Bell Curve The Law Talking Guy Raised by Republicans U.S. West
Well, he's kind of had it in for me ever since I accidentally ran over his dog. Actually, replace "accidentally" with "repeatedly," and replace "dog" with "son."

Tuesday, November 25, 2008

Sociology of a Financial Crisis

Michael Lewis, now perhaps famous for “Moneyball,” wrote an excellent book about his time as a young trader on Wall Street in the 1980s called “Liar’s Poker.” I strongly recommend it to anyone who is interested in this current financial crisis. Everything about the book is out of date or not specifically relevant except its depiction of the culture in the financial sector. That corporate culture is very important, however, because it is the result of choices about how to structure financial firms, and reinforces those choices.

All of Lewis’s books, whether about football, baseball, or what have you, are really about what are euphemistically termed “market failures.” The argument being made through these book-long parables is really more subtle, that many markets behave the way they do because the participants behave in ways that you would not expect if you were approaching the economic problems from a blank slate. It is very surprising to find out that this is true even in what would appear to be the most sophisticated market, the market for financial instruments. It is worth recalling at this juncture that until the 1970s, seats at the NYSE were routinely inherited. The vast majority of its participants, even today, went to a handful of schools. Compared to the amount of money flowing through their doors, the number of firms with market power is vanishingly small. With apologies to Peter O’Toole: The market is a human thing; it does what we do, for our reasons.

Any time some official or pundit proclaims on television or in print that “nobody could have seen this [crisis] coming,” I grind my teeth a little. That’s not true. Even excluding those who professionally gainsay conventional wisdom for academic or journalistic reasons, or those who regularly predict doom, many people genuinely understood that the financial boom connected to the real estate market could not last forever. Some even predicted its downfall. One can do archaeological expeditions through academic journals or magazines and find these people. This does not mean that those individuals were peculiarly prescient or intelligent, although some may have been. The point is that in the financial markets, these people were regarded as cranks or naifs. I had a similar conversation with a well-known real estate attorney in 2006 about the boom, and I hazarded the opinion that the price of the median house could not continue to dramatically exceed the purchasing power of the median home-buyer. I saw the condescending smile. In the real world, I was told, property values climb almost every year, and this was reality. That phrase “in the real world” is crucial. People on the ground had a visceral experience of the boom , and total disdain for outside views and “ivory tower” concepts.

Why were these prognosticators derided and ignored? That is the crucial question.
I don’t think it was necessarily “groupthink,” the concept that everyone just bought into the same ideas. I think there was an evolutionary process by which those who hazarded other ideas were corrected or flushed out. The risks of mortgage-backed securities and other extremely abstract derivative instruments were not ignored by everyone. Each firm had professional risk managers, some of whom were likely smart enough to wonder why mortgage-backed securities were supposed to be an exception to every financial rule. Many realized the problems inherent in buying and selling instruments that nobody understood how to value. But anyone who spoke up too loudly would be dismissed.

The culture of Wall Street proved deadly. Have any of you ever spent much time with a certain kind of arrogant East Coast college graduate? I never went to school anywhere that anyone ever boasted about their grades until I met New Yorkers at my law school. I never met more irritating people to play poker with, because they wanted to win and humiliate other people, not have fun with the group. At my firm, we are in the process of moving to year-round casual dress. The turmoil involved In allowing adults to dress themselves the way they want is striking. And there is resistance. Apparently one recent interviewee from NYU law school said, “I didn’t go to school for seven years so I could wear jeans.” The incredible set of class and cultural concepts that inform this comment is mind-boggling. These same people at firm retreats think that “business casual” means everything except the tie. The status-consciousness is shocking. Everything screams “I wanna be a big shot. “ When I read “Liar’s Poker,” I kept thinking, “I know these people!” As a Californian, I am culturally allergic to uniform of a super-dark woolen suit and a bright pink/purple tie in a windsor knot. The picture I am trying to draw is not meant to be cartoonish. It’s not just “assholes.”

These attitudes in college are reinforced by the Wall Street job market these kids are training for. Here’s the Wall Street concept in a nutshell. In a bull market, the slow get trampled; the brave run with the bulls. This is the crucial insight. In each firm, individual traders – often recruited right out of school with no long-term experience and no sense of perspective – were rewarded for success only. And the rewards were six-figure bonuses with which to buy apartments in Manhattan that exceed the size of a shoebox. The way to get the big numbers in your account was to do what everyone else was doing: take big risks. Since those risks were just on paper, they were fine. In the real world, you see, values kept going up. And the trading desks were littered with the discarded nameplates of those who lost their nerve and sold too early. This risk-taking was encouraged with a hyper-masculinized atmosphere that Lewis describes so well. Those failed were flushed out of the system; nothing was learned from them or about them except that they were regarded as losers.

To draw another analogy, there is a scam in sports betting where a firm sends mailers with predictions to people and asks them to pay money for more predictions after they are proven right. Of course, the firm just sends out opposite predictions to equal numbers of people. Week after week, a small subset will, by chance, happen to have received the proper predictions. These people then buy in to the supposed wisdom of the scammers. Success in the derivatives market had this element of randomness to it, but random success was rewarded with the title of genius and big shot. And they ate it up.

This culture was pervasive within these firms, I believe. Management at the very top faced the same dilemmas. If their firm did not pay out the six-figure bonuses or show the double and triple-digit gains that other firms did, the management would be replaced by boards who knew that, in the real world, you should not pay academic naysayers any mind. Those who are there now are those who took the biggest gambles. This may be the best reason to demand that these executives be dismissed.

Note that the hyper-masculinized atmosphere supposedly rewards courage, but all it really rewarded was conformity. The courageous thing would have been to say “no.” Those who did were no doubt called pussies or worse. They certainly didn’t stay on the trading floor. Slow and steady didn’t win the race; it got fired.

How can a market develop these unhealthy tendencies? The teaching tool of the market is failure. There is no other. In a long bull market, there were more successes than failures. As a friend of mine who is a corporate lawyer in New York likes to say, “It doesn’t take brains to make money in a bull market. “ But these traders thought they were geniuses, and had the beamers to show it. Hubris does not begin to describe it.

Alan Greenspan confessed that he didn’t understand how the market could lack self-correcting mechanisms that would correctly value the risk. He put too much faith in the abstraction of the market, no doubt being very dismissive of anyone who suggested that these firms had developed internal incentives that were self-destructive.

Another stream that fed this culture was the fact that financial sector employees, in particular the leaders of these firms, lacked a decent liberal education that might have given them pause. Business schools and finance programs tend to produce students who are shrewd, good with numbers, and very clever at constructing and understanding finance, but not people with great perspective on life, the universe, and everything. There is something inherently suspect in the intellectual curiosity and breadth of any person who wants to devote every waking moment (that is usually what it takes) to succeed in the financial world. For this reason, I think, professors in these areas are usually much better educated with much better perspective, but they don’t get to pass it on. And, of course, they are ignored as cranks or naifs if they question the prevailing wisdom of go-go-go!
Here’s the conversation I imagine about this financial boom. In an episode of The Simpsons, Homer becomes the head of the Stonecutters (read: Masons) and lives like a god with everyone obedient to him. Lisa tries to warn him about this:

Lisa: Remember Dad, all glory is fleeting.
Homer: So?
Lisa: Beware the Ides of March.
Homer: No.
Lisa: Dad I know you think you're happy now, but it's not gonna last forever!
Homer: Everything lasts forever.

I do not think it is likely that Wall Street culture will change much. After all, Barack Obama’s appointees in the financial world, like 47-year old Timothy Geithner, look just like this same Wall street crowd. They are all Yale and Harvard grads, all immersed in the same culture. They have all been socialized to believing, if nothing else, that Wall Street is so incredibly important (this is why Citicorp gets bailed out but GM doesn’t – these people think the “real America” is on Wall Street. That is the inverse of Sarah Palin’s rural snobbery. Only Barack Obama himself seems to realize that the health of Wall Street firms is not intrinsically important, but only instrumental to building a strong middle class. He alone did not participate in the Big City Culture. His first night in NYC, he reports, he slept on the street. Imagine that.

What needs to happen in New York City is a dramatic change in lifestyles for traders. The end of easy money has to mean that people who work on trading floors earn more normal salaries. Long term health and stability has to replace easy money as the way to go. I doubt this will happen short of a very serious depression, the way the 1930s finally killed the spirit of the 1920s and kept it under wraps until the 1980s. That gives me pause about what may have to happen here.


Bob said...

Have any of you ever spent much time with a certain kind of arrogant East Coast college graduate? I never went to school anywhere that anyone ever boasted about their grades until I met New Yorkers at my law school.

As a Californian, I am...

This is such a good blog, but it often indulges in provincialism. RbR regularly informs us of the virtues of Midwesterners that we Coasters lack. And now "a certain kind" of East Coaster, particularly New Yorkers, are the root cause of our economic woes.

The valuable points of your post, which are significant, would be clearer for me if you weren't deriding a swath of my friends and neighbors.

The picture I am trying to draw is not meant to be cartoonish. It’s not just “assholes.”

Thanks for letting me know that I don't have to be an asshole to be included in your "who's wrong with America" demographic.

USWest said...

I am currently reading "Ahead of the Curve: Two Years at Harvard Business School" by Philip Delves Broughton.

He was the Paris Bureau Chief for the Daily Telegraph and he decided at the age of 32 to go to business school. The book is very readable. But in the end he concludes that HBS does a very good job meeting its mission of turning out business leaders. But he concludes that they are, in the end, very unhappy people. Often, as I read through it, I think of some of the people I saw on Donlad Trump's reality show. Same types of folks. The relievng part of it, if you can even say that, is that many of these people who go to HBS are as lost and confused as I was when I started graduate school. They aren't anything THAT special. I see the same type of machismo when I watch Mad Men. It is a culture that is not new.

I think there are many fields, investment banking being only one, where people can get so caught up in the game that they loose perspective. In a tip of the hat to Bob's, comment, Hollywood is a fine example of equally gross excess as are the Texas energy men who wanted to stick it to grandma by cutting off her power. Greed is everywhere. And in 2000, Silicon Valley types walking out of Standford Business School were making millions on a wing and a half-baked idea. That didn't serve the country well either. I wouldn't lay this at the feet of the East Coasters alone. Many people across the globe were in on the game in places like London and Paris. Even the Swiss gambled and lost.

But the over all point about the sociology of certain sub-cultures is dead on. Organizations, afterall, are merely extensions of the human beings who run them, faults and all. And in ways little and big we all contribute.

Anonymous said...

If you read this blog enough you will notice that LTG tends to mix good ideas with a rather opinionated point of view. A bit of tarnish that blunts his ideas.

Raised By Republicans said...

Why does the cause have to be cultural? If you had looked for the cause in the regulatory structures and "reforms"enacted in the 28 years or so, would it have lead to the assertion that the problem is "east coast college grads?" I doubt it.

Besides, graduates of UC Berkeley say exactly the same thing about Stanford. And UCLA grads say that and worse about USC. Does it really mean anything beyond a little extension of some football rivalries?

The cause of these problems is material not cultural.

The Law Talking Guy said...

You would only have to be to one nationwide firm retreat to recognize that different cultures prevail in different cities. I wanted to give a "thick description" of life in New York. I think it may be a harsh description, but I don't think it's overblown. And I don't think one would say the same thing about the culture in other cities. It's not true that USC grads behave int he same way. They don't, I've seen them. They are irritating in a whole different way. =)

The assumption that cultural causes must be irrelevant is just an academic bias. I do not believe that firm sociology is the only cause of the financial crisis, but it should not be ignored.

USWest said...

I think we can say that a good deal of the problem is the culture as it is absorbed from places like HBS, Standford, etc al. These schools are brands and they want their students to be representative products of that brand. And the networks these guys create build a subculture that has powerful influence over things. Market forces, that deliver these guys success after success also feed the beast. But the market is really a collection of individual actions. I have seen a similar take on this issue written up in several places. Biology seems to play a role as well.

Back in April The Economist ran an article about testosterone's success on the market. Apparently there is a positive correlation between high testosterone levels and market success associated with risk taking behavior. Notice that trading floors aren't filled with women. Hummmmm . . .

USwest said...

I meant to write "Testosterone's effect on success in the market."