Lagging Psychology at Turning Points

The Big Picture: "

Over the past few weeks, we’ve been debating the state of the economic recovery. The posts that have emphasized the shift in data towards the positive have generated a lot of pushback.

This is something that I want to discuss in general terms — I want readers to not only understand my perspective, but to grasp what typically occurs heading into recessions and recoveries, into new bull and bear markets. (Note I am speaking generally, and not referring tot he details of this cycle).

Over the next week, I will put together a broad overview of the positives and negatives of the economy, looking at the risks and opportunities presented. For now, let’s discuss the sentiment that typically accompanies oscillating phenomena, such as markets or the economic cycle.

Today, I want to look at the big overview. Historically, the sentiment that occurs at inflection points are extremes. The are the result of the prior few years of economic/market activity. They lag the cycle — often quite significantly.

Consider:

• Humans have an unfortunate tendency of to overemphasize our most recent experiences. We draw from what has just happened, rather than deduce based on what is occurring right now.

• Following that idea, the analyst community is typically too bullish at tops, too bearish at bottoms. They extrapolate from the most recent data to infinity or zero. Hence, they miss the inflection points.

• Sentiment is a justification of recent actions. Very often, equity buyers describe themselves as bullish after their purchase. The comments they make can are often an attempt to reassure themselves.

• Changing viewpoints is a gradual process. Flipping from bullish to bearish and vice versa is difficult. We remember what most recently rewarded us, and internalize that. After a period of economic expansion, we are slow to grasp the change for the worse. At the tail end of an ugly recession, we find it hard to imagine an imminent improvement.

• Investors develop the equivalent of Muscle memory. During a bull market, every dip that was bought made us money. When the cycle changes, we are slow to perceive it. Bulls become out of phase with what is taking place, buying on the way down in a bear market.

• The reverse takes place after a long Bear market. Selling rallies made us money, preserved capital during the downturn. When the sell off ends and a new bull cycle begins, the bears have a similar hard time getting back into sync with the market. Since it was so rewarding to sell into prior rallies, it becomes difficult to flip towards the positive perspective.

• Excuse making rationalizing the missed turn becomes endemic. We get conspiracy theories (the Fed is buying SPX minis!), complaints about the artifice of the market, Fed bashing, etc. They all have their roots in the missed turn. I even suspect some of the Goldman bashing (deserved tho it may be) is also partly rooted in this issue.

Consider this chart, which I first showed back in 2005 — but its worth reviewing again:

If you like these sorts of things, there are more psychology visualizations after the jump . . .

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Chicken or the Egg?

Another good report from Morgan Stanley:


Chicken or the Egg?
Stephen S. Roach
Chairman, Morgan Stanley Asia

The China debate is terribly one-sided.  The same can be said for the broader  discussion over global rebalancing.  The emphasis in both cases has largely been on the destabilizing impact of the surplus Chinese saver. If China would only stop manipulating its currency, goes the argument, its current account surplus would vanish and an unbalanced world would finally enter the Promised Land of balanced growth.

What about the other side of the story? After all, barring an extraterrestrial imbalance, earthly surpluses must always be counter-balanced by deficits on the other side of the international accounting ledger. Unfortunately, the blame game has focused primarily on surplus savers, paying only lip service to profligate deficit savers.

In that spirit, it is equally important to contemplate an alternative reality. It can best be seen through the lens of America’s massive saving shortfall and its concomitant current account deficit. This version of the unbalanced world poses a very different dilemma: If the United States would only start saving again—namely, reduce its budget deficit and/or boost its long-depressed household saving rate— it would become less reliant on surplus savers such as China to fund its shortfall of domestic saving and provide cheap goods for over-extended consumers.

What came first—the surplus or the deficit? Was it China’s saving-led development strategy that forced the United States to squander its domestic saving and lead the external demand that fueled the Chinese export machine? Or was it America’s penchant for living beyond its means that required the world’s savers, such, as China to run large current account and trade surpluses to provide the US with both cheap capital and low-cost imports?

Like all disputes, there are shreds of truth on both sides of this tale. Yes, China is guilty of staying with an export-led development model for too long and for failing to provide adequate support to internal private consumption. Even so, the US was hardly an innocent bystander here. Without the profligacy of income-short America, China would have faced weaker external demand and might have had to abandon the old model sooner.

At the same time, the United States became addicted to excess consumption—drawing freely on open-ended support from asset and credit bubbles. America probably couldn’t have pulled it off without China. Without the prowess of the Chinese export machine and the surplus capital that made its way into US asset markets, the United States might have found it a good deal tougher to feed its addiction and stay the course of unbalanced growth.

The concept of shared responsibility is missing from the current debate. The West is collectively pointing its finger at China. But it hardly utters a peep about the equally important role the US has played in creating this problem. It is both ironic and hypocritical that many politicians and global thought leaders have concluded that the Great Crisis was made in America but that China should be held accountable for the imbalances that linger in the post-crisis world.

This is where I draw the line. As the global hegemon,  America should have known better. By opting for bubble-dependent growth, it made a conscious choice to shift  from income- to asset-based consumption and saving.  Yet a saving-short US economy could not have pulled off  this transformation without the support of a new form of vendor finance—namely, China’s massive accumulation of foreign exchange reserves that have been disproportionately recycled into dollar-based assets.

At the same time, Chinese mercantilism enabled the American dream of open-ended consumption—providing income- and saving-short consumers with an unlimited supply of low-cost and increasingly high-quality goods. And by turning to China’s low-wage workforce, American multinationals benefited handsomely from Chinese outsourcing options—boosting their earnings, share prices, and wealth of asset-dependent consumers.

In essence, for the United States, it was a virtuous circle of virtual purchasing power—partly made in China at the implicit bequest of the overly indulgent American consumer. This is where hypocrisy enters the equation: China is being chastised for a mercantilist currency policy by those who benefited the most from this so-called manipulation.

Of course, the blame game is always subjective. But, ultimately, this dispute goes right to the heart of the value proposition that shapes economic development. Just thirty years ago, the Chinese economy was on the brink of collapse. Export- and investment-led growth was China’s salvation-producing nothing short of a miracle in the annals of poverty reduction and economic development. China did what it had to do in order to avoid the abyss.

That was then. China knows full well that it now needs to transition to a different growth structure—one that shifts support from external to internal demand. But it puts a high value on 30 years of extraordinary progress, and does not want to squander those gains by acceding to destabilizing western demands for a large currency revaluation. That doesn’t mean China won’t bend. As it shifts to more of a consumer-led economy, China can be expected to do so with a return to the gradual renminbi appreciation strategy that was in place from mid-2005 to mid-2008.

In the end, it always pays to be wary of unintended consequences. China’s coming transition will have profound implications for the United States and the rest of the world.  It will create vast new markets that will benefit most exporters. But as China’s surplus saving gets diverted into internal private consumption, it will have less capital left over to bankroll other nations. Specifically, that means that China will be less capable of funding America’s insatiable addiction for excess consumption. And then, the chicken—or maybe the egg—will finally come home to roost.

The end of the euro

FT Alphaville:

What’s in the water at Morgan Stanley? Its credit and equity strategists are negative on the market and now the bank’s economists are talking about the break up of the euro. And you thought FT Alphaville was bearish.

Here’s Joachim Fels in the latest edition of The Global Monetary Analyst (emphasis ours):

The financial backstop package for Greece and the ECB’s climb-down on its collateral rules have clearly reduced the short-term liquidity risks for Greece. However, as our European economists have emphasised, long-term solvency risks remain firmly in place. More broadly, and more worryingly, recent developments significantly raise the (long-term) risk of a euro break-up, in our view.

The bail-out and the ECB’s softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time. If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union.

And because the Maastricht Treaty does not provide for the possibility of expelling euro area members, the only way Germany could achieve this would be by leaving the euro to introduce a stronger currency.

Of course, it hardly needs saying that support for the Greek bailout has been extremely unpopular in Germany — where a legal challenge to the deal has already been filed, according to the Telegraph.

As such, Fels is surely right when he says the risk of a German-initiated euro break-up is far from negligible.

But what are the signposts that would indicate that this bearish scenario – which would have severe consequences for financial markets – is unfolding?

Fels says there are three:

First, watch fiscal developments in other euro area countries closely: Our suspicion is that the aid package for Greece lessens other governments’ resolve to tighten fiscal policy, especially in an environment of ongoing economic stagnation or recession.

Second, watch ECB policy closely: If the ECB turns out to be slow in raising interest rates once inflation pressures return, this would be a sign of a politicisation of monetary policy.

Third, watch the political debate in Germany: Support for Greece has been extremely unpopular and fears that the euro will turn into a soft currency abound. If the aid package for Greece, which so far is a backstop credit line, becomes activated, eurosceptic forces would receive a significant further boost. And, needless to say, if other countries also needed financial support, this would further strengthen euro opposition.

Full note from The Global Monetary Analyst:

Euro Wreckage Reloaded

Joachim Fels (44 20) 7425 6138

• Somewhat paradoxically, the show of solidarity for Greece by other euro area members and the ECB raises the risk that the euro will break apart eventually.

• Seceding from the euro area to devalue is very costly and risky. But seceding to revalue and introduce a harder currency is easier. Germany might opt to do so one day.
• The road to such a break-up scenario leads through even more fiscal profligacy and divergence in the euro area, a politicisation of monetary policy, and a weaker currency. Recent events suggest that the trip down this road has started.

A pyrrhic victory… The joint euro area/IMF financial backstop package and the ECB’s recent climb-down on its collateral rules have clearly reduced the short-term liquidity risks for Greece. However, as our European economists have emphasised, long-term solvency risks remain firmly in place. More broadly, and more worryingly, recent developments significantly raise the (long-term) risk of a euro break-up, in our view.

… which gives rise to moral hazard: The bail-out and the ECB’s softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time. If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union. And because the Maastricht Treaty does not provide for the possibility of expelling euro area members, the only way how Germany could achieve this would be by leaving the euro to introduce a stronger currency.

Seceding to revalue is easier: It has been our long-standing view that such a break-up scenario – where a country or a group of countries want to leave to introduce a stronger currency – is more likely than a scenario where a country wants to leave to devalue. The reason is that the osts of leaving to devalue are extremely high.

• First, borrowing costs for the seceding country would likely rise significantly as investors will demand a currency and inflation risk premium.
• Second, while contracts between parties in the seceding country could by law simply be redenominated in the new currency, redenomination would not easily apply to cross-border contracts. Foreign creditors would still demand to be repaid in euros (‘continuity of contract’). Thus, a country that secedes and devalues would still have to honour its foreign-held debt in euros and would thus face a rising debt burden. If it decided to default instead, it would, at least for some time, be totally shut off from foreign financing.
• Third, a country that decided to leave the euro to devalue would immediately face a bank run by domestic depositors who would want to shift their funds into banks in other euro area member countries. This would provoke a financial meltdown which could only be prevented by a freezing of bank deposits and the imposition of strict capital controls.

By contrast, none of these costs would apply for a country that wanted to secede in order to revalue. Its borrowing costs would likely fall rather than rise as it would attract an inflow of funds.

How it all started... None of these deliberations are new. In fact, we first started to worry about a potential euro break-up along these lines in 2003-04 in a series of notes (see, for example, Euro Wreckage? January 22, 2004, and Debating ‘Euro Wreckage’, February 9, 2004, with a reply by Noble laureate Robert Mundell). Back then, it had become increasingly clear that the move towards political union in Europe had stalled, partly because the EU has simply become too large and diverse a club due to successive enlargements. Moreover, the old Stability and Growth Pact (SGP), which was meant to ensure fiscal discipline within the euro, was effectively buried in late 2003 when both Germany and France kept violating the 3% budget deficit limit. It was later ‘reformed’ into a toothless tiger that allowed for much more fiscal flexibility. Thus, we worried about an increasing divergence of fiscal policies with widening bond yield spreads and increasing political pressures for an easier monetary policy stance, which could make the monetary union unpalatable for countries like Germany.

…and why it has become more likely now: Obviously, we have not reached the end-game yet. However, with the recent developments, such a break-up scenario has clearly become more likely, for two reasons. First, the lesson for other euro area members from the Greek bail-out package is that no matter how badly you violate the SGP guidelines, financial help will be forthcoming, if push comes to shove. This introduces a serious moral hazard problem into the European equation. Fiscal slippage in other countries has now become more rather than less likely.

Second, the ECB’s climb-down on its collateral rules regarding lower-rated bonds, which ensures that Greek government bonds will still be eligible as collateral in ECB tenders beyond 2010, adds to this moral hazard problem and confirms that the ECB is not immune to political considerations and pressures.

Don’t get us wrong: It is quite obvious that if Greece had not received a financial backstop package and if the ECB had stuck to its previous pronouncements on the collateral rules, the consequences not only for Greece but the whole euro area financial system and the economy could have been dire. However, the unintended consequence of such action is that it sows the seeds for potentially even bigger problems further down the road.

What are the signposts that would indicate our break-up scenario is in fact unfolding?

• First, watch fiscal developments in other euro area countries closely: Our suspicion is that the aid package for Greece lessens other governments’ resolve to tighten fiscal policy, especially in an environment of ongoing economic stagnation or recession.
• Second, watch ECB policy closely: If the ECB turns out to be slow in raising interest rates once inflation pressures return, this would be a sign of a politicisation of monetary policy.
• Third, watch the political debate in Germany: Support for Greece has been extremely unpopular and fears that the euro will turn into a soft currency abound. If the aid package for Greece, which so far is a backstop credit line, becomes activated, eurosceptic forces would receive a significant further boost. And, needless to say, if other countries also needed financial support, this would further strengthen euro opposition.

Bottom line: To be clear, we neither advocate a euro break-up, nor is this our main scenario. However, the risk that it happens is far from negligible and the consequences for financial markets would be very severe. Hence, investors ignore the euro break-up risk at their own peril.

The Greek people are being punished for Europe's errors

Ambrose Evans-Pritchard in Telegraph:

The moment of "Ultima Ratio" has arrived for Greece. Brussels has failed to bluff investors with fudges that mask the battle between Germany and France over the shape of Europe.

Last week's rise in spreads on Hellenic two-year bonds to 730 points over German debt is proof that Greece cannot tap capital markets at bearable cost. It must spiral into default unless the EU-IMF rescue mechanism is activated. "There is no point waiting for an accident to happen," said Nomura's Laurent Bilke.

As I write (on Saturday), it appears that EU experts have agreed on a package of €20bn to €25bn at 350 points above the IMF tariff, or 5pc. This achieves nothing. Such wishful thinking has plagued the Greek/EMU crisis from the start. Simon Johnson, the IMF's former chief economist, said Greece needs €110bn to have any hope of pulling itself out of a tail-spin, given that the twin cures of default and devaluation are blocked. Even that may not work. Greece must squeeze a further 13pc of GDP from the budget to stabilise debt costs by 2012, and do so during a slump when every euro of tightening leads to €1.5 to €2 in lost demand. "The risk is of a viscious downward cycle," Mr Johnson wrote in the Huffington Post.

He likens the crisis to Argentina's slide before default in 2001, a fiasco that led to calls for the abolition of the IMF itself. The Fund concluded in a post-mortem that it should never again throw good money after bad to prop up an unworkable structure with an overvalued exchange rate.

EU officials react with outrage to comparisons with Argentina, but as Mr Johnson says "Greece is far more indebted, is much less competitive in global markets, and needs a greater fiscal and wage adjustment".

Argentina's public debt was 62pc of GDP in 2001: Greece will top 120pc this year. Its budget deficit was 6.4pc: Greece's was 16pc last year on a cash basis. Its current account deficit was 1.7pc: Greece's was 11.2pc in 2009.

The cleanest option for Greece is an Argentine default with a 65pc haircut for creditors, and exit from the euro. Argentina recovered fast after liberation. Greece could expect "decent growth" by mid 2011.

True, but Greece is just "the tip of the iceberg", in the words of China's central bank. The design faults of EMU have left all Club Med trapped in debt deflation or perma-slump. Europe's banks are in turn stuck with fatal exposure. You cannot safely uncork Greece without risking a chain reaction.

This has echoes of Credit Anstalt, the Austrian bank that collapsed in June 1931, exposing the underlying rot of Europe's banks. It set off an earthquake across Germany and Central Europe. Contagion spread back into the Anglosphere, snuffing out the recovery of early 1931.

The global financial order came crashing down. The Great Depression began in earnest.

Liaquat Ahamed recounts in Lords of Finance how rescue talks succumbed to geo-politics. France held up a loan for Austria, using it as leverage to stop a customs union with Germany. (Paris secretly withdrew funds from Vienna to force capitulation.) Disputes over German war reparations poisoned everything. By the time France, Britain and the US could agree on anything, events were out of control.

This time Germany is proving difficult, refusing to be led by the nose into an EU debt union. Chancellor Angela Merkel cannot bend the rules even if she wants to. German professors are itching to launch a complaint at their constitutional court for breach of the EU's "no bail-out" clause the day any rescue is activated.

Yet let us be honest. This is not a bail-out for Greece. It is a bail-out for European creditors that account for most of Greece's €391bn external debt (163pc of GDP). As such it is the first line of defence against greater sums at risk across Club Med. The EU rescue shifts the debacle onto taxpayers in order to prevent a systemic crisis, just like the bank bail-outs after the Lehman failure. The question is whether German Landesbanken with wafer-thin capital ratios can withstand a second crisis after losing so much already on US subprime debt.

As for blaming Greece, let us remember that the European Central Bank stoked property booms in much the same way as the Greenspan Fed. It let the growth rate of M3 money balloon to 12.3pc by late 2007, against a 4.5pc target, pouring petrol on the fire in Club Med, Ireland, and Eastern Europe. Greece can perhaps claim its entry terms into the euro were violated by the ECB. Yet the Greeks are being singled out for punishment under the rescue terms. Mr Johnson says they will have to transfer 8pc to 9pc of GDP each year to foreign creditors from 2012 onwards.

No nation will tolerate such debt servitude for long.

This crisis stems from the original sin of EMU and the collective self-deception that lured debtors and creditors alike into excess. To lecture Greece gets us nowhere. Default will happen one way or another. So will contagion.

The Cover-Up

The Baseline Scenario: "

Wall Street is engaged in a cover-up. Not a criminal cover-up, but an intellectual cover-up.

The key issue is whether the financial crisis was the product of conscious, intentional behavior — or whether it was an unforeseen and unforeseeable natural disaster. We’ve previously described the “banana peel” theory of the financial crisis — the idea it was the result of a complicated series of unfortunate mistakes, a giant accident. This past week, a parade of financial sector luminaries appeared before the Financial Crisis Inquiry Commission. Their mantra: “No one saw this coming.” The goal is to convince all of us that the crisis was a natural disaster — a “hundred-year flood,” to use Tim Geithner’s metaphor.

I find this incredibly frustrating. First of all, plenty of people saw the crisis coming. In late 2009, people like Nouriel Roubini and Peter Schiff were all over the airwaves for having predicted the crisis. Since then, there have been multiple books written about people who not only predicted the crisis but bet on it, making hundreds of millions or billions of dollars for themselves. Second, Simon and I just wrote a book arguing that the crisis was no accident: it was the result of the financial sector’s ability to use its political power to engineer a favorable regulatory environment for itself. Since, probabilistically speaking, most people will not read the book, it’s fortunate that Ira Glass has stepped in to help fill the gap.

This past weekend’s episode of This American Life includes a long story on a particular trade put on Magnetar (ProPublica story here), a hedge fund that I first read about in Yves Smith’s ECONned. The main point of the story is to show how one group of people not only anticipated the collapse, and not only bet on it, but in doing so prolonged the bubble and made the ultimate collapse even worse. But it also raises some key issues about Wall Street and its behavior over the past decade.

This will require a brief description of what exactly Magnetar was doing. (If you know already, you can skip the next two paragraphs.) It’s now a cliche that a CDO is a set of securities that “slices and dices” a different set of securities. But it’s slightly more complicated than that. First there is a pile of mortgage-backed securities (or other bond-like securities) that are collected by an investment bank. The CDO itself is a new legal entity (a company) that buys these MBS from the bank; that’s the asset side of its balance sheet. Its liability side, like that of any company, includes debt and equity. There’s a small amount of equity bought by one investor and a lot of debt, issued in tranches that get paid off in a specific order, bought by other investors. The investment bank not only sells MBS to the CDO, but it also places the CDO’s bonds with other investors. Whoever buys the equity is like the “shareholder” of this company. There is also a CDO manager, whose job is to run the CDO — deciding which MBS it buys in the first place, and then (theoretically) selling MBS that go bad and replacing them by buying new ones. The CDO itself is like an investment fund, and the CDO manager is like the fund manager.

According to the story, in 2006, when the subprime-backed CDO market was starting to slow down, Magnetar started buying the equity layer — the riskiest part — of new CDOs. Since they were buying the equity, they were the CDOs’ sponsor, and they pressured the CDO managers to put especially risky MBS into the CDOs — making them more likely to fail. Then Magnetar bought credit default swaps on the debt issued by the CDOs. If the CDOs collapsed, as many did, their equity would become worthless, but their credit default swaps on the debt would repay them many, many times over.

The key is that Magnetar was exploiting the flaws in Wall Street’s process for manufacturing CDOs. Because the banks made up-front fees for creating CDOs, the actual human beings making the decisions did not particularly care if the CDOs collapsed — they just wanted Magnetar’s money to make the CDOs possible. (No one to buy the highly risky equity, no CDO.) Because the ratings agencies’ models did not particularly discriminate between the contents that went into the CDOs (see pages 169-71 of The Big Short, for example), Magnetar and the banks could stuff them with the most toxic inputs possible to make them more likely to fail.

Now, one question you should be asking yourself is, how is this even arithmetically possible? How is it possible that a CDO can have so little equity that you can buy credit default swaps on the debt at a low enough price to make a killing when the thing collapses? You would think that: (a) in order to sell the bonds at all, there would have to be more equity to protect the debt; and (b) the credit default swaps would have been expensive enough to eat up the profits on the deal. Remember, this is 2006, when several hedge funds were shorting CDOs and many investment banks were looking for protection for their CDO portfolios.

The answer is that nothing was being priced efficiently. The CDO debt was being priced according to the rating agencies’ models, which weren’t even looking at sufficiently detailed data. And the credit default swaps were underpriced because they allowed banks to create new synthetic CDOs, which were another source of profits. So here’s the first lesson: the idea that markets result in efficient prices was, in this case, hogwash.

By taking advantage of these inefficiencies, Magnetar made the Wall Street banks look like chumps. This American Life talks about one deal where Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.

But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan’s bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet. Here’s the second lesson: the idea that bankers’ pay is based on their performance is also hogwash. (The idea that their pay is based on their net contribution to society is even more absurd.)

So who’s to blame? The first instinct is to get mad at Magnetar. But this overlooks a Wall Street maxim cited by TAL: you can’t blame the predator for eating the prey. Magnetar was out to make money for its limited partners; if it had bet wrong and lost money, no one would have bailed it out. Although I probably wouldn’t have behaved the same way under the circumstances, I have no problem with Magnetar.

I do have a problem with the Wall Street bankers in this story, however. Because losing $880 million of your own company’s money to make a quick buck for yourself is either incompetent or just wrong. And allowing Magnetar to create CDOs that are as toxic as possible — and then actively selling their debt to investors (that’s where the banks differ from Magnetar, in my opinion) — is either incompetent or just wrong. But even so, I don’t think the frontline bankers are ultimately at fault. Maybe they were simply incompetent. Or maybe, they were knowingly exploiting the system to maximize their earnings — only in this case the system they were exploiting was their own banks’ screwed-up compensation policies, risk management “systems,” and ethical guidelines.

In which case the real blame belongs to those who created that system and made it possible. And that would be the bank executives who failed at managing compensation, risk, or ethics, endangering or killing their companies in the process. And that would be the regulators and politicians who allowed these no-money down no-doc negative-amortization loans to be made in the first place; who allowed investment banks to sell whatever they wanted to investors, with no requirements or duties whatsoever; who allowed banks to outsource their capital requirements to rating agencies, giving them an incentive to hold mis-rated securities; who declined to regulate the credit default swaps that Magnetar used to amass its short positions; who allowed banks like Citigroup and JPMorgan Chase to get into this game with federally insured money; and who failed at monitoring the safety and soundness of the banks playing the game.

The lessons of Magnetar are the basic lessons of the financial crisis. Unregulated financial markets do not necessarily provide efficient prices or the optimal allocation of capital. The winners are not necessarily those who provide the most benefit to their clients or to society, but those who figure out how to exploit the rules of the game to their advantage. The crisis happened because the banks wanted unregulated financial markets and went out and got them — only it turned out they were not as smart as they thought they were and blew themselves up. It was not an innocent accident."