Financial crisis background and Munger on the banks

Charlie Munger is the long-time partner of Warren Buffet. Of the two, he’s the more politically conservative. Their company, Berkshire Hathaway, has recently bought big stakes in several of the better-off investment banks.

Recently, Munger sharply criticized the management of the investment banks, saying they’ve grown too politically powerful. The key quote:

“We need to remove from the investment banking and the commercial banking industries a lot of the practices and prerogatives that they have so lovingly possessed,” Munger said. “If they are too big to fail, they are too big to be allowed to be as gamey and venal as they’ve been -- and as stupid as they’ve been.” (Bloomberg.com, via Baseline Scenario.)

What does the bankers’ stupidity have to do with the usual themes of this blog? Well, much of the crisis comes down to bad probability calculations: the big banks have been treating highly correlated events as though they were independent events.

Some good background material on the crisis:

A neat visual metaphor for CDOs: Filling a tower of champagne glasses.
Khan Academy videos on the financial crisis (middle column, halfway down).
A confession by the programmer who wrote the software that encouraged this whole mess.

Steven Shaw wrote on May 05, 2009:

Some neat references. The Khan Academy is good stuff. I recognise that you needed to bring this back to a programming topic and hence the conclusion that "bad probability calculations" were the cause of much of the crisis. I'd love to hear what you reckon the rest of the crisis is down to. In a search for a root cause, I would say that the "bad probability calculations" were just an effect. I would recommend the interested to take a look at the Bailout Reader from the Mises Institute.

Eric wrote on May 05, 2009:

Yeah, the Khan academy has all sorts of cool videos on math, physics and economics. If I had to take a guess, there were several factors driving the bad math: 1. Investment bankers receive enormous bonuses based on their short-term performance. So they have a huge incentive to gamble with the firm's money: Heads, they earn tens of millions of dollars; tails, they might get fired. 2. Even if the bankers do fail horribly, the government won't actually let them go bankrupt. So again, the incentive is to place big, risky bets, and offload the downside onto Uncle Sucker. 3. The regulatory agencies have been completely captured by the banks. As people keep pointing out, the Treasury looks like a branch of Goldman Sachs. So there's no external regulator to discourage high-stakes gambling. 4. Thanks to multiple layers of securitization and the software that I mentioned above, I'm not sure that anybody understands the risks. And if anybody does understand the risks, they have no reason to care. 4. During any long-lasting bubble, the most highly-leveraged investors will eventually out-compete more responsible investors. So we're looking at a cocktail of bad incentives, no accountability, and moral hazards. Really, it's no wonder that people got sloppy about probability. As for your links, I'm not sure that the Austrian school has the best theoretical models for this particular kind of economic mess. Liquidity traps are weird, and the usual rules don't always apply.

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