Wednesday, May 12, 2010

Can't Bad Investments Just Be A Mistake Without Blame?

A comment I posted in response to Arnold Kling's blog, "Cognitive Failure or Moral Failure" on Econlog.
To call it a cognitive failure, doesn't one have to show that prices of trades in a liquid market substantially deviated from fundamental value? An underwriter's CDO price based on models and ratings is a guess at the value of a market based price. In the case of CDOs, the guess was off the mark.

The financial crisis began because CDO collateral value (a type of market price) declined, requiring more collateral to fund overnight borrowing, which created the liquidity and solvency crises at Bear Stearns and Lehman. No cognitive failure here.

As equity market participants recognized that the booked par value of CDOs was higher than the market value, bank stocks such as Citi, tumbled, reflecting the lower value of bank assets, the need for more capital and the potential of insolvency. No cognitive failure here.

Additionally, initial investors in CDOs chose these investments because they promised a higher yield than the equivalently rated US Treasury security. Investors switched from US debt to CDOs because of a promised higher yield. Higher yields mean higher risk and were required by investors to switch to CDOs. If investors truly believed the CDOs were AAA and not more risky than US debt, they would not have wanted a higher yield from CDOs. No cognitive failure here.

I have not seen any analysis that says that the ex ante promised yields of CDOs was not commensurate with the higher expected risk at the time of investment.

Analysis after known losses does not reflect the investment world before the losses. It is easy to recognize a poor investment after it loses money. It is not so easy to recognize one before the losses occur.

No one claiming they saw the coming housing crisis and bubble is claiming they sold their home(s) before the downturn, rented and then bought an equivalent home at a lower price and pocketed the profit.

Investors without cognitive failure make investment mistakes. Why can't all the housing market investment just be a mistake without resorting to all kinds of cognitive, modeling and analytical failings?

Is there really any surprise, that a bureaucratic, rigid regulatory scheme using the rating agencies did not reflect real world events? Doesn't that happen all the time with all regulatory agencies?

The future is always difficult to predict. Do we always need to blame someone or something for our inability to predict tomorrow's events?

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