Flawed Thinking and the Financial Meltdown

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Flawed Thinking and the Financial Meltdown

Financial risk management is one area in which the enormous potential of evidence-based management is abundantly clear.  The present economic crisis was rooted in the subprime mortgage industry and in policies that undermined the global financial system.  This web of faulty assumptions and bad practices extended all the way to the stratospheric world of "structured finance."

To comprehend how bad assumptions were pyramided, one atop the other, it's necessary to understand the mindset that underpinned finance in the early 21st century and its implications. 

The fundamental idea behind structured finance is to pool a collection of assets and then sell shares in the pool.  The idea is that pooling lowers the risk for each investor versus what it would have been if he or she was investing in a single entity, like a mortgage or a bond.  In the current mortgage crisis, the assets in the pools were loans to people who were buying houses. 

So-called "collateralized debt obligations," or CDOs, are a typical form of structured finance.  The way they work was well described by Michael Lewis in his book Panic: The Story of Modern Financial Insanity.1  In it, he explains that a bank that creates CDOs buys up debt and uses the first few payments received each month on those loans to pay off the most senior investors in the pools of mortgage securities.  The next few payments are used to pay off the next tier of investors, and so on down the line on "a first-come, first-served basis."  The most senior are promised the lowest interest rate and the least senior investors are promised the highest interest rate.  If mortgage holders begin to default, the most senior investors are paid first and the flow of money stops somewhere before it reaches the least senior investors. 

There is nothing inherently wrong with the idea of CDOs, as long as all but a tiny fraction of the people who take out mortgages are able to make the payments.  Unfortunately, a number of factors converged to create a growing population of home owners who were poised to default on their mortgages and put the entire global system at risk. 

The first factor in this complex scenario was the prevalence in some areas of new laws restricting the uses to which land could be put.  This was especially true in California, where, starting in the 1970s, various laws were passed that prohibited building anything at all on enormous stretches of open land.  The rationale for such restrictions varied — for example, to preserve open space, to protect the environment, or to save farmland — but the result was uniformly the same:  The price of land, which typically accounts for most of the price of a home, soared...

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