Summarizing Russ Roberts' "Gambling with Other People's Money"

Summary

The government bailed out debt-holders in a series of bank failures in the 70’s through the 90’s, signaling an implicit guarantee of creditors. This implicit guarantee combined with a politician-driven effort starting in the 90’s to orchestrate an increase in homeownership led to excessive use of leverage by Wall Street and aspiring homeowners to finance increasingly risky investments in housing in the 00’s. This in turn allowed Wall Street and politicians to privatize gains ($$, votes) and socialize eventual losses to taxpayers. The use of excessive leverage turns a failure into a meltdown. Rescues distort the natural feedback loop of capitalism. We are less capitalist than we would like to admit. We don’t need to more precisely engineer our financial system; we need to reintroduce “skin in the game.”

Q&A-style notes

What role did housing policy and politicians play?

• Originally a tool to correct market failure, GSE’s became a tool for politicians to get wins by increasing home ownership…playing with other people’s money
• Because of the government guarantee, [banks] could borrow money cheaply. They could then earn money by buying mortgages that paid a higher rate of interest than the rate Fannie and Freddie had to pay to their lenders. It was a money machine that was incredibly profitable. 
• Fannie and Freddie increased liquidity to the mortgage market by buying loans from mortgage originators. 
• Pressure from politicians makes Fannie/Freddie a tool to increase home ownership, leading to many riskier loans being made with implicit guarantee
• between 1998 and 2003, Fannie and Freddie played an important role in pushing up the demand for housing at the low end of the mar- ket. That in turn made subprime loans increasingly attractive to other financial institutions as the prices of houses rose steadily. 
• Since they were supporting riskier loans, they played an important role in growth of subprime MBS

What role did commercial and investment banks play?

• Explanation #1: hubris, greed, and myopia— irrational exuberance run wild. That they believed housing prices and MBS prices would continue to climb, so they were happy to keep selling and buying MBS.
• Problems with explanation #1:
  • At least some practitioners (and probably fewer than we know about) did see it coming
  • it wasn’t really the same asset appreciating year after year…The proportion of the mortgage market that was subprime was increasing. The investors were lending money to finance increasingly risky loans. 
  • And the banks invested in the safest mortgage-backed products…if they really were so exuberant, why not get even riskier?
• Explanation #2: Rather than make super-risky bets, banks could make bets w/ smaller upside and higher chance of success, and gain bigger returns through the use of leverage. So they didn’t need to be shooting for inside straights. Executives could make tons of money for themselves by just “picking up nickels in front of a steamroller.” They knew that by the time the music stopped, they’d have nothing to lose and they’d already have made so much money.
• [Wall Street] lobbied for policy decisions that created the mess [which ones? The change in capital requirements? Implicit creditor guarantee?]

But even if debt-holders expected to get bailed out, there are still equity-holders. Why didn’t they restrain the riskiness of the major players?

• Because they’d been making money as stock prices (and revenue) rose in response to these risky bets, and they didn’t have all their eggs in one basket. Content to let things ride.

But executives of these lenders were also big equity holders, and their personal wealth was surely more concentrated in their companies? Why didn’t they constrain risk-taking?

• The downside risk is cushioned by his ability to accumulate [big] salary and bonuses [via leverage] in advance of failure. 
• expected returns to bank executives from bad investments can be quite large even when the effects on the firm are quite harmful. 
• They didn’t intend to have their banks collapse, their cards just didn’t come true this time. Which is okay, because they already made tons of money.
• You’ve borrow money to make other loans. So when those loans default, you don’t have much to lose. And you were making money up until that point, so you had upside.
• Financing their salaries by “leveraging” implicit government backing.
• 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 actu- ally 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 have some truth, but the larger issue is that they bank decision-makers had very little to lose from their banks failing, and had already made out like bandits.

Why did mortgage lenders get comfortable lending to people putting no money down?

• (First potential reason is you believe housing prices are just going to go up, so you just don’t think it’s that risky to do so.)
• The second reason is that you will be very comfortable lending the money if you know you can sell the loan to someone else.  
• 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. 

What role did new financial regulation play?

• Actually, not huge…the biggest issue remains implicit guarantee to creditors…rational exuberance, that was made rational because you were gambling with other people’s money
• Looser capital requirements did create an incentive to hide risky investments under the AAA label, allowing banks to use more leverage
  • The tranching system of CDOs was a way to create AAA-rated investments out of loans that were highly risky. This financial alchemy was particularly attractive because of the regulatory change.
    • How did this work?

But aren’t taxpayers also homeowners? If so, what exactly is the problem?

• The set of taxpayers is not the same set of people that became homeowners. So most people got nothing out of this except a tax bill. And for those that did get homes, good money was used to fund something that soon became worth much less. 

Other factors?

• Though other factors—the repeal of the Glass-Steagall Act, predatory lending, fraud, changes in capital requirements, and so on—made things worse, I focus on creditor rescue, housing policy, tax policy, and monetary policy because without these policies and their interaction, the crisis would not have occurred at all. And among causes, I focus on creditor rescue and housing policy because they are the most misunderstood. 

Shocking numbers:

• By 2005, 43 percent of first-time buyers were putting no money down, and 68 percent were putting down less than 10 percent.
• [Market for subprime MBS] “grew steadily from $100 billion in 2000 to over $600 billion in 2006.”
• Fannie and Freddie bought 25.2% of the record $272.81 billion in subprime MBS sold in the first half of 2006

**Tangent: What is a CDS? **

• W/r to a particular asset, I (seller of CDS) will pay you (buyer of CDS) if the particular asset defaults. Buyer of CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, may expect to receive a payoff if the asset defaults.
• if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk.
• So it is basically an insurance contract. I’m a lender, I’m worried my borrower is going to default, so I buy CDS from another investor (I pay periodic premiums), and I get reimbursed if the borrower does in fact default
• Credit default swaps are customized between the two counterparties involved, which makes them opaque, illiquid, and hard to track for regulators
• I.e., you’d make a loan to someone, or you’d buy their debt…and at the same time, you’d also buy CDS on them, in order to hedge your risk