Tag: economics

Day 284: The Big Short: Inside the Doomsday Machine

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Cover for The Big ShortIn The Big Short, Michael Lewis, a former Wall Street bond trader and financial journalist turned author of best-selling nonfiction, explains what happened in the bond market from 2002 through 2008 that nearly destroyed the economy. He begins, however, a little earlier, with the first financial debacle involving the subprime mortgage market in the 1990’s that, once it was weathered, everyone assumed would not reoccur.

Let me start with a quick comment that I am not by any means knowledgeable in financial matters or even usually interested in them, so it’s possible my brief synopsis could have some mistakes, but this is my understanding.

The problem began with greedy subprime mortgage dealers lending money to people for houses they could not afford (and for which they would normally not qualify) using adjustable rate mortgages and balloon payments and sometimes requiring no down payment. That this money was loaned at all was a reflection of the profitability of this market, where deals were made and then put into packages with other deals and sold immediately to someone else.

Eventually, a few discerning traders and analysts who set out to understand the structure of some of these bonds realized that when the higher interest rates kicked in on the mortgages, or sometimes when the first payment was due, the home owners would default. They also realized that if enough of these bad mortgages were packaged together, the bonds encompassing these packages of subprime mortgage deals would default. Once they could find no serious difficulties with their reasoning, these few traders decided to bet against–or short–these bonds.

A disturbing feeding frenzy went on among traders who did not understand how risky these packages were. And those that did not understand the packages included the rating agencies, like Standard and Poor’s, who apparently made no effort to understand them. In fact, the bond traders willfully convinced the rating agencies to rate bond packages almost completely composed of these bad mortgages as triple A.

The book is full of colorful characters and stories that lend interest to the descriptions of the financial details. I occasionally had problems grasping the details of what was going on, but by and large, Lewis has explained this disaster in a way that is eminently readable and incredibly scary. If you have any illusions about the morals of the people running our financial institutions before you start reading, prepare to give them up.

Day 71: Thinking, Fast and Slow

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Cover for Thinking, Fast and SlowEarly in his career, Daniel Kahneman got interesting in why people, even experts, do not seem to use statistics and follow economic models in making decisions and judgments. His research with his main collaborator Amos Tversky eventually ended in his winning the 2002 Nobel prize in economic science, which is unusual because he is a psychologist. Thinking, Fast and Slow explains the results of years of studies on understanding how the human brain makes decisions and judgments. His major theme in this extremely interesting, well-written book is human irrationality. His work with Tversky, he says, “challenges the idea that people are generally rational.”

For better understanding of the ideas explained in the book, Kahneman begins with the analogy that there are two systems employed in decision making: the fast-thinking, intuitive, unconscious system that keeps us safe and handles our day-to-day actions but is prone to error, and the deliberative system that reasons through more informed decisions but is lazy and has to be actively engaged.

Kahneman shows the evidence from experiments that many more of our decisions are controlled by our unconscious than by conscious decision-making, and therefore, we do not always make decisions the way that economic models have assumed. He makes his points using fairly simple experiments that you can try yourself, so that you recognize the faulty assumptions and cognitive biases underlying your own reasoning. In examining these experiments, he shows their profound implications. The result is an entertaining book full of intellectual surprises that was chosen as one of the New York Times Best Books for 2011.

Although Kahneman provides some ways of recognizing patterns that can result in bad decisions, he cautions that it may be impossible to teach yourself to always avoid these pitfalls and says that he is unable to do it consistently himself. He reminds us that all of us tend to have an exaggerated sense of our understanding of the world and shows that much more of what happens is random than we acknowledge or understand.