In the interesting exchange between Will Wilkinson and Matt Steinglass on Democracy in America, Matt writes

Through the 1990s and early 2000s,Congress progressively raised targets it set for the GSEs to securitise loans coming from low-income neighborhoods. To the extent that I understand what Mr. Rajan is talking about, I think he may be talking about this. Mr. Jaffee argues that it wasn’t relevant, because the GSEs tended to ignore Congress’s targets, and when they did meet them it was because everyone in the world, including private securitisers, were falling over each other to buy up subprime loans, since everyone had convinced themselves they’d be profitable.

This is where everyone goes wrong.

It wasn’t that everyone had convinced themselves that subprime would be profitable. Subprime WAS massively profitable. There were subsequent losses for those who, unlike Goldman, didn’t jump ship in time. But, make no mistake, plenty of people made bank off of subprime.

Here is Lehman Stock Chart

Subprime securitization began around 2002 and took off after 2004. Lehman stock went right along with it.

People get confused here when they try to think about concepts like “fundamental value.” I will remind you again Saks Fifth Avenue does not accept fundamental value as payment. You will not be dining at the Ritz if you attempt to pay with value added. They do, however, accept cash or cash equivalents.

You do not become rich by creating fundamental value. You become rich by having a lot of cash. If you don’t get that, you completely miss the incentive structure that actually runs the world.

Sometimes, yes it is the case that there is a one-to-one correspondence between fundamental value and cash. Often, the relationship is something less than one-to-one and occasionally its inverted. However, whatever the relationship is, a rational agent will seek cash, not fundamental value – cash.

The simple fact of the matter is that people who were massively into subprime in 2002 made lots and lots of cash. You don’t need the government to explain the attraction there.

The question there is: why did they make so much money when what they were selling was junk? I argue that no one knew for sure that it was junk. I say this as someone who at the time thought it was junk but sure as shit wasn’t going to risk my life savings betting against it.


Because I didn’t KNOW it was junk. There were a lot smart guys with very sophisticated arguments that it wasn’t junk. And, they were making money.

I even said at the time that when you – as in me – argue year-after-year that a strategy can’t be profitable and year-after-year people keep making profit there is a point where you have to say to yourself: maybe there is something I just don’t get about this.

That’s where I was in late 2006, early 2007. Now soon after the tide turned and things went bad. However, I just don’t buy it from anyone who says that the run-up wasn’t pure yield chasing and that it didn’t work extremely well until the whole house of cards came down.

Incidentally, perhaps others will tell you differently, but I got the impression from the debates that I was in, that individuals who were pushing structured products really and truly believed that the world had changed.  They weren’t just running a pump-and-dump. As is evidenced by the fact that they bought a lot of the stuff themselves.

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