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The Books > The Big Short

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message 1: by Mike (new)

Mike W | 20 comments Mod
Does anyone have any thoughts about the book?... For my part what's most striking so far is the stupidity of the AIG management and the financial products division. They were essentially gambling the whole company on a speculative bet that housing prices would continue to rise, despite ample evidence that prices were too high.


message 2: by Jeremy (new)

Jeremy K | 4 comments I have a couple thoughts on the book. As to your thoughts that AIG management and the financial products division was stupid - yes that is true, and many others were stupid as well. But, as Lewis notes towards the end of the book, people respond to incentives, and those folks at AIG didn't have the incentive to be smart on behalf of the company's long-term financial interest. I e-mailed this idea to you a while back - one of the main causes of this and other crashes is that management and ownership do not have the same interests in a publicly traded corporation. I suggested a solution that we abolish the publicly traded corporation and return to partnerships and sole proprietorships as the only legally allowed methods of business ownership. You disagreed, stating that the corporation was an ingenious and irreplaceable wealth-generator for the nation. So, then, what's your solution to the ownership/management conflict, where stupid management still gets paid millions and billions despite their screw-ups?

Of course, the corporation isn't going to be abolished. The wealthy benefit too much from it, and too few people can follow an argument for why we should abolish it. So, considering the corporation is here to stay, we should learn to benefit from the market flaws created by big dumb Wall Street firms.

My other thought is this: The guys at Cornwall Capital made a decent amount of money by buying call options on companies whose prices were about to take a massive swing, though the Black-Scholes model priced the options as if the stock price was likely to be stable. Does anyone know if Wall Street has adjusted their pricing of options? It seems like an easy enough thing to figure out which companies have been misjudged as having a stable future price, buying both a put and a call option, waiting for the price of the underlying stock to spike or tank, and then cash in.


message 3: by Mike (new)

Mike W | 20 comments Mod
I'm only through page 140 at present... I think there is something to your criticism that the employees and management of publicly traded companies have incentives that are imperfectly aligned with those of the shareholders. But that shouldn't blind us to the importance of equity markets for intermediation.

Companies that have profitable investments will want to borrow to fund their investment. Equity markets allow those who have capital to be matched more efficiently with those who have profitable investment opportunities. That's why Apple, Microsoft, Google, Amazon, etc... all went public eventually--not to exploit their investors but to get capital more cheaply to avail themselves of business opportunities.

Besides, even if stock markets didn't exist, there would still be pervasive moral hazard problems. One example is that the bondholders' and bank lenders' interests are very different from those of the company borrowing the funds. Indeed, this seems to me a much bigger problem than the divergence between stockholders and management...

The Cornwall Capital story is very interesting and amusing. I don't know whether Wall Street has abandoned Black-Scholes but I doubt it. Wall Street craves mathematical models that offer precise valuations, not the sort of qualitative analyses being done by Cornwall (or Warren Buffett). The Wall Street people would rather be precisely wrong than vaguely right.

Surely one could come up with a pricing formula based on something other than a normal distribution of returns, but it too would fail in some situations... So, there does seem to be an opportunity to exploit market inefficiency in option pricing.


message 4: by Jeremy (new)

Jeremy K | 4 comments Whether it's religion, political ideology, or option pricing, people would rather be precisely wrong than vaguely right.

I never claimed that abolishing public companies would solve all moral hazard problems, just that it would solve one of them - and a problem that crops up from time to time throughout the stock market's history, not just once.

The difference between a lender's interest and a borrower's only matters when one of the parties, usually the borrower, is unsophisticated or desperate. It is expected that the lender and borrower be on different teams and therefore naturally mistrustful of each other. Aside from some regulations to protect unwary borrowers, there is no need for major government intervention here.

On the other hand, management and owners should be on the same team. The fact that they are so often not shows that there is a fundamental incentive flaw that needs to be corrected, and has not been corrected yet. Aside from junking the idea of the public company, which would actually mean a lot less government regulation, since the corporation is a legal entity created and run according to various laws and regulations, I just don't see a way to align management and owner interests. Corporate governance regulations don't work, since the boards tend to rubber-stamp management decisions. But you might be right that there is more to gain from equity markets than to lose from this moral hazard.

Either way, it's time to brush up on my value investing and options knowledge, for the day when I am once again in the black and able to invest money.


message 5: by Mike (last edited Aug 30, 2010 02:30PM) (new)

Mike W | 20 comments Mod
I believe the social benefits of equity markets do greatly outweigh the costs. I think though that the efficient market hypothesis is clearly false, that equity markets are prone to bubbles based in part on psychological weaknesses of investors and that the kinds of moral hazard problems you are pointing to are serious... Actually, moral hazard seems to me the most important problem according to Lewis' account--more important than greed, arrogance or stupidity, though these were also present in abundance during the real estate boom.

Incidentally, I didn't mean merely that your proposal wouldn't solve all moral hazard problems, but rather that it wouldn't solve what are by far the most important ones. Even if AIG had been a private company, there would still have been an incentive to gamble if the company had borrowed significantly in bond markets. When you gamble with borrowed money, most of the profits are yours, while the lender bears all or nearly all of the risk. And of course government bailouts create still more moral hazard... My argument is that these sources of moral hazard were far more important than the one you were pointing to.

I haven't paid much attention to options or other sorts of derivatives either. I intend to learn more about them also. We should exchange thoughts about them when we both know more...


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