Not all the smart money was dumb

One of the biggest mysteries — to me, at least — of the recent financial meltdown is how few “smart” money managers bet against the housing market, even though house prices had skyrocketed “thanks” to if-you-can-breathe-you-get-a-0%-down-mortgage lending standards and the Fed’s cheap money. Michael Lewis and others have chronicled a handful of investors who made a fortune betting against housing, but most of the “smart” Wall Street firms apparently suffered large losses from their net-long positions on mortgages.

Well, a bit of my mystery has been resolved by this article detailing how top executives at Goldman Sachs decided in late 2006 to force their mortgage business to take a net-short position. The executives became remarkably involved in their mortgage business, asking tons of questions and forcing their mortgage traders to sell off large mortgage holdings and buy bets (mortgage credit default swaps) that would pay off if housing nosedived.

Perhaps the most interesting aspect of this story is that some of Goldman’s top mortgage portfolio managers — who should have been frightened by rampant mortgage lending fraud — instead failed to see the obvious, believing home prices would never drop. Nevertheless, Goldman-the-organization overruled some of its top mortgage managers.

Perhaps those too close to the action can’t see the forest for the trees. And many in the mortgage business had become so drunk making money on mortgages that they couldn’t take the punch bowl away from themselves. Many firms that should and could have predicted this housing crisis lacked Goldman’s strong organizational culture, strong leadership, and access to information — esp. knowledge that huge hedge funds were working with Goldman to place massive bets against the housing market. All the smart people at Goldman banging heads and arguing over the data made an informed collective decision. Other firms instead continued with business-as-usual because doing so is easy.

Posted by James on Monday, April 19, 2010