Over Optimized

I was reading this article on Slate.com about a number of subprime mortgage holders who are weathering the financial storm just fine. They have delinquency rates of around 3% in an area of finance where the national average is closer to 19%.

How is this possible?

The explanation that stuck with me came from Mark Pinsky, president and CEO of of the Opportunity Finance Network. “We have to be profitable, just not profit-maximizing.”

What sets the “good” subprime lenders apart is that they never bought into all the perverse incentives and “innovations” of the bad subprime lending system—the fees paid to mortgage brokers, the fancy offices, and the reliance on securitization. Like a bunch of present-day George Baileys, ethical subprime lenders evaluate applications carefully, don’t pay brokers big fees to rope customers into high-interest loans, and mostly hold onto the loans they make rather than reselling them. They focus less on quantity than on quality.

And in a world where Neil Cavuto is saying that “loaning to minorities and risky folks is a disaster,” minorities with tiny savings accounts are being served and are paying back their debts. The profits for these companies weren’t as high as they were for the big lenders (one CEO earns a “mere” $190,000/yr), but on the other hand, they are still running.

Compare this to the story that Nassim Nicholas Taleb tells about the wider financial markets (skip to 4:20). “We don’t have slack, it’s over-optimized.”

I keep thinking about the impending extinction of the Cavendish Banana a worldwide mono-culture that was propelled to the #1 spot when the previous favourite, the Gros Michel Banana was wiped out, also by disease. And of the injuries (careful about clicking that link) sustained by Super-G skiers when their highly optimized gear turns against them during a crash. And of Koalas which have evolved to eat a tree no one else eats and who will die off when the trees do.

Then I think about apples which come in a variety of types, casual skiers who make it to the bottom of the hill eventually and raccoons who will eat just about anything. These are all generalists that manage to thrive in a variety of areas, and seem to be pretty good at adapting to massive changes to their environments.

We’re in the midst of the 6th mass extinction in earth’s history and it’s the specialists, with their highly optimized, fragile ecological niches that are going to go first. Cockroaches will still be here when it’s all over, I imagine.

The rule is clear. When things are stable, specialization and optimization is the recipe for success. When things are bumpy, allowing some of the inefficiency that comes from flexibility is probably the thing that will let you survive.

The mistake of the latest market crash seems to be that all the incentives and all the players were aligned to act as if the boom in housing prices was a stable situation that would last and last. You’d think that by now, the financial markets would have learned their lesson.