Wednesday, November 3, 2010

Free Markets vs. the Greater Fool

With the elections over, many believe the new Congress will attempt to rollback much of the Wall Street recent re-regulation. Pundits like the cocaine-addled Lawrence Kudlow will champion “free markets” as the panacea for the current economic malaise and whine about “socialism.” The nation would be better served by observing the Greater Fool Theory. It got us into the mess we’re in and it will get us into another in due time . . . it always does.

The greater fool theory is the belief that one can make a questionable investment if he or she can sell it later to "a greater fool"; in other words, buying something not because it is worth the price, but rather because it can be sold to someone else at an even higher price. The mortgage meltdown is a prime example.

Tea Party clowns like Rick Santelli constantly rail against people who took out mortgages without the financial wherewithal to pay them. Excluding those whose circumstances changed later because of the recession or (uninsured) family illnesses, why would any institution write a mortgage for people who clearly couldn’t make the payments to begin with? Were they just plain stupid or was there a greater fool in the wings?

Enter the mortgage bundlers. Wall Street firms, having gone public and needing to continually boost profits, found packaging mortgages and selling them as investments would be a wonderful business. Subprime mortgages in particular became attractive, increasing the incentive to write huge volumes; after all, the mortgage issuers had a greater fool who was happy to take them off their hands for healthy fees. Wall Street found willing accomplices in the rating agencies, which assigned AAA ratings to BBB-worthy securities. With this seal of approval, the money machine was cranked up and ready to peddle this junk.

I won’t attempt to describe how these “synthetic collateralized debt obligations” worked (read The Big Short by Michael Lewis), other than they were sliced and diced further to create tranches of the worst of the worst and sold too. The so-called best and brightest at the big Wall Street firms later claimed not to have understood these investments. They did, however, understand the huge profits they created and, with it, their stratospheric compensations before the whole thing blew up in September 2008.

A safety net supposedly existed: credit default swaps. AIG, the nation’s largest insurance company and one of the biggest in the world, was a major underwriter. Perhaps investors should have heeded the simple fact a client at a bankrupt real-estate syndicator told me twenty years ago: Your guarantee is only as good as your guarantor. Once the defaults started, there wasn’t enough capital to pay the fools. Just think of the Smokey Robinson-written lyrics, “Like a snowball rolling down the side of a snow-covered hill, it’s growing.”

So I ask: Why didn’t the free-market system save us from a possible global meltdown? The bank bailout, probably the last major bi-partisan cooperation on Washington, has been wildly reviled by politicians seeking political gain. I was in New York at the time, attending the last two White Sox games at Yankee Stadium. The Yankees would play three more games there before the historic edifice was closed and razed. Perhaps if the free-marketers had had their way, the edifices on Wall Street would have been razed too. Then again, a new Yankee Stadium was constructed for $1.5 billion, and tickets my cousin pays $40 or $44 at Sox Park originally cost more than $500 each. Like musical chairs, the trick is ensuring you aren’t the last fool standing. Remember that when you hear the next call for unfettered free markets.


  1. We'll be hearing that call even more now that our newest Senator (Pennsylvania) was just elected. I find it hard to believe that Toomey was able to escape from his connection to the countries financial downfall. Now we all have to hope and pray for six years that he's too wacky to be effective at implementing his own agenda.

  2. An almost $2 million contribution from the Chamber of Commerce certainly helped.