iang surveyed the events that conspired to our present ever mounting economic problems. Interestingly enough Charlie Munger identified much the same themes (not all the particulars) way back in Wesco Financial's 1990 letter
Granting the presence of perverse incentives, what are the operating mechanics that cause widespread bad loans (where the higher interest rates do not adequately cover increased risk of loss) under our present system? After all, the bad lending, while it has a surface plausibility to bankers under cost pressure, is, by definition, not rational, at least for the lending banks and the wider civilization. How then does bad lending occur so often?
It occurs (partly) because there are predictable irrationalities among people as social animals. It is now pretty clear (in experimental social psychology) that people on the horns of a dilemma, which is where our system has placed our bankers, are extra likely to react unwisely to the example of other peoples' conduct, now widely called "social proof". So, once some banker has apparently (but not really) solved his cost-pressure problem by unwise lending, a considerable amount of imitative "crowd folly", relying on the "social proof", is the natural consequence. Additional massive irrational lending is caused by "reinforcement" of foolish behavior, caused by unwise accounting convention in a manner discussed later in this letter. It is hard to be wise when the messages which drive you are wrong messages provided by a mal-designed system.
In chemistry, if you mix items that explode in combination, you always get in trouble until you learn not to allow the mixture. So also, in the American banking system.
So Munger identified this volatile combination about 17 years ago at least. In the same letter Warren Buffett added:
A few small sections of Mr. Munger's letter have been excluded: When Berkshire's report exceeds 72 pages, we have problems in binding it. Because of this limitation, either Charlie's letter or mine had to be cut and I decided a coin flip was appropriate. In fact - as things turned out - I finally decided nine flips were appropriate. -- W.E.B.
Only thing I would (and did) add to iang's post is that historically speaking when things are looking bad is when deals are found. Jason Zweig (channeling Ben Graham)
"Could things possibly get worse? I don't know, but I am an optimist -- so I certainly hope things do get worse. Nothing else should satisfy an intelligent investor."
I think there is something important to bear in mind in all the above ... in order to make sense of it. And this is:
banks are no longer in banking.
More on the blog :)
Posted by: Iang (banks not in banking :) | July 16, 2008 at 11:37 AM