice as much as insiders had sold over the same span in each of the preceding two years.
As always, the biggest losers would be those who could least afford it. By February of 2002, 100 million individual investors had lost $5 trillion. Many were not wealthy. By 2002, a majority of Americans earning $30,000 to $50,000 had been drawn into the market. And these middle-income investors had come to the party late. While wealthier investors had gains to offset their losses, most of these investors didn’t.
Now we face the collapse of yet another bubble: housing. And once again, those hit hardest will be the poorest and the most gullible. The winners will be those cynical enough to have profited from sub-prime mortgages.
I'd love to hear more from you about the subprime bubble. I honestly don't know what to think.
On the one hand, I think a lot of greedy lenders are going to get away with making a bunch of money and since they have already securitized and sold off the loans, they'll be mostly insulated from the risk.
The victims will be the borrowers, as you say.
But, absent subprime lenders, isn't it true that many of these borrowers wouldn't have been able to buy houses in the first place?
To an extent, don't arguments against the subprime industry also amount to saying that a lot of people should not have been assisted in their purchasing of houses. How do you look a hard-working, lower income person in the eye and say, "Sorry, no house for you?"
That's where I get confused. Are the borrowers victims? Do they see themselves as victims? Is it that some are victims and some aren't? Should we have a subprime market?
There's been a suggestion that mortgage loans should meet some suitability standard. But won't the standards amount in some way to freezing people out of the housing market?
thosethingswesay.blogspot.com
May 15, 2007 11:07 AM | Reply | Permalink
IMO supporters of bubble economics are all too often boosters of scams and the confidence men who profit by creating/exploiting them. I have more respect for pool and card sharks…just my two cents.
May 15, 2007 11:24 AM | Reply | Permalink
Destor--
Part of the problem is that sub-prime mortgages have been marketed very, very aggressively to people who are not in a good position to understand the terms--or just how much risk they are taking.
Typically, someone goes to a real estate broker, says they are interested in looking at houses, and the broker says "I know someone who can help you get the money-- with no downpayment, or a very low-downpayment--or very low monthly payments (for the first five years).
Then the broker sells the cusomter a house that he or she cannot afford.
In other cases, people selling a chance to refinance mortgages "cold call" potential customers.
As to whether sub-prime mortgages represnt an "opportunity" for low-income famliles. It's not always a good idea to invest in real estate. If you can't afford it, and the bank forecloses, you lose your home and your money. That's much crueler than being turned down for a loan.
Finally it is NEVER a good idea to buy a home in a roaring bull housing market. At that point, homes are over-priced; you are bound to pay too much. And then, when the market finally cracks, you may watch the value of your house slide to a point where you have negative equity in teh house. (For example, you buy a $200,000 house and put down $20,0000. Two years later, it has lost 20% of its value and is now worth $160,000.
If you try to sell it, you still owe the bank nearly $180,000. If you don't have that $20,000, you're stuck. At that point, many people just walk away from the house, losing their $20,000 downpayment and whatever monthly payments they have made.
It's always better to keep on renting and wait until you are in a "buyer's market"--when prices are soft and sellers are willing to come down in price.
Here's an excerpt from a NYT story about what happens to people who become victims of sub-prime mortgages:
"At greatest risk in Cleveland’s suburbs are the low- and moderate-income neighborhoods where subprime lending has soared. The practice involves lenders issuing mortgages at high interest rates for people with lower incomes or poor credit ratings, usually involving adjustable rates and sometimes no down payment and no investigation of the borrower’s circumstances.
“What makes the subprime mortgages so devastating from a community perspective is that they’re so concentrated geographically,” said Dan Immergluck, a professor of city planning at the Georgia Institute of Technology.
Rosa Hutchinson Yates, 62, had kept up payments on her tidy two-story house on Chagrin Boulevard in Shaker Heights for 30 years. Now, she may well lose the house because of a disastrous refinancing deal in 2003 that brought her $24,000 in cash but bills she could not pay.
Ms. Yates, who has worked as a beautician and a cocktail waitress, was emotional and confused as she tried to explain what happened. Though she signed the closing documents, she said she did not realize that she was getting an adjustable rate mortgage that did not include taxes and insurance. . .
In a report for Shaker Heights, Mark Duda and William C. Apgar of Harvard University found that expensive refinancing deals had been aggressively “push-marketed” in the city’s less affluent west and south sides, bordering Cleveland. They said that “the rising number of foreclosures threatens to undermine the stability” of those areas. [Note from mm: Many houses are now vacant because the owners have walked away and the banks can't sell them. The whole neighborhood then begins to deteriorate.]
“The moral outrage,” Ms. Rawson, the mayor, said, “is that subprime lenders have targeted our seniors and African-Americans, people who saved all their lives to get a step up.”
About one-third of the residents in Shaker Heights and Euclid are black. "
May 15, 2007 11:55 AM | Reply | Permalink
Thanks, good points, especially about the cold calling and customer targetting.
I bet that most people don't think of buying their house as an "investment," in the sense that'd we'd use the word when talking about our 401(k) plans.
I suspect people buy their first house at the moment they think they can afford it. They don't wait for a bull market to go bear and if they do they find that credit is tight during the bear market anyway and that they can't buy.
Sure, it is an investment. But people think of it more in terms of self-determination -- to own rather than rent. We've built up home ownership as the true test of a successful life in a lot of ways.
It's odd that the risks are so great but that you basically get more government protection in the stock market, where you can only really lose the money you put in.
thosethingswesay.blogspot.com
May 15, 2007 12:05 PM | Reply | Permalink
that is precisely the pickle when it comes to sub-prime lending.
almost any effort to rein in unscrupulous and predatory lenders has the effect of also hamstringing honest and legitimate lenders and limiting homeownership opportunities for the poor. in most cases, if a person or family can't qualify for an FHA mortgage, from a strictly financial perspective it would be best for them to get their finances in order and wait until they are in a better position to buy. but homeownership is NOT a strictly financial decision. homeownership is a lifestyle choice, an emotional decision, and for many it is part of their family and community values.
for individuals and for communities it is difficult to balance the benefits of homeownership with the risks of defaulting. but ultimately, if the costs and the risks are effectively communicated in a transaction, to what length is it appropriate for gov't to interfere in that transaction? it is important to keep in mind that there are plenty of people who understand the costs, weigh the risks and take on sub-prime mortgages and DON'T default. plenty of people calculate the benefits of rebuilding their creditworthiness while living in their own home and making the monthly payments until they can refinance their home with a less expensive mortgage.
May 15, 2007 12:40 PM | Reply | Permalink
precisely. most home sales and purchases are the result of life changes. a new job. loss of a job. getting married. having children. life has a way of happening whether the real estate market is up or down, bubble or burst.
May 15, 2007 12:48 PM | Reply | Permalink
The issue of sub-prime lending, predatory lending, and push marketing also relates to the issue of education. Perhaps it is different now, but when I when to high school in the early eighties, I learned trigonometry but I did not learn personal finances: interest rates, lending, basic investing. Poverty and a lack of education can go hand in hand and become generational. This is part of why targeting low-income groups is where the money is for high-risk/unscrupulous lenders. A greater percentage of people in this group do not understand how these loans work and they simply trust what they are being told.
Aside from high school curricula, stronger consumer laws requiring certain types of disclosures and funding for non-profits that provide free or low cost financial counseling for low income populations would be helpful. Also, regulation of the mortgage brokerage business, such as requiring a license, could also help.
May 15, 2007 12:55 PM | Reply | Permalink
most states, incl. AZ, already having licensing requirements for mortgage brokers. though in most states, the regulations are fairly lax (as they are for most licenses).
May 15, 2007 1:10 PM | Reply | Permalink
Re: On the one hand, I think a lot of greedy lenders are going to get away with making a bunch of money and since they have already securitized and sold off the loans, they'll be mostly insulated from the risk.
This is not true. Why do you think New Century and others are in bankruptcy? Originators who sell bad loans are often required to repurchase them from the Wall Street firms that bought them.
Re: To an extent, don't arguments against the subprime industry also amount to saying that a lot of people should not have been assisted in their purchasing of houses.
We should not be making argumenst against subprime lending in general. After all, the vast majority of subprime loans are NOT in foreclosure (and there are non-subprime loans which are). The issue was not the borrowers' credit as such, it was the nature of the loans they were led to take: ARMs, Interest-Only loans and other complex, non-traditional deals which, as soon as their houses ceased to go up in value, became an unsupportable expense leading to foreclosure. Additionally, the failure to document income and assets allowed speculators to buy houses based on nothing but an affirmation of resources they did not in fact have, thus fueling much of the bubble.
May 15, 2007 1:25 PM | Reply | Permalink
I appreciate the post a lot. No one else (well, except in omments) seemed willing to describe the book accurately as a light, breezy version of free-market fundamentalism. Sure, capitalism is basically a good thing and isn't going away. But you have to be a bit into the religion to go on to defend every outcome and every market failure as intrinsically desirable and beneficial.
I'm sorry, but Josh sure invites a heck of a lot of "centrists" to the table here. One or two more liberals would be awfully nice for a change.
John
http://www.haberarts.com/
May 15, 2007 1:47 PM | Reply | Permalink
Destor23 asks
I can only go anecdotal on you, and I have only one anecdote. In 1991 I bought my first house, paid $84,000 for it, and sunk not quite another 60,000 into it to make it habitable (it had been abandoned for four years, first while the original owner was in a nursing home, and then while relatives tried to subdivide the lot and build a second house on the property).
Last assessment, the same house, a fairly modest 6 room bungalow, with detached garage, circa 1928, was assessed at $279,000. What I'm thinking is that the creation of a lot of subprime mortgages, and weird mortgage instruments like interest only mortgages, brought so many new people into the housing market that housing prices went through the roof. I don't know if ultimately many holders of those mortgages will save any equity in their houses. I know that I couldn't afford to buy my house today at its assessed value, and I expect that the next assessment, the value will go down. (Of course then the tax rate will go up a mil or two and the taxes will be a wash). :-)
aMike
May 15, 2007 2:02 PM | Reply | Permalink
John-- I agree that you "have to be a bit into the religion (of capitalism) to defend every outcome and every market failure as intrinsically desirable and beneficial."
I think of Treasury Secretary Paul O'Neill's comment in January of 2002 when Enron collapsed: "This is the genius of capitalism," O'Neill declared. "Companies come and go . . . people get to make good decisions or bad decisions and they get to pay the consequence or enjoy the fruits of their decisions."
O'Neill's statement must have seemed unfeeling to the many Enron employees whose life savings were wiped out. But those who worship at the altar of laissez-faire capitalism tend to argue that, in the end, whatever happens under capitalism is good. The market knows best.
I don't agree. Capitlaism is an amoral system. It does not puniish the greedy and reward the virtous. Nor does it work for the greater good of the majority. To the contrary, capitalism is, as a 19th century econoomist once put it, "a system set up to make sure that the smallest number of people possible become very rich." (I'm paraphrasing; does anyone know the exact quote and who said it? )
So I think that government needs to try to protect people against the excesses of laissez faire capitalism. Sometimes that means protecting them against themselves --regulations that sharply limit the amount of your 401-k that be invested in your employer's stock, for instance, so that you don't have too many eggs in one basket.
And often, government needs to protect individuals against the excesses of capitalists who know how to play the game of speculation much better than the average person.
Enron never would have happened if U.S. hadn't fallen under the spell of deregulation.
As for sub-prime mortgages, there government has done a very poor job of protecting people from unscrupulous lenders.
I understand what other people here have said about the desire to own one's own home.
I don't think of renting as a terrible alternative because I live in New York (where so many middle-class and even upper-middle class people rent) and have lived in CT. (where condos available for rent are commonplace.)
I'd add that in other areas where real estate is expensive (Southern California, D.C. Boston, etc.) renting is, I think, often a much better alternative for many low-income famlies. (Ideally famlies living in these places would wait for a point in the cycle when real estate prices are low--and then buy.)
That said I realize there are many parts of the country (like upstate New York where I grew up) where there are relatively few places available for rent, and often they are not in very good condition. So I can understand why, in those areas people are anxious to buy. Though if they could find a bargain to rent, long-term, and fix it up, they could enjoy many of the pleasures of home-ownership without the crushing burden of debt
Real estate in this country has just gotten too expesnive. . .
May 15, 2007 2:11 PM | Reply | Permalink
What I'm thinking is that the creation of a lot of subprime mortgages, and weird mortgage instruments like interest only mortgages, brought so many new people into the housing market that housing prices went through the roof.
actually the subprimes and 'weird instruments' still only account for a fraction of the market. and seems to me that many of them were 'created' (or more accurately, utilized more often and marketed more aggressively in most areas) in response to rapidly rising housing prices which (in many areas) were fueled in large part by the low interest rates for conventional (and FHA) mortgages.
as for your anecdote: of course you could afford to buy your house today at its assessed value IF you had bought a fixer-upper at the low end of the market 16 years ago and built up enough equity... which it turns out you actually did do! :) perhaps your house is over-assessed and perhaps your local real estate market is over-heated or in the process of deflating (you would know better than i to be sure), but it is also certainly possible that you simply made a good investment at the right time and the current assessment of your house is an accurate and healthy reflection of your home's actual sustainable value.
May 15, 2007 2:37 PM | Reply | Permalink
While subprime mortgages represent a small percentage of all mortgages, they represent a significant percentage of mortgages written since 2000--when the subprime market took off.
So they did help drive levitating real estate prices at the begininng of this decade--though of course low interest rates played a major role.
Finally, the stock market crash also helped. As people moved out of stocks, many were eager to put their savings (and any new money in the form of bonuses, etc) into real estate -- an investment which, they believed, "always goes up" (just as they believed, in the nineties, that U.S. stocks always go up.)
May 15, 2007 3:05 PM | Reply | Permalink
Real estate in this country has just gotten too expensive. . .
out of genuine curiosity, i wonder if you could support that assertion with any data? random sampling of local markets comparing median household incomes against median home prices?
my impression is that while affordability is a serious issue in many markets (moreso larger, urban markets), in most markets it is not. not that i don't welcome policies that promote affordability (even when affordability isn't a problem for many, it is always a problem for some).
May 15, 2007 3:12 PM | Reply | Permalink
MM: "I think of Treasury Secretary Paul O'Neill's comment in January of 2002 when Enron collapsed: 'This is the genius of capitalism,'" Love it. A conservatie friend defended the crash of the grid that led to the day-long northeast power outage a few summers ago, on the grounds that it's how the system was supposed to work. Which is true. The question is how many beged questions add up to lousy policy.
John
http://www.haberarts.com/
May 15, 2007 6:25 PM | Reply | Permalink
Capitlaism is an amoral system. It does not puniish the greedy and reward the virtous. Nor does it work for the greater good of the majority.
a drinking glass is an amoral object and it works for everyone and rewards those who use it to satisfy their thirst. a word that comes to my mind is "affordance."
John Dewey, "america's only philosopher," would probably label the word "capitolism" as abstract since, in and of itself, it has no meaning.
regardless, in my mind, capitolism-- ideally, works for the greater good of all and that's why it's pursued.
i've heard people say that true capitolists would protect the earth because they'd know it was "the golden goose that lays golden eggs" and thus, those who knowingly destroy it, aren't capitolists since they like destroying essential capitol for their own means.
in my mind, it's simply because we worship false goods, have jealousy, covet more, etc... that we fall short of aligning OUR purpose to achieving nirvana.
for most of the population, renting would be a much better option because we'd be sharing capitol! As howard noted in the "digital divide" thread, "other countries have higher internet penetration rates simply because lots of people live in high occupancy apartments."
in the US, on the other hand, we continue to destroy our capitol by building and maintaining a large amount of sprawl and this process does nothing but burn through capitol.
so, metaphorically, our sprawl is a bubble that should pop because it wastes a lot more capitol than the tech bubble ever did but, instead, we protect it even though it destroys wider prosperity.
additionally, as I wrote a while back, the US was the only country in the world who didn't print the last Harry Potter book on recycled paper, probably to ensure that the economy of cutting down trees, grinding them up and making new paper was kept profitable.
people call me a libertarian because I believe that knowledge sets us free, not the government. and, more specifically, the government got us into this mess, so why should I believe that it wants to get us out of it?
we live in a culture that loves to destroy capitol probably because, historically, the resources in north america have been abundant and kept us from seeing them as "needing protection" and our war victories (read destruction) also let us control resources in other nations for our own pleasures.
the solution, in my eyes, is to tell the elite that socialism-- the aim of sharing our resources optimally, is the stewardship that inherently belongs to capitolism and we shouldn't treat it as the heart that needs to be ripped out of it!
To boldly go...
May 15, 2007 7:13 PM | Reply | Permalink
Thanks Maggie--you nailed it.
And thanks for reminding me of Kuttner's Everything for Sale--a really great book puts this type of discussion in perspective.
I'm sure others have stressed this point--I can't bring myself to read all this 'in praise of bubbles' stuff. But my take is that there's far too little appreciation of a) the damage done (eg, the longest jobless recovery on record, following the dot.com bubble burst), and b) the "counterfactual"--ie, other, more efficient, less distortionary, and less destructive, creative or otherwise, ways to acheive the investment or innovation that the bubble crowd is celebrating.
It's wrong of me to criticize an argument before I've read the book, so forgive me, but I fear this emperor has no clothes.
Re: subprime problems, folks might find this interesting.
May 15, 2007 8:02 PM | Reply | Permalink
T.Rollie Fisher
The losers in this cynical game are both the subprime borrowers/homeowners, and those counting on the large teacher and nurse pension funds that were placed to hands of the private subprime mortgage companies. Those bad loans won't be repaid, but the private fund managers certainly got their money.
May 15, 2007 8:13 PM | Reply | Permalink
We still labor under the spell. Witness telecommunications.
If the idea of regulated monopolies doesn't appeal, I think one must embrace the idea of unregulated ones, because that is where the so-called "free market" inevitably leads, especially when abetted by a compliant government. (If not monopolies, at least oligopolies which do not compete in any productive way.)
Concentration of money leads to concentration of power which leads to restraint of competition. The ideal of free markets is not achievable in the hands of human beings, so we have no experiential way of ever knowing whether they would work.
Regulation in the public interest is a pragmatic recognition of that fact and a practical and flexible, if imperfect, instrument for tuning the economy to counter the tendency of capitalism to concentrate wealth an power in as few hands as possible.
May 15, 2007 8:59 PM | Reply | Permalink
While the sub-prime market is where most of the obvious and outrageous lending happens, it's in no way limited to that. Just a couple of years ago, my partner and I -- with a combined annual income at the time in the ballpark of $100k -- decide to look into whether we could swing a condo in one of the slightly-less-crazed parts of the Boston area.
By our own calculations -- based on somewhat more traditional (and more financially conservative) advice taking into account income, pre-existing debt, etc -- we could theoretically just barely swing a modest condo. But the bank we went to was eager to lend us significantly more than we wanted to borrow. Sure, theoretically we could have afforded the payments (and taxes and etc), but one miss-step or bad bit of luck -- major medical expense, whatever -- and we'd have fallen behind and never caught up. If we hadn't been smart enough to look into the subject and run our own numbers, we might have gone along with the bank's suggestion.
May 16, 2007 9:17 AM | Reply | Permalink
You are correct. I meant to say loan officers. Here is a blurb from an article about lending fraud in Arizona:
"Arizona regulators formed a mortgage fraud task force to tackle the state's growing problem late last year.
In January, legislation making mortgage fraud a felony and a bill to license loan officers were introduced. It is estimated that 18,000 unlicensed people are taking mortgage applications and loan commissions in Arizona."
Link
May 16, 2007 4:26 PM | Reply | Permalink
Schumpeter's concern was how a market system could endure DESPITE its many propensities toward ruinous competition. He was no advocate of 'creative destruction.’”
A side point in the larger discussion but Robert Kuttner is wrong. Despite the irony that any more than a casual reading of Schumpteter, especially Theory of Economic Development and his prodigious literature attacking any & all who would dare regulate the economy in the slightest degree, can more than establish where he stood on the matter. No he was not a fan of the "destruction" component of creative destruction any more than anyone else is a fan of destruction, but he most assuredly recognized that the destruction of the old orders & ways of doing things was a neccessary outcome of innovation & long term growth. Not something that was to be avoided.
There's a discussion about Joseph Schumpeter's works prompted by a recent piece published by Robert Solow on them, going on over at Mark Thoma's blog. The Economist & frequent Max Blog guest poster Barkley Rosser makes an appearance as well.
May 17, 2007 3:45 PM | Reply | Permalink