Judgment Call

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Three things caught my eye about this book. The first was the statement in the subtitle that Wall Street had betrayed capitalism. The second was the co-author, Richard Vigilante. I had read his book, “Strike: The Daily News War and the Future of American Labor” (1994). It was a thoughtful account of a newspaper strike that was critical of the unions but not rabid about them. It was notably well written. Vigilante had been a columnist at New York Newsday and an editor at the Manhattan Institute’s magazine, City Journal.

A third thing: this was not just a journalist’s book. The other author, Andrew Redleaf, runs a hedge fund. Redleaf had made a name for himself by writing in December 2006 to clients of his company, Whitebox Advisors, that “some time in the next 12 to 18 months, there is going to be a panic in credit markets.”

And there was, soon after his prediction expired.

At least one of the authors of this book, then, understood some essence of the event before it happened. That makes it worth a look. It is also a book about ideas and should appeal to libertarians on that account, particularly because both Redleaf and Vigilante are supporters of capitalism. They have a view of capitalism that is much like George Gilder’s in “Wealth and Poverty” (1981) and that sometimes sounds even Randian — a view based not so much on the mechanistic description of markets as on understanding and respect for the entrepreneur.

There is much in this book about judgment, a word you don’t hear much from economists. Mainstream economists want to reduce human decisions to a model. But how to express judgment as algebra? “Economists dislike the notion of judgment,” the authors write, “not only because they have no way of verifying that it is not actually luck but also because it limits economics.” They refer here to the sort of economics that expresses its central ideas as mathematical formulas.

Redleaf and Vigilante are for the free market, but they write, “No matter how free the market, it is the men, not the market, who do the creating.” In their view, the market crashed “because both the regulators and the major players believed the same bad ideas.”

Bad Idea No. 1 was the efficient-market hypothesis. This is the idea that the investment markets are so information- efficient that they take into account all the information people know. When market prices change, it means the information has changed. This is the view that when it comes to price, “the market is always right.”

If the market “knows” more than any individual player, then an individual can’t expect to beat the market — at least, not consistently. And this does seem to be true with mutual-fund managers. Each year some beat the market and some fall short. But market studies indicate that the ones who beat it this year are not any likelier to beat it next year.

The authors, however, don’t accept the hypothesis. They don’t think the market reflects only investors’ “information.” It also includes their hopes, fears, beliefs and unfocused strivings.

This contrary thought leads the authors to identify Bad Idea No. 2 as: “You can’t beat the market.” They maintain that if you are smarter than average, you can beat the market. They have the old-fashioned idea that the investment markets are “a proving ground, where the wise can be sorted from the fools.” If mutual fund managers don’t beat the market, the authors say, it’s because “mutual fund investors are dumb.”

They are thinking especially of public investors. A public investor is a person investing his own money in securities of companies about which he has no inside information. He’s just an ordinary guy who says, “I think I’ll buy stock in the New Horizons Fund.” A public investor is distinguished from an inside investor (investing in the stock of a company he works for) or a professional investor (making a living by investing other people’s money). I believe that studies have confirmed that public investors tend to buy and sell at the wrong time. Certainly that is an old belief of investment professionals. And it is the belief of our authors.

After a fund manager has had a couple of good years, they argue, and should be selling because the fund’s stocks are overpriced, the public investors are noticing how well the fund has done. When the manager ought to be liquidating, and paying cash out, they’re piling in, putting cash in his hands. But when the manager ought to be buy- ing aggressively because his stocks are cheap, his investors are demanding cash. The fund managers may be good at what they do, but whether they buy or sell is mostly not their decision. It is the public investors’ decision, and public investors tend to buy and sell at the wrong time.

The way to beat the market, the authors say, is to look for “price anomalies,” where other investors have pushed prices too far, or not far enough. And that requires paying attention to detail and using judgment.

Modern portfolio theory says otherwise. The thing to do, the theory says, is not to look at each investment up close. The thing to do is to buy things in certain patterns. Diversify. And for most investors, diversification is a good rule.

But the reason is not that the market is so smart. It’s that you may not be, and diversification limits the cost of a single mistake. “Diversification is always and everywhere a confession of ignorance,” the authors write.

It is one thing to admit your ignorance, even as you hack at it like a field of weeds. It is another to surrender to it, and go into the weed-management business. Essentially this is what large investors did when they stopped con- cerning themselves with the quality of the mortgages behind their bonds.

In the mortgage markets, this meant putting mortgages in bundles and turn- ing them into bonds. The bond buyers did not look at individual mortgages. Their view was statistical only. And as long as the mortgages were made in the same old way, with income verification, 20% down, payment of full principal and interest, et cetera, these bonds were good.

But then came structured finance. This was a way of setting up a bond with interest payable from a pool of mortgages, so that the first X number of defaults from the pool would be charged to one group of bonds only. That would make the one group high- risk; it would therefore sell at a discount. But another group, the larger group, would be virtually zero-risk and would sell at top dollar. This allowed the investment bank to make a considerable number of triple-A rated bonds out of a lower-rated pool, creating more value for investors and more profit for itself.

As a mathematical idea the thing is elegant. But it works for investors only if the underlying default rate on mortgages stays below a certain amount. That means the mortgage originators have to lend money according to the old rules, or new rules that are just as good — rules that minimize defaults by minimizing foolish investments, investments that canny lenders recognize as far too likely to go bad. But they didn’t play by the old rules of thumb. Part of the reason was that the government was ordering Fannie Mae and Freddie Mac to lend to low-income borrowers, and the way to do it was to lower credit standards. Part of the reason — the “greed” part — was that the lower the standards were for all borrowers, the more mortgages could be written, and

the more money each seller in the chain could make in the short run. And part of the reason — the part the authors stress — is that the buyers in the chain had a theory that told them their risk was managed, and they didn’t have to worry about it.

The problem, the authors say, wasn’t so much that the bankers were reckless. The problem was that they were following a theory that said they weren’t reckless.

When bankers realized their banks might be broke, they panicked. “The real problem,” the authors write, “was not that some of the banks were broke but that at the critical moment none of them could prove they weren’t.” The structured-finance bonds were difficult to analyze — and because of modern portfolio theory, the banks had cut back on analysts.

The arguments about the role of modern portfolio theory are not unique to this book. What sets these authors apart is their attitude and style. Theirs is a moralized account, focusing on fundamental ideas. One is ownership, subdivided into possession by strong owners and possession by weak owners. In comparing a person buying a house and a person refinancing his house so as to pull cash out, the authors say:

The new buyer putting down 20% and the old owner taking money out of his house are doing profoundly different things. One is becoming an owner, the other is weakening his ownership. One is buying in, the other is selling out.

About business they write:

Capitalism rests on strong ownership. Being an owner means more than having the right to the income from an asset. Ownership implies both the legal right and the practical capacity to make judgments about the care and use of the asset.

A small public stockholder is a weak owner — and a taxpayer is the weakest owner of all:

Both the mortgage crisis and the crash are best understood as the result of government policies that pushed trillions of dollars in assets out of the hands of relatively strong owners and into the hands of weak owners.

The authors are not against all government intervention. They point to the provision of the Constitution that authorizes the federal government “to coin money [and] to regulate the value thereof.” They go further: “Any institution the disorderly collapse of which would prevent the government from keeping the dollar stable is rightly considered too big to fail.” This, they add, “does not mean the government is obliged to ‘bail out’ the offender. Summary execution is a fine and venerable option. But the government is absolutely obliged to keep the offend- er’s collapse from destroying credit markets and thus the currency of the United States.”

Before government money went into the banks’ capital, the idea for the bailout was for the Treasury to buy the banks’ bad assets. But in the course of the panic, the market froze for certain categories of good assets as well. The authors argue that the government should have intervened “in ruthless capitalist fashion” by bidding openly for the good assets.

That assumes, of course, that the people working for the government would know what the good assets were. This part of the authors’ argument is not too clear.

In their view, what the Treasury actually did was an example of crony capitalism. “Contrary to the fevered rhetoric of the left,” they say, “the Bush Administration was not actually managed by idiots. It was, however, overpopulated with personally successful, anti-intellectual, unreflective crony capitalists.”

This is not an academic book. It is colloquial and middlebrow. It simplifies, maybe sometimes too much, and it does not tell the whole story of the panic. It has little to say about credit default swaps or the Basel accords or the monetary policy of the Federal Reserve. About the credit rating agencies it says only that they “recycled marked prices as credit ratings,” meaning that they lowered the ratings on bonds only after their prices had gone down, which was too late for the warnings to be of any use. That is an interesting observation, but it is not saying enough. Yet this book does analyze a central part of the story, and in a colorful and idea-centered way that should be attractive to a libertarian reader.

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