Today in Economists are NOT Totally Clueless (Interlude 2; Part 4 of 5)
Note: I planned to finish this here, but the post became far too long, and splits quite well. What follows is applications of economic theory and background material on financial decisions.
To be clear, I hate the phrase “casino capitalism.” It’s rather unfair to casinos, which know how to do risk management: make an offer that is close to fair, enough to cover your expenses, and offer non-monetary benefits (inexpensive food, table-service drinks, floor shows, etc.) so that even the losers enjoy the experience. Unless you forget that Atlantic City is a dreary place in the Winter, it’s a license to print money. Capitalism, on the other hand, thrives because people have a dollar, a dream, and the inability to calculate odds correctly. (This is a good thing—at its worst, it leads to more frictional unemployment as those dreams fade or are restructured.)
But “casino capitalism” is good for presenting an example. Consider the following scenario: you and I go to Atlantic City, each with $190. We also have a Mysterious Benefactor, who offers us the following: “You must each make 19 bets of $10. If you will play only Red or Black, I will make you whole for the $10 for any time the wheel produces 0 or 00. If you make any other bet (a specific number, for instance), you win or lose your bet as the wheel results. I do not care if you both bet the same color, or only one of you bets in a round. My offer covers your first 38 bets.”
Ex ante, the expectation should be that each of us will go home with $190, while our Mysterious Benefactor will be $20 poorer. This is because
- It would be irrational to play anything other than Red or Black
- For each spin, there are 18 chances of Red, 18 chances of Black, and 2 chances of green (0 and 00). So if I play Red every time and you play Black every time, one of us should win 36 of 38—or 18 out of 19—times, with the other(s) covered in full by our Mysterious Benefactor.
- In any other scenario, the odds favor the house. (Any individual number pays 36:1, but there is only a 1 in 38 chance of being correct.) Therefore, our Expected performance would be to lose money. (Or, slightly more accurately, to trade some money for the pleasure [“utility”] we receive from “gambling.”)
All of the above, of course, assumes we have agreed to pool our winnings, and that we hold to the agreement. (If you want to simplify the exercise, assume that only one person has $380 and a Mysterious Benefactor offering the same terms. For the following, I’ll use the simplified example and “you.”)
But ex ante is not ex poste, and reasonable plans at the beginning may be altered as time goes by and “randomness” affects the model.
For instance, assume you have made 37 of the 38 bets and your current result is that you are up $50. Do you follow the pattern, or do you perhaps make a larger wager—say $40, knowing that your worst result now is better than your Expected result at the beginning?
Consider the same scenario, but that you are down $50. Your best case following the pattern is to win and be down $40; your worst would be to lose and be down $60. Do you continue to follow the “rational” path, or take a chance on the last roll, knowing that any other action destines you to a lower-than-Expected result?
As The Boss once sang, “Down here it’s just winners and losers/And don’t get caught on the wrong side of that line.” In a situation where there has been a long winning streak—or a long losing streak—the actions may blur enough that you cannot tell the difference between the two.
For years, Fannie, Freddie, and the FHA stayed out of the exotic mortgages market. Their payoff was that their risk was manageable, but their market share declined. As a government-owned entity, FHA’s abstinence was both prudent and within its mandate. As Government-Sponsored but Private Entities, Fannie and Freddie had an obligation to their shareholders that was antithetical to their original purpose. Under Daniel “Son of Roger, Acts like Harry” Mudd, Fannie expanded their actions into exotic mortgages, stoking a fire that might well have dimmed, if not gone out, for another 18 to 24 months.
The infection had moved from the skin into the system. There is good reason that the opening chapter of John Quiggin’s forthcoming book discusses the religion of privatization.
Led by cheerleaders such as David Malpass, the houses-are-a-liquid-asset crowd came to dominant the discourse, even as and—thanks to Mudd and his FHLMC peer—well after Dean Baker sold his condo.
Who were the winners? The people who had always acted as if they were casinos: the investment banks that gathered, packaged and securitized loans, taking their cut off the top and moving on to the next set. The servicers, who used the same type of business model—take a quarter (25 bp) or less off the top, and pass the rest through. The Investment Banks that played in the market, but were not dependent upon it, such as Goldman Sachs and Morgan Stanley, and, to a lesser extent, Merrill Lynch. And the speculators who had flipped houses throughout the upturn (though some of them didn’t stop soon enough, or bet too much on that last roll).
The losers were the people left holding the securities when the music stopped. Your pension fund, for instance. Or originators such as IndyMac or WaMu, whose business model ceased to work. And the investment banks with high fixed costs in mortgage-related areas, the two most prominent of which happened to be Lehmann Brothers and Bear Stearns.
By all reports, the securitization bubble burst at Hallowe’en of 2006. I’m told the desert states—CA, AZ, NV—went to the well then and discovered that it was dry. That’s not the whole story, of course; someone cut off the flow, for reasons related or other. (The most reliable story I’ve heard is that Commercial and Investment Banks cut off credit lines to suppliers who were, in turn, sending them the product they securitized and sold. Which only brings the question back another step: why did they choose then to do it?)
This left deals in the pipeline, most especially at the firms that focused on the mortgage market. (At Bear, the flow did not die until January of 2007. By that time, the firm had acquired a couple of the originators, integrating the model.)
The effect was similar to the roulette example above. While people such as then Fed Governor William Poole were denying that the Greenspan Put would be used, the abiding belief in it served the role of the Mysterious Benefactor.
Firms that had “losing streaks” went quietly away, like hedge funds in the night. Firms that won tended to “let it ride,” increasing their investments in the area both in anticipation of future profits and as a way to keep their producers happy by making their job easier. (The MBS slice-and-dice system that Tom Marano had wanted five years before, and been promised by at least three different Line Managers, went live in December of 2006. Marano—who is no slouch and knows the mortgage market inside and out—failed up, and is now CEO of GMAC’s mortgage operations and their “chief capital markets executive.” GMAC, as I noted at Tom’s Place nearly three years ago, is a mortgage originator disguised as a car financing company. He’s both the right person for the job, and a sign that the job itself is likely impossible.)
They bet Black every time, and were right until they were wrong and it came up Very Red.
The cost is slowly becoming apparent, as even the denier-economists (including Hans-Werner Sinn, author of Casino Capitalism) are slowly realizing that the problem was never subprime (not large enough to damage the whole market, though certainly a contributor) but asset inflation in an unregulated environment combined with easy money and the associated low interest rates that made the true cost of a mortgage progressively less transparent.
The proof of that is, to some extent, in the timing. Look back at Ben Bernanke’s speech, and see the points at which the Federal Reserve finally starts addressing the issues: they talk in 2005—Alan Greenspan’s last year—begin hearings under Bernanke in 2006, and only take action in 2007. As capital requirements actually moved into place and some losses from the private paper issued four and five years earlier that began resetting—combining the full force of negative amortization with higher interest rates and stagnant-to-negative wages—the barn door was closed, with the cost of those horses that had escaped still not fully realized.
As I noted in Part 3 of this ramble, Economists like equilibrium. It’s when the bettors start amassing a “run of luck” that incentives get out of place.
The thing about equilibrium is that you don’t necessarily return to it just by declaring that a new set of bets can be placed. Sometimes, the house hasn’t been paid for all the bad bets. And until it has been, pretending a return to equilibrium doesn’t make it so.
Two points — both tangential.
1. One of the examples that Taleb uses in The Black Swan is that casinos have the formal wagering part of their business entirely under control and don’t/can’t lose money at the tables. The wagering actually follows models that they understand. He cites a casino whose four largest financial hits over the years were all due to things unrelated to gambling — e.g loss of entertainment income when a star performer was mauled by a tiger. Taleb would appear to agree with you 100% that the financial markets in no way shape or form resemble casino gambling. The casinos also put a great deal of effort into detecting cheaters. i.e. regulation of the wagering.
2. I assume that it’s true that GMAC is more a mortgage company than a car financer. However, my understanding is that the vehicle financing part of their operation really is quite important to GM and I believe Chrysler as well. Perhaps there is an argument here for using antitrust law to force separation of the two activities.
I think at the crux of the disaster was the fact that unregulated markets allowed, indeed encouraged, reckless bets since the winnings could be huge and the losses would be picked up by others. This combined with a tax regime that let the big better keep almost all their “winnings” made the wild betting too attractive to resist. The remedy (that is being ferociously resisted) would be drastic regulation PLUS much higher taxation on high incomes. These would make the betting difficult and the rewards from doing it much less.