Recipe for Disaster: Keeping Up With The Joneses

Justin here. The single best (and by far most fascinating) explanation I've found of the current financial crisis is This American Life’s The Giant Pool of Money episode that aired on NPR. (You can listen to the 30 second promo here, the full story here, or read the transcript here.)

Mostly because excerpts like this:

“I wouldn't have loaned me the money. And nobody that I know would have loaned me the money. I know guys who are criminals who wouldn't loan me that and they break your knee-caps. I don’t know why the bank did it. I’m serious ... $540,000 to a person with bad credit.”

It made me realized that the sole cause of the crisis (literally ... the ... sole ... cause) is this: the need to keep up with the Joneses.

At every level of the chain: from countries needing to boost their investment returns so they sell out of treasuries and go to higher yielding alternatives, to homeowners taking out mortgages and second mortgages because their neighbors and friends are, to mortgage brokers creating riskier and riskier loans because their competition are, to banks buying those mortgages because the other banks are buying them.

The desire to “keep up” overtook the need to act rationally. I urge you to read or listen to it. Below are some more excerpts (emphasis mine) and my key takeaway:

"An interesting fact, here. Mike Garner's bank did not care how risky these mortgages were. This was the new era: banks didn't have to hold on to these mortgages for 30 years. They didn’t have to wait and see if they’d be paid back. Bank's like Garner's just owned them for a month or two and then sold them on to Wall Street. Wall Street would sell them on to the global pool of money."

And this:

"No income no asset loans. That's a liar's loan. We are telling you to lie to us. We're hoping you don't lie. Tell us what you make, tell us what you have in the bank, but we won't verify? We’re setting you up to lie. Something about that feels very wrong. It felt wrong way back when and I wish we had never done it. Unfortunately, what happened ... we did it because everyone else was doing it."

And lastly, this about the current and future landscape:

"The global pool of money is avoiding anything with even the slightest hint of risk and that affects everybody, no matter who you are. It's harder to borrow money to buy a house, or build a factory, or bring your country boldly into the 21st century."

My key takeaway is this: things are generally not as good or as bad as they seem.

Translation: if Mr. Market underpriced risk on the outset of this mess (ie - he bought risky securities he shouldn’t have), is it so crazy to think that Mr. Market could overprice risk today (ie – Mr. Market might not be buying some low risk securities that he should be buying?)