The systemic problems on Wall Street skewed the collective judgments of the market in the last decade.
Question: How did financial institutions understand the wisdom of crowds in their approach to the economic crisis?
James Surowiecki: Well, it’s actually an interesting question, and I don’t know that there’s a simple answer to it. I mean, I think that no bank really fared that well during the crisis, but you’re right. There actually was a pretty significant gap between those that survived, not just those that survived, even of those that survived, those that did better and those that did worse. I think that there are a few things to keep in mind. One is that there were systemic problems on Wall Street that I think reach across all institutions. And that I think helped skew the collective judgments, so to speak, of the market in the last sort of decade or so. I think that one of the things is that the way compensation structures work on Wall Street, so the short-term versus long-term compensation issue makes a big difference. To the extent that you were rewarded primarily, or in some cases I think maybe entirely on the basis of short-term results. Let’s say short-term being a year, or whatever it is. That I think actually inclines you to try to do more of the looking at what others are doing and trying to guess what they’re going to do next, rather than trying to actually value the asset at what it’s really, really worth.
And that tends to basically distort the entire market, especially when you have most of the people doing that. Because if you think about it, what you end up with is a situation where instead of trying to say to yourself, how much should this collateralized debt obligation that is made up of these home mortgages. How much is this actually worth. What’s the cash flow that it’s going to produce discounted by the – whatever or however you’re supposed to do it? Instead of doing it, you’re basically saying, everybody else says it’s worth “X”, right? And so therefore, it must be worth “X”, or I’ll be able to at least gain the system in that way. That’s a huge issue. And if this thing isn’t going to blow up in a few years, even if I’m wrong, well then my incentive is to do it.
I think the same thing was true, obviously, in terms of the home mortgage market more generally. So, to the extent that, what’s called a securitization model, so people would make the mortgages and then package them together and sell them off, so they no longer had a stake in the individual mortgage that they made. That tended to, I think, diminish the, I’m looking at you trying to decide how reliable you are, how likely it is you’re going to pay me back, etc. And as a result, again, you kind of get a distance between the real decision and the actual price of the asset. I think that had a big problem as well.
And I think to be fair, one of the things that starts to happen, and interestingly, I don’t think it was the presses fault in the housing bubble case. I mean, people disagree with me I think, but I actually think if you go back and look it’s surprising how many accounts there were, not necessarily in newspapers, but in magazines. Not just business magazines, but across the board about the unreasonableness of the housing price run up. But on Wall Street, there really was a kind of across the board conviction that housing prices would not fall across the board, basically. So, there really was a lack of diversity of thought and people who were trying to offer up other opinions at a lot of institutions, basically found themselves isolated. And so you really had that kind of breakdown of diversity that I talked about and I think that that was one of the big problems.
And I think if you look at institutions that did better and those that did worse, those that did better did a better job of accepting diverse opinions, basically. And accepting the possibility that what might cost them in the short run would be better for them than in the long run.
You know, if you look at J.P Morgan, for instance, and J.P. Morgan’s decision to get out of the CDO market and a lot of the sub prime market. A lot of it really consisted of – they didn’t get out of it completely, but they were obviously able to avoid most of the excesses. A lot of it came simply from the fact that the looked at the numbers and they couldn’t make the number work. That is to say, they were quite literally just thinking for themselves in this way that I said that you needed to. And when they found that the numbers didn’t work, in other words, you couldn’t buy something at this price and have it justified by the return you were going to get, they basically were willing to say, no. And I think that, in general on Wall Street, people were not willing to say, no. They were basically willing to say, if people are willing to buy it, we are willing to sell it and etc. So, I think that’s one of the biggest differences too.
Question: How did the crash finally happen?
James Surowiecki: I think the housing bubble in large part was a case of, to use an overused metaphor, a case of running on air and being okay until people looked down, basically. And that what happened was finally people looked down and realized that there was nothing below. And the reason that people looked down was they were forced to because at a certain point, incomes just basically would no longer support the housing prices that people were being expected to pay. As interest rates to some extent started to rise and as the refinancing boom ended, the entire mortgage bubble had been built to some extent on people’s ability to refinance when that started to fail, the whole edifice started to crumble, and I think at some point in bubbles, and no one really knows exactly why it happens, at some point in bubbles people are just no longer willing to keep paying just in the expectation that others will keep paying and once that starts to happen, the whole thing starts to fall apart because there’s nothing really that – there are no fundamentals justifying the bubble. That was the case in 1999 when it came to technology stocks and it was the case in housing, I would argue, probably from about – depends on when, but I would say from 2004, 2005 on.
And so that was really how it started to accelerate. The other thing I would say though about the lone voices thing that’s interesting is, I do think one of the other problems with this bubble, and it was also a problem in the technology bubble, maybe not to the same extent, is that even to the extent that there were lone voices, or voices out there that were trying to challenge the dominant discourse on the housing bubble, it was actually until relatively late in the game. Hard for them to have their opinions registered in terms of market prices. So, it was possible to bet against the housing bubble using credit default swaps and the like. That’s how John Paulson, the hedge fund manager, made $15 billion I think. And what Gregory Zuckerman has called the greatest trade ever made. But it was actually hard to do that on any kind of systematic basis.
With the stock market at least, if you think a stock is overpriced, you can sell it short. It’s hard to do that, I mean, it’s not too hard to do that, but most people don’t do it during the Internet, but it’s hard to do it because it’s actually hard to borrow shares. But you can do it. But with the housing market, for the most part, if you thought the housing prices in Las Vegas were incredibly overpriced, if you were an ordinary person who was like, I want to bet against the housing market in Las Vegas. Well, you couldn’t really do it. I mean, it was very difficult for an ordinary person, or even an ordinary investor to actually do that. As a result, if you were against the housing market, you registered your opinion by just deciding not to participate in it. And so, again, you don’t really have that true diversity of information, diversity of opinion that sets prices because prices were set primarily by people who thought the housing market was perfectly healthy. So, that was another problem.
Question: What lessons should we understand as we go through these situations?
James Surowiecki: Yeah. I mean, I think the fact that we have now lived through two massive bubbles should make us skeptical of the ability of markets to simply self-correct in the absence of regulation and in the absence, I think, of better organizational models.
I think that a few lessons that need to be learned are, first of all, we need to think hard about how compensation affects people’s decision making. That’s sort of an obvious lesson. I thought it was one we had learned after the technology bubble, but we did not. So, I think the short term, long term problem which we had talked about for a very long time, is not an illusion and it is not just something that we can count on to go away. It is a big issue and getting people to think long term is a huge, a huge problem. And when I say that, it isn’t just the banks, it’s also investors. Mutual fund investors.
So, let’s go back to ’99. One of the big problems, one of the things that continue to inflate the bubble long after it probably should have popped was the fact that, if you were a mutual fund manager who was not participating in the bubble. If you were someone who was not jumping on the NASDAQ bandwagon, after a certain point, it was very hard for you to get people to continue to give you money to invest because people looked around and said, “My neighbor,” I mean, the NASDAQ was in ’98, the NASDAQ returned maybe 46%, I don’t remember what it was. In ’99, it returned like 80%. So, people looked around and said, “My neighbor is getting rich on these stocks and you as my mutual fund manager are still buying very traditional stocks, or even worse, you’ve got a bunch of money in cash. Give my money back; I’m going to go give it to the high flyer.” And so, as a result, there were a lot of mutual fund managers that said I have to buy these tech stocks, or else I’m basically not going to be able to continue to stay in business. So, that’s a huge problem. It’s not just a problem of the banks. It’s a problem of individual investors have to really think about, I think.
The other thing that I think is important is actually this question of shorting. That creating tools, mechanisms to make it easier for people to bet against assets as well as bet on them is important in terms of keeping markets honest and keeping markets accurate. It’s not that markets that don’t have a lot of shorting in them are necessarily going to be skewed, but when they are skewed, they are going to be really skewed. And short sellers take a lot of bad mouthing and there were times in 2008 when there were definitely jumping on the bandwagon to kill companies, I have no doubt about that, but in general shorting makes markets healthier and not weaker.
And then the last thing I would say that’s kind of obvious, but is really important inside organizations is, just to repeat myself, really important to allow people to descent from the prevailing wisdom and not be treated as you’re not a team player, or you’re basically naive, or whatever it is. It’s really fundamental to try to aggregate the general wisdom of people inside the organization rather than just kind of saying, if everyone else is doing it, I’m going to – There’s a famous Chuck Prince quote about, he was speaking specifically about lending to private equity, but in some sense he was talking about it all, right?
Question: How involved should the government be?
James Surowiecki: Well I think there are definitely, I certainly think there is a tremendous – well tremendous doesn’t sound like quite the right word. I think there’s a fundamental role for the government to play in regulation. And I thought that we were going to see some of it, well we did see some of it in the technology bubble, frankly. And yet there have been things that the government has done that are good, although people disagree. I think regulation, which basically got companies to disclose information to everyone rather than to a few people. I think that that’s a good thing. That tends to foster access to information, it tend to foster diversity of opinion and the like. I think that that tends to be a good thing. I think to the extent just to get back on the shorting hobbyhorse, I think to the extent that the government makes shorting easier rather than harder, I think that that’s a good thing. And until the, sometime in the mid ‘90’s, mutual funds for the most part could not short stocks. So, if you were in a mutual fund, you basically had to buy stocks if you wanted to be in the stock market. Well, what does that do? Well, that creates a kind of upward pressure. That changed, but even today, lots of mutual funds don’t do any shorting at all.
I think that’s a mistake. I think regulating the amount of leverage that institutions can use is actually important. For a reason that isn’t always – I think there’s a variety of reasons, but I think the most important reason is one that people maybe don’t think that much about, which is one of the things you don’t want, at least in my mind, is you don’t want a small number of players in a market exerting excessive influence over that market.
Now that follows pretty straight out of my idea of what makes markets healthy. My view of what makes markets really healthy is not having a small number of really smart players. Well supposedly smart, I guess. But a small number of really smart players playing in it. I actually think you want lots of players in the market. And that one of the things that access to leverage does, and by this we really mean allowing investment banks to leverage themselves up 20, 25, 30 times, is it magnifies, obviously, the effects of the mistakes these people make. And if you have a small number of players who dominate a market and they make mistakes, the consequences are just immense.
The classic example of this would be long-term capital in 1998. Long term capital, you were using so much leverage and playing in small markets in some cases that in a lot of markets, they were basically almost the entire trade. So, when things started to go wrong, basically they were doomed. So, I think that’s another place where regulating leverage was something else that the government has a major role to play.
I do think also that I think securities regulation in principle is a very good idea still. I would still say that. I would think that to the extent that you can disperse risk even though it creates these problems in terms of lending, I think to the extent that you can disperse risk it’s probably better than concentrating it in the hands of a few people. But I think it actually makes sense to say, for instance, if you want to make a loan to a homeowner, you have to keep at least a percentage of that loan on your books. Not all of it, maybe only 10% or whatever it is, but you have to keep some of it on your books because that keeps you focused on what’s the value of the loan, not what I can sell it for to somebody else, and I think that that is actually good.
The most complicated question that I have to say, I’m still very ambivalent about what the right answer to is, the credit default swap question and derivative question, more generally. I tend to think that in general, those things can be quite useful, that actually it’s useful to allow people to lay off risk. It’s useful to allow people to take more risk to get it and people who want to take less risk to sell it off. But I also think – and I actually have no problem as a lot of people with the credit default swap market which allows people to bet on whether or not a company’s going to fail, or default, or whatever. In general, I think that’s not actually a bad thing. It gives you a market judgment on the health of a company; all those things I think are good. But I think to the extent that these things are all done behind closed doors. The informational value of them is less useful and it also creates situations like the AIG one, where people are essentially writing hundreds of billions of dollars in insurance and do not have the ability to pay it off. That creates tremendous problems. So, that’s another place I think the government has a role to play, although I don’t have a good sense of exactly what the role should be.
Recorded on January 15, 2010