A CDO manager finds himself living in Chapter 12 of Keynes’ General Theory

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Barry Ritholtz reprints a scary e-mail from a friend in the collaterized debt obligation business (don’t you have a friend in the CDO business?):

I was talking to CDO managers in mid-’05 that were saying how rich sub-prime MBS was and how wrong everyone was for buying that stuff at the spreads they were. To a man, they all agreed they were paying too much for the risk, they all believed that HPA [ED: home price appreciation] was going negative soon. But, sadly, they had to buy the stuff because they needed to accumulate collateral for their CDO issuance. F*&%, we all knew we were overpaying, even back in 2005. We knew it was essentially a bet that home price appreciation was going to continue at levels that couldn’t be sustained. No way that could keep going on.

So why did they keep buying?


This is an important element of what’s called the “limits of arbitrage” (Andrei Shleifer and Robert Vishny, Journal of Finance, March 1997) or “career risk” (Jeremy Grantham, in various investor letters) explanation for why markets get so crazy sometimes. Brad DeLong has pushed this argument lately in his blog, and I’d like to second his endorsement: The smart professionals we rely on to keep market prices sane (or “efficient”) sometimes face career incentives that make it almost impossible for them to act on their own rational judgments. The most famous and eloquent account of this can be found in Chapter 12 of John Maynard Keynes’s General Theory of Employment, Interest and Money:
