Who Spent the Money?

New subdivision, upstate New York. From City-Data.com.

In the fall of 2007, after two Bear Stearns-owned hedge funds trading in subprime debt suddenly went bankrupt, I sat down with a friend of a friend who worked in finance to see if he could explain it to me. That conversation became the first in a series, which we began publishing at n+1. The conversations continued through the crisis and after, following the trajectory of one financier facing the hardest days he’d yet seen. This week HarperPerennial is publishing Diary of a Very Bad Year, the book that resulted from those conversations. We hope it’s a valuable contribution to the growing literature on the crisis. All this week on the site we’ll be featuring excerpts and outtakes from the book. —Keith Gessen

n+1: When you were talking about misallocation of resources, right, what you were really talking about was that somebody was given money to do something that didn’t need to be done. . .

HFM: Exactly. Some very smart, intelligent people, very intelligent physicists spent their time creating mortgage-backed securities to fool S&P into giving them a rating that they shouldn’t have given them. That’s one example. Another example is a Mexican, a rural Mexican, swam across the Rio Grande to hammer together houses in the exurbs of Arizona that no one is ever going to occupy.

n+1: But somebody . . . money changed hands. And the people who got that money–the misallocatees, say–well, they get to keep it.

HFM: Ah, yes, but here’s the question. Who paid that Mexican guy to hammer together those houses? Well, the developer. Where did the developer get the money from? The developer got the money from a bank. Where did the bank get the money from? The bank got the money from a depositor. The depositor doesn’t think he spent the money. The depositor still thinks he has a claim on the money, right? The problem is that what underlies that claim is an empty, uninhabited, uninhabitable house in Arizona. That’s what I mean by allocating the losses. There’s a loss there; the depositor doesn’t know that he’s lost yet.

n+1: But he lost that money to someone. What I’m saying is, somebody has that money.

HFM: Yeah, the Mexican guy who hammered the house; he sent it back to his family in Mexico.

n+1: You’re saying the Mexican guy has the money? Surely the developer has some of the money?

HFM: No! The developer spent it all developing these houses! The developer’s bust too.

n+1: You’re saying the Mexican guy spent all the money? That doesn’t make sense.

HFM: He spent it on himself, or he sent it to his family, and his family bought stuff they wouldn’t have been able to afford otherwise.

n+1: Billions of dollars? You’re saying the Mexican guy took billions of dollars?

HFM: Well a billion Mexicans…not one Mexican guy! How about all the mortgage brokers who were brokering these mortgages that didn’t make any sense? They all got paid, right?

n+1: Right, those guys! So it’s not just…

HFM: No! Anybody who worked in sectors where there was a tremendous amount of activity where there shouldn’t have been. So we’re talking about housing: It means the Mexican guy who hammered together the house. It means the logger who cut down the wood that was used in the structural lumber. The guy who worked at the saw mill. It means the steel company that created the steel for the nails. It means the mortgage broker who sold the mortgage. It means the physicists who decided instead of doing physics they should work on Wall Street to create the asset-backed security that helped to fund the mortgages that the mortgage broker was originating. All of these people were doing things that turned out not to be productive.

The loser was whoever turned out to be the investor at the end of the chain. So there’s a loss that needs to be allocated. That’s backward-looking. On a forward-looking basis, now we all know there shouldn’t be 50 zillion mortgage brokers, right? There shouldn’t be 50 zillion people working on this stuff. What do you do with those people now? They need to find, we need to, the economy needs to find another use for them. These pay scales will shift, and those people will be moved to their highest and best use, right? But the dynamics are very tricky because these are quantities in a–ultimately people are not quantities in an equation–but it’s difficult for that mortgage broker to find the right job for himself. Maybe he needs to move across the country? All of that is a slow process. And a costly process. And a difficult and disruptive process.

n+1: Well, but and also I mean there might not be jobs for those people.

HFM: At some price there’ll be jobs for those people. If you have perfectly flexible prices, there will be a clearing price for the labor of people with various skill sets. But yes, they overinvested in skills that maybe aren’t worth that much. So if you really know a lot about mortgage brokering, that may be worth nothing. Maybe the only thing you have to offer is the strength of your back when you’re moving boxes. And that is a very painful adjustment for somebody to make. I mean let’s just say that we have a class of people who were very highly paid to be witch doctors, and then tomorrow Western medicine comes to the economy, and everybody realizes that witch doctors . . . it’s much better to take pills than go to the witch doctors. Well these witch doctors had some very specific knowledge that was worth a lot but now is worth nothing. But there’s some use for them, right? They can become manual laborers. That’s a very difficult transition. They’re not just going to accept that right off the bat, that witch doctor skills are worthless and the price of their labor has gone from very high to practically nothing.

n+1: But what I’m saying is, the witch doctors were making a lot of money during this period, and they got to keep that money. Whereas I, me, I didn’t make any money. And now they’ve ruined the economy and I might never make any money.

HFM: Ah, right, and your point is we should try to get that money back from them?

n+1: I don’t know. No . . .

HFM: They don’t have it. They spent it.

n+1: No! They couldn’t spend all of it.

HFM: The mortgage brokers probably spent all of their money. The mortgage-backed securities structurers maybe didn’t spend all of their money. But when you have an economy where contracts can be rewritten and you can go back and try to claw back money from people years after the fact, that’s going to be tremendously destabilizing and it’s going to really disincentivize investment in human capital. And it’s going to incentivize people to work in the gray economy. I think the answer is, you need to contract, for some of these jobs, jobs like in the investment business, going forth contractually, we should make it easier, we should create compensation arrangements where there are claw backs. But you have to do that by agreement and in advance. You can’t reopen contractual arrangements years after the fact. At least not without some strong indications of knowing fraud.

n+1: Actually, the people who made a lot of money were the people on Wall Street, right?

HFM: Well the physicists who…

n+1: Not the physicists! The brokers of this stuff…the sellers of these securities…

HFM: Those people made a lot of money, sure.

n+1: OK, those are the people!

HFM: Well, I mean, it’s one of the things we talked about…that profits and pay, the fraction of profits and pay in the economy that accrued in the financial sector had gone up a lot. And that’s going to go back down.

n+1: And this goes to a bigger problem. We also talked about these bubbles, right? That they happen and happen, like a wave–it goes from one sector to another sector to a third sector. And then we’ve had this long bubble in the financial sector–isn’t it possible simply that there was no other place to make money, there was no other place for growth. That people have all the stuff that they need?

HFM: Well, look, this is one of the axioms of economics, tha
t people have unlimited wants and limited resources. Personally, I feel like I have enough stuff–it’s painful for me when I get a gift. The idea that I have to put it somewhere is painful for me. But then I think if you look at a broad swath of the population of the US and then if you think about poorer countries and people, there’s much more that they want. People will always find new things to want.

n+1: But you don’t think this is a real, systemic problem we’ve run into, finally?

HFM: Is it new? Here’s what I believe. I believe when you’re looking at economies, because I do emerging economies, this is a pretty important part of emerging economies. You have to be epistemologically modest. Let me give you a sort of analogy–when emerging markets were doing well, say in 2005 to 2006, people were saying: “Emerging economies, they’ve emerged. They’ve figured out the institutions that are required for sustainable growth.”

But Latin America, practically from the time Europeans came to the Western hemisphere–or very shortly thereafter–North America actually diverged from Latin America. There wasn’t convergence, there was continued divergence. What are the odds that it just so happens that the day I show up, that the few year period that I’ve shown up in the financial markets, that this multi-hundred year process has suddenly and sustainably reversed? I mean, you have to be incredibly epistemologically immodest to think that. By the same token, we have, you know, ten thousand years of human history where people are always wanting more, making more, and getting more. What’s the probability that it just so happens that you and I have been born into the generation where we finally run out of wants? I just think it’s impossible Maybe we’re that special–I dream of being special in some way, but I think I’m just another human involved in a very long chain that stretches far back into the past and will stretch far forward into the future, of human beings that have the same intellectual equipment and tend to behave in similar ways.

n+1: You know, we haven’t had capitalism for ten thousand years.

HFM: But we’ve had property for ten thousand years. We’ve had monetary exchange for ten thousand years. We haven’t had advanced capitalism, but people have always striven to get more and in general the trend has been for a higher level of consumption. There’ve been periods of setback, but the long trend is very clear. I think it’s very unlikely that we’ve suddenly hit our limit, that we can’t come up with more needs, and therefore we’re at crisis because we can’t grow anymore. Ultimately the thing where we might be heading into a change that is challenging to our economies is if, in the advanced economies, we see the end of population growth. And we are seeing some countries where there has been a very important pivot, countries going into long and sustained population shrinkage for reasons not related to war, reasons related to reproductive choices. And it’s not clear whether, I take your point that it’s not clear whether our brand of capitalism, call it our political economy, capitalism plus the welfare state, can be easily sustained in this era of shrinking population. But that’s a much bigger question, and I think it’s different from the one you asked.

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