Thursday, December 04, 2008

Blodget says bubbles are rational

Henry Blodgett, a man whose greatest accomplishment was making a trend call on Amazon in 1998, has done it again. He substitutes narrative for analysis and now explains to us that the bubble was rational.

After constructing a list of possible culprits for bubble-mania (a list which includes mortgage brokers, real estate agents, Wall Street bankers, the SEC, and Alan Greenspan), he then lays the blame on the public - in his word "us". He excuses all of his straw-men with the following:
Everyone else on that list above bears some responsibility too. But in the case
I have described, it would be hard to say that any of them acted criminally. Or
irrationally. Or even irresponsibly. In fact, almost everyone on that list acted
just the way you would expect them to act under the circumstances.
He argues that every individual participant in the market had a specific aim, and that participating was a means to that end (and was therefore rational). He points out that buyers wanted houses (though in many cases so they could sell them to some other fool who would pay even more), agents wanted commissions, brokers wanted fees, and so on and so on. Playing the game was "rational" - and only the buyer had a real interest in predicting the future of the housing market (since he was the one who would have to pay for the asset, albeit over 30 years).

But what he overlooks, largely because his article is an act of narrative, not one of analysis, is the investor PURCHASING the loan in the form of a bond. What was irrational, ultimately, was that Mortgage Backed Securities (MBS) would always offer the same default risk as a government bond for substantially higher yield. This was idiotic. The price of the asset against which the security was secured (the house) in relation to the intrinsic value of the asset (the potential rental income of ownership) was already becoming strained in 2003-2004 in most markets. To believe that liquidation at anything approaching par would be possible, or that borrowers would really follow historical trends when it was obvious that an orgy of buying was pushing prices higher, was simply not rational.

True, the rating agencies wanted to rate bonds (because they wanted fees), but relying on the recommendation of a third party to do your homework for you - for free - now that is what I call irrational.

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