A CDO manager finds himself living in Chapter 12 of Keynes’ General Theory

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Barry Ritholtz reprints a scary e-mail from a friend in the collaterized debt obligation business (don’t you have a friend in the CDO business?):

I was talking to CDO managers in mid-’05 that were saying how rich sub-prime MBS was and how wrong everyone was for buying that stuff at the spreads they were. To a man, they all agreed they were paying too much for the risk, they all believed that HPA [ED: home price appreciation] was going negative soon. But, sadly, they had to buy the stuff because they needed to accumulate collateral for their CDO issuance. F*&%, we all knew we were overpaying, even back in 2005. We knew it was essentially a bet that home price appreciation was going to continue at levels that couldn’t be sustained. No way that could keep going on.

So why did they keep buying?

The answer is quite simple: DEAL FEES. I gotta keep buying collateral, in order to keep issuing these transactions as a CDO manager. Its my job: I gotta keep accumulating collateral, and I gotta issue the liability against that collateral.

This is an important element of what’s called the “limits of arbitrage” (Andrei Shleifer and Robert Vishny, Journal of Finance, March 1997) or “career risk” (Jeremy Grantham, in various investor letters) explanation for why markets get so crazy sometimes. Brad DeLong has pushed this argument lately in his blog, and I’d like to second his endorsement: The smart professionals we rely on to keep market prices sane (or “efficient”) sometimes face career incentives that make it almost impossible for them to act on their own rational judgments. The most famous and eloquent account of this can be found in Chapter 12 of John Maynard Keynes’s General Theory of Employment, Interest and Money:

Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely lead much more laborious days and run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous coincides with that which is most profitable. It needs more intelligence to defeat the forces of time and our ignorance of the future than to beat the gun. Moreover, life is not long enough; — human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate. The game of professional investment is intolerably boring and over-exacting to anyone who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll. Furthermore, an investor who proposes to ignore near-term market fluctuations needs greater resources for safety and must not operate on so large a scale, if at all, with borrowed money — a further reason for the higher return from the pastime to a given stock of intelligence and resources. Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

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