The Four Horsemen of Subprime Stupidity

Op-ed in the International Economy

January 1, 2008

Given the sums of money involved, it is no wonder that financial companies would like us to believe that their businesses are complex and special. Real rocket scientists perform mathematical prestidigitation on trading floors where transactions unfold in split seconds. Smart policy economists have gotten caught up in concerns about the opacity of pricing their distressed products, and educating the public about the difference between mere risk and “Knightian uncertainty.”

Yet the business mistakes of the major banks and investment houses in recent months really have little to do with the complexities of their products. Just as high-tech firms’ relative fortunes depend less upon the intricacies of airframe assembly and genetic engineering than upon strategic, marketing, and production decisions, the fault here is with basic management failures. And public policy should not be guided astray into excessive restraint in dispensing haircuts or in punishing fraud as a result of distraction by financial complexity.

The major financial intermediaries in trouble all made some combination of four bad basic strategic calls. First, they blew their inventory management. There is a high correlation between the degree of trouble in which these firms find themselves, and the extent to which they kept on their books securitized assets in hopes of capital gains rather than selling them off. This kind of warehousing— practiced egregiously by Freddie Mac and Fannie Mae in direct exploitation of their implicit government guarantees—is no different than that of the grain broker or Beanie Babies distributor who gambles that the future price of their products will be higher than the price currently available in the markets.

So the banks got caught short when that wager fell through and they did not rely solely on income from fees and markups on repackaging their inputs. Whatever the perceived difficulties of pricing their products, supervisory measures to force institutions with deposit guarantees and discount window access to provision for assets on their balance sheets are not rocket science. They just have to be enforced.

The key is not to allow this to be turned into a brief against securitization. Current proposals to force intermediaries to retain some capital stake in their products when sold go exactly the wrong way. The point is to force these firms (and especially the agencies) to be intermediaries warehousing as little of their inventory as possible, getting securities off of their balance sheets as quickly as possible.

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Adam S. Posen Senior Research Staff

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