Gambling with Other People's Money

How Perverse Incentives Caused the Financial Crisis

Russ Roberts

• Publisher: Hoover Institution Press
• Year: 2019
• Print ISBN:
  9780817921859
• Edition: 1
• eBook ISBN:
  9780817921866
• Topic: Economics
• Subtopic: Banks & Banking
• Index: Economics

Uncover the hidden causes of the 2008 Financial Crisis and how to prevent the next one. This book challenges conventional wisdom by arguing that government bailouts, not private sector greed, were the primary culprit. Explore how perverse incentives and moral hazard fueled reckless risk-taking in the financial system.

Russ Roberts exposes how past interventions distorted the market, leading to the crisis. Discover the roles of Fannie Mae, Freddie Mac, and other key players. Learn why regulatory reforms may fall short and what steps are truly needed to restore financial stability. This insightful analysis is for economists, financial professionals, and anyone seeking a deeper understanding of our economic system.

• Understand the perverse incentives that led to the crisis.
• Learn how government bailouts created moral hazard.
• Discover the role of Fannie Mae and Freddie Mac.
• Explore alternative solutions for financial stability.

 

1

Gambling with Other People’s Money

Imagine a superb poker player who asks you for a loan to finance his nightly poker playing.1 For every $100 he gambles, he’s willing to put up $3 of his own money. He wants you to lend him the rest. You will not get a stake in his winning. Instead, he’ll give you a fixed rate of interest on your $97 loan.

The poker player likes this situation for two reasons. First, it minimizes his downside risk. He can only lose $3. Second, borrowing has a great effect on his investment—it gets leveraged. If his $100 bet ends up yielding $103, he has made a lot more than 3 percent—in fact, he has doubled his money. His $3 investment is now worth $6.

But why would you, the lender, play this game? It’s a pretty risky game for you. Suppose your friend starts out with a stake of $10,000 for the night, putting up $300 himself and borrowing $9,700 from you. If he loses anything more than 3 percent on the night, he can’t make good on your loan.

Not to worry—your friend is an extremely skilled and prudent poker player who knows when to hold ’em and when to fold ’em. He may lose a hand or two because poker is a game of chance, but by the end of the night, he’s always ahead. He always makes good on his debts to you. He has never had a losing evening. As a creditor of the poker player, this is all you care about. As long as he can make good on his debt, you’re fine. You only care about one thing—that he stays solvent so that he can repay his loan and you get your money back.

But the gambler cares about two things. Sure, he too wants to stay solvent. Insolvency wipes out his investment, which is always unpleasant—it’s bad for his reputation and hurts his chances of being able to use leverage in the future. But the gambler doesn’t just care about avoiding the downside. He also cares about the upside. You as the lender don’t share in the upside—no matter how much money the gambler makes on his bets, you just get your promised amount of interest.

If there is a chance to win a lot of money, the gambler is willing to take a big risk. After all, his downside is small. He only has $3 at stake. To gain a really large pot of money, the gambler will take a chance on an inside straight.

As the lender of the bulk of his funds, you wouldn’t want the gambler to take that chance. You know that when the leverage ratio, the ratio of borrowed funds to personal assets, is 32–1, the gambler will take a lot more risk than you’d like. So you keep an eye on the gambler to make sure that he continues to be successful in his play.

But suppose the gambler becomes increasingly reckless. He begins to draw to an inside straight from time to time and pursue other high-risk strategies that require making very large bets that threaten his ability to make good on his promises to you. After all, it’s worth it to him. He’s not playing with very much of his own money. He is playing mostly with your money. How will you respond?

You might stop lending altogether, concerned that you will lose both your interest and your principal. Or you might look for ways to protect yourself. You might demand a higher rate of interest. You might ask the player to put up his own assets as collateral in case he is wiped out. You might impose a covenant that legally restricts the gambler’s behavior, barring him from drawing to an inside straight, for example.

These would be the natural responses of lenders and creditors when a borrower takes on increasing amounts of risk. But this poker game isn’t proceeding in a natural state. There’s another person in the room: Uncle Sam. Uncle Sam is off in the corner, keeping an eye on the game, making comments from time to time, and every once in a while, intervening in the game. He sets many of the rules that govern the play of the game. And sometimes he makes good on the debt of the players who borrow and go bust, taking care of the lenders. After all, Uncle Sam is loaded. He has access to funds that no one else has. He also likes to earn the affection of people by giving them money. Everyone in the room knows Uncle Sam is loaded, and everyone in the room knows there is a chance, perhaps a very good chance, that wealthy Uncle Sam will cover the debts of players who go broke.

Nothing is certain. But the greater the chance that Uncle Sam will cover the debts of the poker player if he goes bust, the less likely you are to try to restrain your friend’s behavior at the table. Uncle Sam’s interference has changed your incentive to respond when your friend makes riskier and riskier bets.

If you think that Uncle Sam will cover your friend’s debts …

• you will worry less and pay less attention to the risk-taking behavior of your gambler friend.
• you will not take steps to restrain reckless risk-taking.
• you will keep making loans even as his bets get riskier.
• you will require a relatively low rate of interest for your loans.
• you will continue to lend even as your gambler friend becomes more leveraged.
• you will not require that your friend put in more of his own money and less of yours as he makes riskier and riskier bets.

What will your friend do when you behave this way? He’ll take more risks than he would normally. Why wouldn’t he? He doesn’t have much skin in the game in the first place. You do, but your incentive to protect your money goes down when you have Uncle Sam as a potential backstop.

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.

Who got to play with other people’s money? Who was highly leveraged—putting very little of their own money at risk while borrowing the rest? Who was able to continue to borrow at low rates even as they made riskier and riskier bets? Who sat at the poker table?

Just about everybody.

Homebuyers. The government-sponsored enterprises (GSEs)—Fannie Mae and Freddie Mac. The commercial banks—Bank of America, Citibank, and many others. The investment banks—like Bear Stearns and Lehman Brothers. Everyone was playing the same game, playing with other people’s money. They were all able to continue borrowing at the same low rates even as the bets they placed grew riskier and riskier. 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.

Without extreme leverage, the housing meltdown would have been like the meltdown in high-tech stocks in 2001—a bad set of events in one corner of a very large and diversified economy.2 Firms that invested in that corner would have had a bad quarter or a bad year. But because of the amount of leverage that was used, the firms that invested in housing—Fannie Mae and Freddie Mac, Bear Stearns, Lehman Brothers, Merrill Lynch, and others—destroyed themselves.

So why did it happen? Did bondholders and lenders really believe that they would be rescued if their investments turned out to be worthless? Were the expectations of a bailout sufficiently high to reduce the constraints on leverage? And even though it is pleasant to gamble with other people’s money, wasn’t a lot of that money really their own? Even if bondholders and lenders didn’t restrain the recklessness of those to whom they lent, why didn’t stockholders—who were completely wiped out in almost every case, losing their entire investments—restrain recklessness? Sure, bondholders and lenders care only about avoiding the downside. But stockholders don’t care just about the upside. They don’t want to be wiped out, either. The executives of Fannie Mae, Freddie Mac, and the large investment banks held millions, sometimes hundreds of millions, of their own wealth in equity in their firms. They didn’t want to go broke and lose all that money. Shouldn’t that have restrained the riskiness of the bets that these firms took?

NOTES

  1.  I want to thank Paul Romer for the poker analogy, which is much better than my original idea of using dice. He also provided the quote about the “sucker at the table” that I use later.

  2.  Many economists, including this one, grossly underestimated the potential impact of the subprime crisis because we did not understand the extent or impact of leverage. Mea culpa.

2

Did Creditors Expect to Get Rescued?

Was it reasonable for either investors or their creditors to expect government rescue?1 While there were government bailouts of Lockheed and Chrysler in the 1970s, the recent history of rescuing large, troubled financial institutions began in 1984, when Continental Illinois, then one of the top ten banks in the United States, was rescued before it could fail. The story of its collapse sounds all too familiar—investments that Continental Illinois had made with borrowed money turned out to be riskier than the market had anticipated. This caused what was effectively a run on the bank, and Continental Illinois found itself unable to cover its debts with new loans.

In the government rescue, the government took on $4.5 billion of bad loans and received an 80 percent equity share in the bank. Only 10 percent of the bank’s deposits were insured, but every depositor was covered in the rescue.2 Eventually, equity holders were wiped out.

In congressional testimony after the rescue, the Comptroller of the Currency implied that there were no attractive alternatives to such rescues if the 10 or 11 largest banks in the United States experienced similar problems.3 The rescue of Continental Illinois and the subsequent congressional testimony sent a signal to the poker players and those that lend to them that lenders might be rescued.

Continental Illinois was just the largest and most dramatic example of a bank failure where creditors were spared any pain. Irvine Sprague, in his 1986 book Bailout, noted, “Of the fifty largest bank failures in history, forty-six—including the top twenty—were handled either through a pure bailout or an FDIC assisted transaction where no depositor or creditor, insured or uninsured, lost a penny.”4

The 50 largest failures up to that time all took place in the 1970s and 1980s. As the savings and loan (S&L) crisis unfolded during the 1980s, government repeatedly sent the same message: lenders and creditors would get all their money back. Between 1979 and 1989, 1,100 commercial banks failed. Out of all of their deposits, 99.7 percent, insured or uninsured, were reimbursed by policy decisions.5

The next event that provided information to the poker players was the collapse of Drexel Burnham in 1990.6 Drexel Burnham lobbied the government for a guarantee of its bad a...

Table of contents

• Contents
• Acknowledgments
• Preface to the 2019 Edition
• Introduction
• 1. Gambling with Other People’s Money
• 2. Did Creditors Expect to Get Rescued?
• 3. What about Equity Holders?
• 4. Heads—They Win a Ridiculously Enormous Amount; Tails—They Win Just an Enormous Amount
• 5. How Creditor Rescue and Housing Policy Combined with Regulation to Blow Up the Housing Market
• 6. Fannie and Freddie
• 7. Fannie and Freddie—Cause or Effect?
• 8. Commercial Banks and Investment Banks
• 9. Picking Up Nickels
• 10. Basel—Faulty
• 11. Where Do We Go from Here?
• Index
• About the Author