Opinion

Edward Hadas

Madoff/subprime – spot the difference

Edward Hadas
Jan 15, 2014 15:36 UTC

Bernard Madoff still has some magic. The public finds anything connected to the fraudster’s case fascinating, from a prison interview to JPMorgan’s agreement last week to pay $2.3 billion for Madoff-related sins. And why not? Madoff was a grandmaster of the confidence trick. But there is more to it than that. His way of doing business was alarmingly close to the perfectly legal practices which brought down the financial system in 2008.

To see that, compare Madoff to a hypothetical pre-crisis hedge fund manager – one with a special interest in U.S. subprime residential mortgage securities. The common tale starts with a commitment to provide higher returns than the economy can safely offer to financial investors. Both Madoff and the hedgie took in funds without making any specific promises, but their investors’ expectations were lofty.

Madoff, of course, knew that he could not live up to those expectations. That makes him smarter than the hedgie, who was either foolish, if he thought American house prices would keep rising for many years; or arrogant, if he was confident that he could sell out before the losses hit.

Both Madoff and the hedgie relied on the inability of most investors to accept deep in their hearts that market skills very rarely produce portfolios that massively outperform the overall market and the economy for a long time. It is not surprising that almost no one at JPMorgan was bothered by the consistent 10.5 percent annual returns. A similar complacency about investment returns cost investors far more in subprime losses. Financial engineers got away with claims that subprime housing could be turned into financial assets that combined high rewards with low risks.

When trying to attract funds, Madoff and the fictional hedgie made similarly exaggerated claims about their strategic expertise. Madoff just lied. The hedgie had to put together the data in a way that helped them tell clients what they wanted to hear. But gullible investors are all too often looking for a story that calmer souls would consider too good to be true. They are willing to trust doubtful claims, whether Madoff’s new wrinkle in options strategy or the hedgie’s new paradigm of housing finance.

The knots of development

Edward Hadas
Feb 6, 2013 15:35 UTC

Why are so many poor countries stuck with huge economic problems? Why, for example, are there so many unemployed young people in Egypt – 41 percent of 19-24 year-olds? The poor state of British housing can help answer these questions. 

By developing world standards, the British housing system works quite well. In Egypt, it takes 77 bureaucratic procedures in 31 offices, and between six and 14 years, to get legal approval for construction of a new house, according to the 2012 doctoral dissertation of Abdel Hamid El Kafrawy of the University of Glasgow. The result: housing is in chronically short supply and 65 percent of the population live in unregistered and untaxed buildings. 

For a rich country, though, the UK does remarkably badly. Construction has been inadequate, at half the modest target rate set by the government in 2007. The relatively few new houses and apartments which are built are mostly relatively small – new American houses have almost three times as much floor space and new French houses have 45 percent more, according to a 2009 study by the British Commission for Architecture and the Built Environment. And rental and mortgage payments for these under-sized living quarters take a higher share of income in the UK than almost other developed country. 

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