I dig lingo. Sure, a picture might be worth a thousand words, but a nice hunk of jargon has got to be worth at least a few hundred. And if it's jargon you're looking for, I'd bet there's no better place to find it than Silicon Valley. The cocktail of business and technology – with a splash of disregard for the rules of grammar and spelling – make this place a jargoneer's paradise. (Although sometimes the whole thing goes too far: One. Word. Sentences. Quit. It. Srsly. Hey, I wonder if grammr.combeta is taken?)
Anyhow, there I was at the Fall potluck dinner at mini-LP's nursery school, feeling a smidge out of place since I was the only one not sporting gear emblazoned with the logo of a NASDAQ 100 company, and the topic turned to (bum bum bum buuuuuum) The Subprime Crisis! Suddenly, all eyes were on me: Financial Dude. One dad growled, "so how did it get to this?" in that same exasperated tone that TV detectives use as they toss the legal pad and bic pen toward the perp demanding: "write it all down, just like you told me."
And so I started talking about what I thought had really gone on. At first it was kind of cathartic, but then, the more I talked the worse I felt about the whole thing. It was like I was describing a case study in the principal-agent problem. Make that the World's Biggest Principal-Agent problem. And that's what got me down: professional investors should be attuned to agency issues. Everyone should've seen this coming, but the good times were rolling and there was always a greater fool in another time zone to take the mess off your hands. Of course, that's a game that works until it doesn't. But I digress.
So I'm going on and on about marginal borrowers (my favorites were the NINJAs: No Income, No Job or Assets), CDO tranches, investors looking for spread product, and mark-to-whatever accounting when I notice a few eyes starting to glaze over. And right then, one dad pipes up: "So it sounds like they were overclocking the financial system." Now I didn't quite know what that meant, but I sensed some good jargon coming on and I was eager to unpack that box like a kid on Christmas morning.
Your Humble Narrator: "Overclocking? What's that?"
Really Smart Dude: "It's when you mess with your computer's processor to get some more performance out of it."
YHN: "Why do that?"
RSD: "Well, most overclockers are gamers looking to push the limits. Exceeding the processor's specs can result in a major framerate bump. Others do it for ego reasons; you know, they just want to have the fastest processor on the block. And some people even go out and buy old processors on the cheap, overclock them and sell them as the latest chip to unsuspecting buyers."
RSD: "It gets pretty crazy! The problem is that overclocked processors run really hot – often hotter than conventional heat sinks can handle – so overclockers sometimes build crazy structures to keep the whole thing from blowing up."
YHN: "Blowing up? For real?"
RSD: "Well, blowing up is a bit extreme, but the processor can catch fire for sure. And once you get a fire inside the machine, the whole system could be at risk. Either way, if you get to that point it's an expensive fix."
Expensive, indeed. Aside from the magnitude of their blow-ups, overclockers of the processor and financial variety sounded a lot alike. Of course, it looked like the financial overclockers were going to get all of us to pick up the tab for their blow-up . . .
When I was a kid, a bank in my neighborhood got robbed and the block was abuzz with talk of the brazen heist. Among all the hand-wringing and fist-shaking, Old Man O'Malley, ever the neighborhood cynic, dropped a nugget through the fog of Garcia Y Vega smoke that continually encircled his head. "Morons," O'Malley growled, " . . . if you're going to rob a bank, don't take down the one on the corner, go hit the Federal Reserve. That's where the money is." I've thought of that line a lot recently and I can't help but feel that's exactly what just happened.
For the sake of discussion I thought I would introduce a new player into the drama, rating agencies. Theoretically, the free market had this mechanism to assess and inform corporate and financial managers of oustanding risk.
Now either the risk was not understood or controls were not enforced. I’m included to believe the latter. Like Arthur Anderson, both internal risk managers and external risk managers had zero incentives to warn and curtail risk and every incentive to allow it to perpetuate.
It’s like the story of the frog and the scorpion (with financiers playing the role of the scorpion) told in The Crying Game (via Wikipedia):
The scorpion, wishing to cross a stream, asked the frog to let him ride his back over the stream. When the frog asked the scorpion how he could be sure that the scorpion would not sting him, the scorpion replied that if he did sting him, it would mean death by drowning for both of them. The frog complies, carrying the scorpion on its back across the stream. Before they reach the other side, however, the frog feels pain and realizes that the scorpion has stung him. He protests, “Why did you sting me, Mr. Scorpion? For now we both will drown!” The scorpion replies, “I can’t help it, it’s in my nature.”
The scorpion (like the financier) does exactly what you’d expect it to do – it’s in his/her nature to push the limits. The rating agencies, on the other hand were charged with being the honest beat cop and they failed miserably. Because they sold themselves so cheaply, because they abdicated their responsibilities so readily, they’re the ones in whom I’m most disappointed. We needed them on that wall, we wanted them on that wall and they let us down.