Gambling With Other People's Money

Gambling With Other People’s Money is a sensible, accessible, intuitively appealing treatise from Russell Roberts on the financial collapse. It centers on the incentives and behaviors of those involved, not on the financial instruments they used.

Short version: if you have the idea that the government will bail you out when you are about to lose, you feel safer being reckless. You are even more reckless when you get to keep all the upside, and lose nothing on the downside, because someone else bails you out when you lose. The gains are private, and the losses are public. This, combined with bad regulation and other bad incentives, shows Washington and Wall Street to be tightly intertwined; they are together the fox, and we the people are the chickens in the henhouse. We taxpayers are the ones who pay for the bailout, a huge transfer of wealth to the already-wealthy bailed-out lenders.

Following are many excerpts that I found especially good. The entire conclusion “Where Do We Go From Here?” in particular is excellent, and defies excerpting.

Until we recognize the pernicious incentives created by the persistent rescue of creditors, no regulatory reform is likely to succeed.

Capitalism is a profit and loss system. The profits encourage risk taking. The losses encourage prudence. Eliminate losses or even raise the chance that there will be no losses and you get less prudence. So when public decisions reduce losses, it isn’t surprising that people are more reckless.

Only at the very end, when collapse was imminent and there was doubt about whether Uncle Sam would really come to the rescue, did the players at the table find it hard to borrow and gamble with other people’s money.

Did this history of government rescuing creditors and lenders encourage the recklessness of the lenders who financed the bad bets that led to the financial crisis of 2008?

For the GSEs’ creditors, the answer is almost certainly yes. Fannie Mae and Freddie Mac’s counterparties expected the U.S. government to stand behind Fannie and Freddie, which of course it ultimately did. This belief allowed Fannie and Freddie to borrow at rates near those of the Treasury.

Why didn’t lenders to Fannie and Freddie require a bigger premium as Fannie and Freddie took on more risk?

The answer is that they saw lending to the GSEs as no riskier than lending money to the U.S. government. Not quite the same, of course. GSEs do not have quite the same credit risk as the U.S. government. There was a chance that the government would let Fannie or Freddie go bankrupt. That’s why the premium rose in 2007, but even then, it was still under 1 percent through September 2008.

But the owners’ salaries were ultimately coming out of the pockets of taxpayers. What the owners were doing was borrowing money to finance their salaries, money that the taxpayers guaranteed. When the S&Ls failed, the depositors got their money back, and the owners had their salaries: The taxpayers were the only losers.

This kind of looting and corruption of incentives is only possible when you can borrow to finance highly leveraged positions. This in turn is only possible if lenders and bondholders are fools--or if they are very smart and are willing to finance highly leveraged bets because they anticipate government rescue.

The standard explanations for the meltdown on Wall Street are that executives were overconfident. Or they believed their models that assumed Gaussian distributions of risk when the distributions actually had fat tails. Or they believed the ratings agencies. Or they believed that housing prices couldn’t fall. Or they believed some permutation of these many explanations.

These explanations all have some truth in them. But the undeniable fact is that these allegedly myopic and overconfident people didn’t endure any economic hardship because of their decisions. The executives never paid the price. Market forces didn’t punish them, because the expectation of future rescue inhibited market forces. The “loser” lenders became fabulously rich by having enormous amounts of leverage, leverage often provided by another lender, implicitly backed with taxpayer money that did in fact ultimately take care of the lenders.

Bad regulation and an expectation of creditor rescue worked together to destroy the housing market.

The buyer of a house who puts 3 percent down and borrows the rest is like the poker player. Being able to buy a house with only 3 percent down, or ideally even less, is a wonderful opportunity for the buyer to make a highly leveraged investment. With little skin in the game, the buyer is willing to take on a lot more risk when buying a house than if he had to put up 20 percent. And for many potential homebuyers, a low down payment is the only way to sit at the table at all.

The second reason is that you will be very comfortable lending the money if you know you can sell the loan to someone else. Who is that someone? Between 1998 and 2003, just when the price of houses really started to take off (see figure 2), the most frequent buyers of loans were the GSEs Fannie Mae and Freddie Mac.

Fannie and Freddie bought those loans with borrowed money. Fannie and Freddie were able to borrow the money because lenders were confident that Uncle Sam stood behind Fannie and Freddie.

But Fannie and Freddie (created in 1970) were not the textbook creations of economists. At some point, Fannie and Freddie stopped acting like models in a textbook and became something more than conduits. Politicians realized that steering Fannie and Freddie’s activities produced political benefits. And Fannie and Freddie found it profitable to be steered.

The politicians told Fannie and Freddie to be a little more flexible with their guidelines. As a result, more people got to own houses and the politicians got to take the credit without having to raise taxes or take away any politically provided goodies from anyone else.

Fannie and Freddie’s increases in loan purchases, especially loans to low-income borrowers, helped inflate the housing bubble. That bubble in turn made the subprime market more attractive and profitable to lenders. It also set the stage for the collapse. Housing policy interacting with the potential for creditor rescue pushed up housing prices artificially. When it all fell apart, the taxpayer paid (and is still paying) the bill.

With the encouragement of politicians from both parties, Fannie and Freddie relaxed their underwriting standards, the requirements they placed on originators before they would buy a loan. They called it being more “flexible.”

When the government implicitly backed Fannie and Freddie, it severed the usual feedback loops of a market system.

Consider an investing odd couple: the Chinese government on the one hand and my father, a cautious investor in his 70s, on the other. Both invested in Fannie and Freddie bonds because they paid more interest than Treasuries and were probably just as safe. They weren’t paying attention to what was going on with Fannie and Freddie’s portfolio of loans because they didn’t need to. They counted on the implicit guarantee. It was a free lunch for my father and the Chinese--a good return without any risk.

The availability of piggyback loans and federal and state programs to help people buy houses with no money down did much to create homeowners with little or no home equity, the proximate cause of the crisis.

For those who accept this narrative, the subprime collapse is a lesson in hubris, greed, and myopia--irrational exuberance run wild. The investment bankers believed their risk models that said that the AAA portions of mortgage-backed securities were safer than safe--and that the risk of bankruptcy was therefore very small.80 This failure of imagination, this failure to appreciate the real odds of a housing collapse, explains part of the enthusiasm investors had for an asset that was appreciating year after year.

One problem with this explanation is that many practitioners were surely aware of the shortcomings of their models. Consider Riccardo Rebonato, the chief risk officer of the Royal Bank of Scotland (RBS). In his thoughtful book, The Plight of the Fortune Tellers, written before the crisis, he argues that the standard measures of risk, such as value at risk, were not as reliable as they seemed and that the whole enterprise of risk management is less scientific than it appears.81 I presume that Rebonato knew that RBS was on thin ice as it expanded its purchases of mortgage-backed securities. Shortly after Rebonato’s book was published, the Bank of England took over RBS because of the collapse in the value of RBS’s investments. I suspect Rebonato warned his bosses plenty about the risks they were taking. They either viewed the situation differently or their incentives reduced the appeal of prudence.

When everyone is picking up nickels in front of the steamroller, the odds of a complete rescue are higher. So when a bunch of firms got flattened, Uncle Sam came to the rescue and used taxpayer money to cover the hospital bills.

As in the Fannie and Freddie story, the firms aren’t the real financers of the salaries associated with picking up nickels. The taxpayers ultimately fund picking up of nickels, and the taxpayers get flattened.

But as I have shown, the key players weren’t reckless with their own money. They made sure to invest it elsewhere. When it was their own money, they picked up quarters rather than nickels in markets that were relatively free from steamrollers. And they made sure that regulations that might have restrained their ability to exploit the system (looser capital requirements) were relaxed, so they could effectively use taxpayer money instead of their own to fund the risky investments.

An unpleasant but unavoidable conclusion of this paper is that Wall Street was (and remains) a giant government-sanctioned Ponzi scheme. Homebuyers borrowed money from lenders who got their money from Fannie Mae, Freddie Mac, and banks that borrowed money from investors who expected to be reimbursed by the politicians who took that money from taxpayers. Almost everyone made money from this deal except the group left holding the bag--the taxpayers. There is an old saying in poker: If you don’t know who the sucker is at the table, it’s probably you. We are the suckers. And most of us didn’t even know we were sitting at the table.