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Gaming the Market

by Michael Shermer, Oct 28 2008

Treating Wall Street and the financial industry like professional sports brings a new perspective to the motivation of traders and financers

In the midst of our financial crisis it was inevitable that there would be references to the 1987 film Wall Street, in which Michael Douglas’s character Gordon Gekko explains what really drives market capitalism: “The point is, ladies and gentleman, that greed — for lack of a better word — is good. Greed is right. Greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms — greed for life, for money, for love, knowledge — has marked the upward surge of mankind. And greed — you mark my words — will not only save Teldar Paper, but that other malfunctioning corporation called the USA.”

Is greed good? Bad? Consider an analogy. Would sports’ writers say that Lance Armstrong, Michael Phelps, and Kobe Bryant are greedy in the same way that pundits describe financial officers, professional traders, and home flippers? Of course not. The whole point of competing in sports is to do the best you can and to win within the rules established by the governing sports organizations. In fact, if you are not greedy in the sense of wanting to succeed in your sport, you will likely be cut from the team. It is in the nature of sports for athletes to greedily desire to succeed and win.

The analogy holds for everyone in the marketplace — from you and I as shoppers and home-buyers looking for the best bargain we can find, to corporate CEOs and Wall Street traders looking for the largest profit they can attain. The whole point of shopping and investing, in fact, is to do your best to succeed and win — defined by finding better deals and making more money — within the rules established by the organizations governing the marketplace. We should no more blame greedy home buyers, loan officers, and stock traders for the current financial crisis than we should blame individual athletes for making so much money playing sports.

Who should we blame? The organization governing the marketplace — the government — for interfering with the normal signals of risk. Let me explain.

People and corporations are normally risk averse. Behavioral economists who study risk aversion have discovered that most people will reject the prospect of a 50/50 probability of gaining or losing money, unless the amount that can be gained is at least double the amount that can be lost. That is, people feel worse about the pain of a loss than they feel better about the pleasure of a gain. Twice as worse in fact.

Since corporations and financial institutions are run by people, they should show the normal risk aversion when investing money and granting loans. Why didn’t they? In short, the risks were removed or delayed by government intervention. Fannie Mae and Freddie Mac, for example, do not make loans directly to customers — they buy loans from banks who make those loans directly. The more removed the direct risk is from the brains of those granting the risk, the less risk averse they will be.

Well, a remarkably prescient September 30, 1999 article in the New York Times, entitled “Fannie Mae Eases Credit To Aid Mortgage Lending,” reported that the Fannie Mae Corporation began a program that spring to encourage banks “to extend home mortgages to individuals whose credit is generally not good enough to qualify for conventional loans.” Why? According to the Times, “Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.” In point of fact, in July of 1999 the Department of Housing and Urban Development insisted that Fannie and Freddie increase their portfolio of loans made to lower and moderate-income borrowers from 44 percent to 50 percent by 2001.

Now, there’s nothing wrong with corporations taking higher risks — whether under political or profit pressure — as long as they adjust for it by charging more. The higher price acts as a risk signal to keep the market in balance. This is what Fannie Mae was doing by only purchasing loans that banks made charging three to four percentage points higher than conventional loans. But under the new program implemented in 1999, higher-risk people with lower incomes, negligible savings, and poorer credit ratings could now qualify for a mortgage that was only one point above a conventional 30-year fixed rate mortgage (and that added point was dropped after two years of steady payments). In other words, the normal risk signal sent to high risk consumers — you can have the loan but it’s going to cost you a lot more — was removed. Lower the risk signal and you lower risk aversion.

When sports governing bodies either relax the rules or fail to enforce them (think of steroids in baseball or doping in cycling), it signals to the athletes that there is little risk in pushing the boundaries of the sport. Lowering the risk aversion encourages gaming the system, and once the top competitors do it, everyone else in the sport has to do it just to compete. The result is a catastrophic collapse in the integrity of the sport.

Analogously, when the government encourages corporations to relax the rules of financial transactions, and then signals to them that if the system fails it will bail them out (as the government did when it rescued the savings and loan industry in the 1980s), it signals to the players in the marketplace that there is little risk in pushing the boundaries of the market. Lowering financial risk aversion encourages gaming the system, and once the top corporations do it, everyone else has to do it just to compete. The result is what we have today.

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53 Responses to “Gaming the Market”

  1. JimV says:

    I have seen it reported – I think at the blog “Obsidian Wings”, with some corroboration at Brad Delong’s “Grasping Reality With Both Hands” blog – that the additional CRA-based loans are a small percentage of Fannie Mae’s portfolio, and they have defaulted at less than the average rate. That is, that the the ring-wing theory that the Clinton Administration’s Community Restoration Act was the primary cause of the current financial crisis is not based in reality (although deregulation that happened during the Clinton administration was germane). If you have information to the contrary, please cite it.

  2. Bill says:

    JimV,

    Actually the deregulation under Clinton (repeal of the remaining parts of Glass-Steagal) may not be as germane as many think. Fannie and Freddie did not fall under those regulations, nor did Lehman and Bear. In fact, not having those regulations is helping contain the meltdown somewhat. For instance, companies like Citi and JP Morgan can now buy up some companies that they would have been prevented from buying prior to the repeal of Glass-Steagal.

  3. einniv says:

    I have always found it deliciously ironic that the publisher of a leading skeptical magazine is a member of one of the most delusional groups around, Libertarians. When I heard on Skeptic’s Guide that Mr. Shermer would be participating on this new blog I had a feeling we would be treated to many delusional tidbits on economics. Sure enough, when the page loaded there it was at the very top of the page, Mr. Shermer and this piece full of factually incorrect nonsense.

    Let’s see what fellow libertarian Alan Greenspan thinks of this idea of Mr. Shermer’s that it was all the fault of mean old government that made the nice, rational bankers give their money to poor people.

    “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief.”

    “The whole intellectual edifice, however, collapsed in the summer of last year.”

    You got that Mr Shermer? Your ridiculous ideology is dead. It was wrong and has been wrong. The self-interest of firms is not enough to keep them from engaging in activities that put not only themselves but everyone else in danger.

    Here are the facts. The subprime lending and securitizing of such lending was done overwhelmingly by private institutions not Freddie and Fannie. As the subprime bubble grew Mae and Mac’s market share shrunk. This is because unlike the unregulated private institutions they still had lending standards. They weren’t buying the worst of the bad junk because it didn’t fit their standards. It wasn’t until 2005 , way after the bubble had started, that they were pressured in to buying up some of the more risky stuff. Even then they never bought up the worst of the junk and their market share was still lower. So, how can they be responsible for the types of products that they refused to buy? One of the pressures on them was from Country Wide. They were told they either had to start buying the risky stuff or Country Wide was going elsewhere. This is absurdist post-hoc rationalization from Mr. Shermer. Looking for any scapegoat other then the correct one, which is his ideology of unregulated markets.

    Another thing to consider is the housing bubble itself. Without that bubble collapsing many of these people would just have refinanced their loans. Or, if they couldn’t afford it, the bank would just take the house and sell it. No big deal because if the bubble hadn’t collapsed the house would have been worth the same or more as it had originally. It didn’t work out that way but why did we have a bubble in the first place? It was due to Mr. Greenspan’s laissez-faire attitude toward the markets. Many competent economists saw the housing bubble for what it was. Something should have been done to discourage it but in the ideological world of libertarians like Greenspan that just not a reasonable thing to do.

    This comment could go on and on (that’s how wrong the original article is). I would suggest Mr. Shermer remove his ideological blinders (if that is possible but I won’t hold my breath) and do some actual research on the subject.

    I have to say I am supremely disappointed to this kind of uninformed drivel on a skeptical blog of all things. More facts less ideology please.

  4. Greg Martinez says:

    I hate to appear like I am piling on, but I have to agree with the comment by einniv. I view Libertarianism as something like religion in it’s faith in an invisible, all knowing power — in this case “the market” as opposed to God, Jehovah, Allah, etc. It is disappointing to see someone who otherwise displays such fine critical abilities regurgitate a talking point from Fox News (and their ilk) that is so easily punctured by the posters in the thread above. (And it has spread like a meme — even the respected science fiction author Orson Scott Card has joined in http://www.snopes.com/politics/soapbox/honestreporter.asp). Skepticism ought to be about challenging the easy, convenient solutions offered by ideology to look towards a more accurate assessment of facts and evidence.

    This is my problem with the west coast version of the skeptic movement (as opposed to the east coast version embodied by the Center for Inquiry). It’s libertarian bent, loose association with the Cato Institute, and it’s lean towards the ideological is counterproductive and lowers it: it’s no longer above the fray, it’s just another snarling voice, with nothing to distinguish it from the palaver.

    Skepticism needs to be free of political and economic ideologies, or it will cease to be of value.

  5. Bill says:

    Claiming that Greenspan had a “laissez-faire attitude” toward the markets is a bit simplistic. After all, he was head of the most un-libertarian institution for nearly 20 years. The monetary policy that he helped promote was anything BUT laissez-faire. It was his refusal to follow a more laissez-faire approach early in this decade when the first bubble popped that helped feed this last bubble.

    The gist of Mr. Shermer’s article is that removing downside risk distorts markets. The Fed took part in this by making credit too easy to obtain. Politicians took part in this by rigging regulations for favorable parties.

  6. Bill says:

    “Skepticism ought to be about challenging the easy, convenient solutions offered by ideology to look towards a more accurate assessment of facts and evidence.”

    Agreed. But making the sweeping statement that libertarianism is a religious ideology is NOT looking at the evidence. Claiming that all we needed to do was have government regulate the markets is just as religious. What regulations would have prevented this situation? Would those regulations have had other, undesirable effects? Were there existing regulations that, as Mr. Shermer says, removed some of the downside risk that is inherent in the market process?

    I would call myself a libertarian, but I don’t look at markets as god. I would say most libertarians don’t. All human institutions are flawed (including the institution that many want governing them). In fact, I tend to stay away from the term “markets” anyway. It’s a deceiving term. I like the term “market process” much better because it describes the situation more accurately.

  7. Sundeep says:

    It’s hilarious to see people blaming libertarianism or free-market ideology for the current mess.

    einniv, you use Greenspan’s words to dismiss libertarians like Shermer and … Greenspan. By using his comments to substantiate your argument, you are selectively choosing comments of his which suit your viewpoint and dismissing any others. I’m quite sure that’s a bias of some kind. As an example, you should quote the rest of that statement: “The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.”

    You ask the rather pertinent question: how can they be responsible for the types of products that they refused to buy? Interestingly, you may have answered that question yourself: [t]he self-interest of firms is not enough to keep them from engaging in activities that put not only themselves but everyone else in danger.

    The fact of the matter is there were probably multiple factors at play, from low interest rates to capital inflows from Asia, lax regulations to government interference. That anyone suggests that one single factor (or an ideology) was at play, especially this early into the event, is unbelievable. Decades after the Great Depression, we are still trying to understand fully precisely what factors were at play and how much each of them caused it.

    Greg, you are right that skepticism should be free of political and economic ideologies, but a support for markets has little to do with economic ideologies. It is based on their study by economists. Accusing economists of faith in markets is not unlike accusing biologists of faith in evolution: they both have seen these complex structures at work and understand why they work. The market is nothing more than multitudes of complex, interacting agents interacting with each other based on signals of various kinds. It’s more like natural selection than any deity.

  8. Eric Hanneken says:

    From what I’ve read, einniv is correct that Fannie Mae and Freddie Mac were not the largest subprime securitizers. However, they were part of the problem, not the solution, which is why they became insolvent and got bailed out at the expense of taxpayers.

    I recommend reading Arnold Kling (who used to work for Freddie Mac) on this topic. He has libertarian leanings, but he’s not starting from there and trying to find an explanation that fits them. Instead, he’s analyzing the institutions involved and trying to figure out what incentives led to their self-destructive behavior. The heart of the story seems to be that regulations on capital requirements were skewed to favor holding securities over traditional mortgages, no matter the underlying risk, but there’s more.

  9. einniv says:

    Sundeep,

    Which economists exactly support the type of unregulated markets like Mr. Shermer? Not Nobel Prize winning Joe Stiglitz for example.

    “Whenever there are “externalities”—where the actions of an individual have impacts on others for which they do not pay or for which they are not compensated—markets will not work well. But recent research has shown that these externalities are pervasive, whenever there is imperfect information or imperfect risk markets—that is always.
    The real debate today is about finding the right balance between the market and government. Both are needed. They can each complement each other. This balance will differ from time to time and place to place.”

    Agree with Stiglitz or not he is certainly a qualified expert. Mr Stiglitz is on record as blaming the private institutions not the big bad ‘ole government. So when we have a situation where qualified experts have differing opinions then what place does the subject have on a skeptical blog? The answer is none at all.

    The place Mr. Shermer’s article has on a skeptical blog is as an example of the type of thinking skeptics should be working against. First he started with his conclusion. It must the government’s fault because on their own private markets don’t make those kinds of mistakes. Then he works backwards to find some evidence to fit his pre-conceived notion. Ah ha Fannie wanted to lend to more poor people at low rates that must be it. Then he proceeds to ignore all the contrary evidence such as the fact that Mae and Mac did not buy the kinds of loans that are failing at the highest rates. It is sheer absurdity to suggest that Mae and Mac taking on loans with higher standards made the private firms cook up scam loans and sell them off, at first, to other private firms. It took a new CEO at Fannie and the pressure of lots of groups including private firms like Country Wide before they started buying some of the more risky stuff. Are we to believe that their influence was magically projected back through time???

    How about some actual facts instead. 1st according to a study by UNC Center for Community Capital (http://tinyurl.com/6lsoxe) it was not lending to poor people at low rates that caused the problem.

    “The results of the study show that home loan borrowers with similar risk characteristics defaulted at much higher rates when they borrowed subprime mortgages than when they received loans made primarily for Community Reinvestment Act (CRA) purposes.

    “The results are timely given the frantic rush to identify culprits in the financial crisis and to develop policies to rescue and rebuild the mortgage market,” says center director Roberto Quercia. “These results show clearly that mortgages made using traditional affordable housing guidelines are holding up much better than subprime mortgages. Homeownership can remain an important and primary path to financial security for Americans, even among those of modest means, as long as home buyers have access to safe-and-sound mortgage products.”

    By contrast, he says, CAP loans typically are fixed-rate, 30-year-amortizing loans without prepayment penalties, and are originated by banks using significant underwriting regarding the borrower’s ability to repay.”

    The problem for Shermer is that the subprime loans are higher priced than their more traditional counterparts not less. So he has it exactly backwards. But little things like facts don’t get in the way of ideologues. It also shows quite clearly that there is no conceivable reason why the loans the private institutions dreamed up had to be in the form they were in. Non-predatory loans were possible. It wasn’t Mae and Mac that came up with the CDOs it was places like Meryl Lynch.

    Fallacious garbage like the original article have no place here. Last I checked I typed in SkepticalBlog not LibertariansRUs.

  10. Greg Martinez says:

    In the interests of a continuing dialogue (and not a flame-war):

    I wrote that Libertarianism was “something like a religion”, I didn’t call it a religion — it isn’t that irrational. But then, ideologies of all stripes can elicit an almost religious fervor from their more ardent followers. They insist that their ideology is still correct, despite evidence to the contrary. I have seen examples of this in Libertarianism, Liberalism, Conservatism, heck, any -ism. Such thinking resists any new information. That’s something shared with religion.

    I don’t have any issue with what Shermer wrote about risks — that’s all sound. What I take issue with is the uncritical repeating of an assertion — that Clinton’s adjustments of lending standards to lower-income people was a significant, if not the only, cause of the global economic collapse — as factual that collapses under simple scrutiny. It’s shabby thinking, and we as skeptics ought to be better than that.

    I take shots at Libertarian purists just like I take shots at supply-siders and others: they often suffer from blinkered thinking due to advocating an ideology over scholarship. If you don’t think that economists can become ideological, then take a look at the Chicago School of economics led by the late Milton Friedman.

    And Sundeep, a handy comparison between economists and biologists.

    You know, if Shermer hadn’t trotted out that creaky right-wing hobbyhorse about the CRA, we wouldn’t be having this conversation. I react to it when I hear it because the current economic woes that are sweeping the earth are certainly more complex and involved than the scapegoating of a program that simply wasn’t big enough to be the cause of these problems. I feel that this is a poor illustrative example of a sound ecomnomic idea.

    What I really hope for is more rigorous thinking and discussion — like what we are having in this thread!

  11. fatherdaddy says:

    I would like to expand on Sundeep’s analogy relating markets to evolution. Accusing economists of having faith in the market and then blaming them for a failure is like blaming biologists for having faith in evolution and then blaming them for species extiction. Neither have control over the system, neither can be held responsible for a failure in the system to provide the benefits you think you deserve from that system. To blame a libertarian attitude for a problem that Libertarians and libertarians have had no control over and little influence upon is truly lacking in skepticism.

  12. DanielB says:

    Michael,

    I think your analogy was apt, but the republican H.R. 5660 (vetoed by Bush) and the credit default swap (CDS) deregulation is a much better example of corporations feeling invincible due to government intervention. Your example of lower middle class mortgages being lent out were barely the tip of the iceberg of this crises; churning them into explosive securities due to poorly thought out deregulation was the iceberg part.

  13. Eric Hanneken says:

    Neither “Community Reinvestment Act” nor “CRA” appears anywhere in Michael Shermer’s post.

  14. Greg Martinez says:

    To fatherdaddy: I am not blaming Libertarians for what is going on in the world economy right now, though others might (and I would NOT agree). I am concerned with ideology coloring clear thinking on matters.

    To Eric Hanneken: The “Community Reinvestment Act” is what Dr. Shermer is addressing in the 7th paragraph of his post.

    To DanielB: an excellent illustrative example!

  15. Eric Hanneken says:

    The “Community Reinvestment Act” is what Dr. Shermer is addressing in the 7th paragraph of his post.

    No, it isn’t. Hereis the New York Times article he was referring to.

  16. Greg Martinez says:

    Mr. Hanneken:

    The Community Reinvestment Act was passed by the 95th congress in 1977, during the Carter administration, and has undergone several legislative and administrative changes over the years. A significant legislative change was enacted in 1999 (the Gramm-Leach-Bliley act), and it appears to me that the article referenced addresses this act during it’s early stages of discussion.

  17. Greg Martinez says:

    Actually, having checked the chronology, this is AFTER the act had been signed into law. The article may not identify the act by name, but I feel sure that this is what it is describing.

  18. Eric Hanneken says:

    A significant legislative change was enacted in 1999 (the Gramm-Leach-Bliley act), and it appears to me that the article referenced addresses this act during it’s early stages of discussion.

    I’m sorry, but that isn’t true either. The purpose of the Community Reinvestment Act was to force banks to lend some portion of their reserves to borrowers who lived in the same communities as their depositors. Fannie and Freddie are not commercial banks, and they don’t deal with individual depositors or borrowers, so the CRA never applied to them.

    That’s not to say that they were free to buy whatever mortgages they wished. As the New York Times article reported, the Department of Housing and Urban Development required that 44% (later 50%) of their portfolios be composed of loans to “low and moderate-income” borrowers. The rest of the story is in the Arnold Kling piece I linked to earlier. Private securitizers began to outcompete Fannie and Freddie for low-income borrowers, Congress complained, Fannie and Freddie lowered their standards without raising their capital reserves to cover defaults, the housing market slowed, and Fannie and Freddie became insolvent. The Community Reinvestment Act was not involved.

  19. Greg Martinez says:

    Okay, I’ve gone to different resources (with more details — and I read more in Mr. Kling), and I can see now where I misunderstood.

    This did take us far off the real point of the matter, though.

    So…take away the idea that this is directly related to the CRA.

    I still think this is another trite case in which right wingers try to tie all problems to Bill Clinton first, and then poor and minorities second. (How on earth these people put me in the position of defending Clinton…). These kinds of things are always complicated, and yet people lazily try to fit them into whatever is their ax to grind.

    I’ll reiterate what really matters to me: political ideologies should not be part of skepticism. When you let this stuff creep in, you run the risk of discrediting whatever good work you do. (I personally don’t identify with any political ideology — I am interested in what works and what is evidence-supported. Ideology elevates what agrees with it’s preconceptions and disregards what doesn’t — like intelligent design!)

  20. Greg Martinez says:

    This is a pretty good resource for the whole “blame the CSA” thing, just for supplimental information:

    http://bigpicture.typepad.com/comments/2008/10/misunderstandin.html

  21. Greg Martinez says:

    And this is sure to light a few fuses:

    http://www.slate.com/id/2202489/

  22. miller says:

    I didn’t complain the first time, but I’d like to file my formal complaint now that you are talking too much about politics and not enough about skepticism. It’s interesting and all, but your first two posts on SkepticBlog have little to do with skepticism. If you had written something arguing for the injection of critical thinking in politics, that would have been something, but all I see here is yet another person who thinks our recent economic troubles only confirm their previously held political views.

  23. Andrew says:

    I agree with miller that this blog should be about skepticism, not about individual political opinions. Shermer, you’re great at skepticism and science writing and I’d stick to them rather than politics. Not that you’re necessarily a bad political commentator, but it’s definitely not your forte.

  24. Timmeh says:

    You people who don’t like Michael Shermer’s commentary:

    It’s not your blog! Did you notice there’s a whole Internet of other stuff out there if this isn’t your cup of tea?

    No one is forcing you to read this stuff!

  25. miller says:

    Well, of course Shermer can write about whatever he wants–and I’ll read it too! But presumably, the bloggers want feedback for their new blog, right? So there you have it.

  26. Devil's Advocate says:

    Whether I agree with Shermer is irrelevant. What I see here is a ‘name’ skeptic using his fame and expertise in one field to declaim from a bully pulpit on an entirely different field: politics. This is like reading a political blog from some Hollywood actor who has decided his fame somehow lends credibility to his political opinions, and whose expertise in one field translates into expertise in another, unrelated field. How do skeptics react when woo-sters do this?

    If Shermer speaks on skepticism, I’m interested. I couldn’t care less about his political ideology, just like I don’t care who he thinks the best rock and roll guitarist was, or what he thinks the ‘best’ color is.

    This sort of off-topic, irrelevant blogging reduces the Comments section to nothing more than an ongoing and very boring Battle of Ideologies. You can’t throw a figurative rock on the internet without hitting one of the millions of political blogs doing just the same, and doing it much better since that’s the relevant goal of those blogs.

    The risk here is a new blog ostensibly claiming to unite people under the skeptical flag, but instead creating divisions among skeptics along political lines. Nice work.

    Not to mention that in these times I enjoy skeptical reading as an escape from the constant press of political opinion masquerading as fact. Politics is opinion based on ideology. All politics is even more local than we suppose. I think we all know there are camps of liberals, conservatives, libertarians, socialists, federalists, etc., etc. ‘Skepticism’ is not going to prove one camp better than another.

  27. Sundeep says:

    I’d like to make it clear, at the start, that I have no interest in making this a flamewar. I am extremely intrigued by the place of economics amongst skeptics. Also, in the interest of full disclosure, I like Clinton, I believe in free trade, free markets and fiat currency (sorry, Austrians). I believe government has an important role to play, but the actions of government should be viewed through rigorous cost/benefit analyses.

    einniv,

    I don’t believe Shermer is for unregulated markets. He does seem to realize that government (and any other agent) can screw up the normal dealings of the market. This appears, to me, to be the gist of his article.

    Stiglitz is indeed right. It accurately summarizes the viewpoints of most economists, except perhaps the Austrians. Even Friedman granted that government does have its uses, especially in dealing with externalities. However, the question is, to what extent is government useful, where and what are the costs? That Stiglitz places the blame on private institutions is not sufficient. He is but one voice, one viewpoint in economics, even if he does have a Nobel Prize. That’s just an argument from authority.

    There is no question that the event Shermer is discussing, that of Congress encouraging home-ownership, is not a response to an externality. Moreover, while it appears to be a benevolent action, it was, perhaps, a part of this situation. That well-meaning actions can have adverse effects is something all skeptics should be aware of.

    Interest rates alone do not tell the full story. Micro-loans charge a much higher interest rate. A problem occurs when borrowing is done against the house itself and when the price falls, there is negative equity. Arnold Kling has identified the low down-payment as a cause of greater defaults as well. This would fit with UNC’s findings and I’m not entirely sure if they considered it.

    I’m not so sure that Shermer has it backwards. He appears to agree with you that subprime loans were of a higher cost (“Now, there’s nothing wrong with corporations taking higher risks … as long as they adjust for it by charging more.”). What he points out is that the cost of taking on marginal risk was much lower than it should have been. This is correct and I don’t see how UNC’s study disputes that.

    Greg,

    I, like you, agree that there isn’t a single cause and if Shermer believes that, then he is wrong (as far as I’m concerned). To me, it seems like he was pointing out one of the issues. I hope he plans on clarifying his position.

    The Chicago School was ideological in its economics. It did believe lesser government was better, but by no means did it believe no government was best. Friedman’s ideas were developed after the New Deal, when government was prevalent. As such, it provided a strong bulwark against the reigning socio-political ideas of the day. Friedman, for example, had no problems with the pre-handover government of Hong Kong.

    I’d finally like to point out that I’m encouraged all of you see so many factors at play. We must however note that Shermer cannot tackle all of them at once. The best we can do is to show that each acted in unison. I hope this is Shermer’s view as well.

  28. Jeff says:

    “I view Libertarianism as something like religion in it’s faith in an invisible, all knowing power..” Greg Martinez

    …and therein lies the problem…

    There is no “faith” involved, it is not “invisible,” and it is not an “all knowing power”. It is, however, a self-leveling, self-regulating organism, which, when allowed to work freely, NEVER creates these intractable disasters which our wise rulers can NEVER seem to steer clear of.

    In fact, one of THE cornerstones of Libertarian “theology” (call it what you will) is that, due to the inconceivably vast amount of information flowing back and forth throughout the world’s economy, it is IMPOSSIBLE to gain the knowledge which might make any sort of intelligent broad-stroke market-control even remotely possible. You know the old Law of Unintended Consequences? It’s as incontrovertible as “For every action….”

    And, of course, when you add to the inescapable knowledge-void the unfortunate fact that each and every market-control mechanism introduced WILL ALWAYS be created by (and for) political animals—political animals with great sums of loot to protect, heavy axes to grind, clandestine favors to repay and control-freak ideologies to shove down our throats—you can see that even if the Federales actually had any clue what they were doing, it’s unlikely they’d do it without poisoning the pot in so doing.

    Basically, the logical end result of market regulation is not “market control” per se, but pure unadulterated socialism: Wealth redistribution. Fairness. Whatever you want to call it, the only way you can control the market is to control the people. An animal farm. And that is the slippery slope we’ve been hurtling down for the last 75 years.

    Theory aside, what it all boils down to is this: it’s up to each and every one of us to make sure WE are not putting our money where the risk is too great for our ability to survive its loss. If YOU lost money because you expected the govt to make sure your investments were “safe,” you were foolishly naive, and, in a completely “fair” Darwian sense, you DESERVE to have your money taken from you by people shrewd enough to do it.

    And, by the way, calling Greenspan a libertarian is akin to calling W a peacemaker.

  29. Jeff says:

    Oh, and by the way, Shermer, after reading hundreds of articles, from everything from NYT to the Economist, your piece is the first truly intelligent thing I’ve read. Muchas Gracias. Keep up the stellar work.

  30. Bob says:

    I, too, am not sure exactly why this discussion is occurring in a skeptic’s domain, but since it is, let me add.

    I think einniv is not quite correct in his description of a part of the problem. Country Wide did not threaten to take their business elsewhere if Fannie and Freddie did not take their mortgages. Country Wide had some powerful voices in Washington (thanks, it does seem, to other than fiscal logic). It also appears that Fannie and Freddie were more than happy to accommodate them (albeit with the blessing from our representatives, some of whom apparently profited from their efforts).

    The portion of sub-prime loans by Fannie and Freddie may not have been much at any one time, but when it came time to backup the loans , it was enough to cause insolvency. What the two of them also did was to bundle many of the loans, the bad mixed in with the good, and sell them to other banks and investment houses (which, in turned bundled them more thus making it even harder to discern the risk). This, in turn, gave Fannie and Freddie money to buy more of those bad investments which they could, again, sell. Their action pumped money into the market and assisted greatly in the housing boom, and at the same time, it dispersed bad investments warranted under the good name of Fannie and Freddie (i.e., the U.S. government). When the housing bubble burst, and it had to, Fannie and Freddie had too many bad debts to absorb and went belly-up. Others who had bought earlier bad loans found that their gamble on making a good profit from the housing market vanished — and the rest you know.

    No, Shermer was quite correct in his description of how risk is managed, and thanks to the standing of Fannie and Freddie in the financial community and their action, the risk was not priced into the market.

    This risk was recognized by many inside and outside of government and communicated to Congress (which was not very receptive to these warnings), but the warnings, especially from the executive branch, were, in my opinion, poorly done. (And where they were more forceful, the castigation of the messengers was harsh, and the animosity between the involved committees and the President made apparent.)

  31. bob says:

    Add me to the list of people disappointed by Michael Shermer’s first two blog entries. I’ve loved absolutely everything I’ve read or heard from him, until these last two entries. I’m not very versed in either finances or libertarianism, but I can say that his articles seem extremely heavy on the ideology and light on the science and skepticism.

    Perhaps he is using this blog format to shoot from the hip with his thoughts and opinions, but I don’t think he’s doing himself, the blog, the television show, or the movement any favors. Mike, please. We already have two skeptical superstars who let their libertarianism taint their skepticism (Penn & Teller), we don’t need a third.

  32. adent says:

    The general public, including skeptics, have an anti-market bias that is evident in most of these comments (see Bryan Caplan’s, The Myth of the Rational Voter). As skeptics, we should be aware of our own biases and welcome views that challenge our political beliefs.

  33. Jim Brock says:

    Enlightened self-interest is the key. “Greed” is simply a pejorative. Every person wants to maximize his/her situation. The real problem is when we separate the consequences from the act, as in the risk-free environment for mortgages that are insured by Fannie Mae or Freddie Mac, or alternatively by AIG etc. Once the papers are signed and the commission for the loan is paid…sayonara.

    We have created a nation where bad decisions are socialized, much to the detriment of society as a whole.

    JB

  34. kidigus says:

    For all who would like to understand better how this all happened I highly recommend two 1-hour joint-productions from “This American Life” and NPR News called “The Giant Pool of Money” and “Another Frightening Show About the Economy”.

    “What happened?” and “What do we do about it?” are questions that are not easily answered. Until I listened to these excellent primers, all I heard or read were people using this crisis to validate their personal views about the way the world should be run. Everyone came to the conclusion that “See? I and like minded citizens were right all along.”

    When standing in the shaky rubble we find ourselves in now, seek out the person saying “Oooo… my bad.”

    They’re the ones who are most likely telling the truth.

  35. einniv says:

    A few points.

    First, I don’t care that Shermer is a libertarian. He is free to believe in any half-baked ideology he pleases. What I object to is trying to push it in to the realm of skepticism. And also his use of techniques that are common to all pseudo-science. Starting from conclusions, failure to investigate facts and ignoring inconvenient ones. The principles of “enlightened self interest” being enough to make markets work efficiently is very far from being well established.

    Shermer cherry picks a study that confirms his pre-existent conclusion and ignores those that show others wise. He does this throughout his book on markets as well. The data that shows Fannie and Freddie were losing market share as subprime exploded and that they were not the ones that originated the “creative” subprime terms and securitization is readily available. For the record I certainly do not hold Fannie and Freddie or any political party blameless. However, stating that they are the cause instead of a latecomer to the mess is simply factually incorrect.

    CRA. I fully realize that no mention was made of the Community Reinvestment Act in the original article. I think some others on the thread have misunderstood that. I posted the study that involved the CRA to show one thing. That the directly stated assertion in the original article that increasing lending to the underprivileged without increasing price of the loans was wrong. It was the high priced loans that failed not the lower priced ones.

    It should be noted that many have pointed the finger at securitization as a culprit. It was the Financial Services/Commodity Futures Modernization Act that stopped CDO securities and credit default swaps from being regulated. Someone on the thread asked what kind of regulation could have averted the crisis. It was regulation of these financial instruments that could have done the trick. The reason they weren’t is that some believe, like Shermer states above, that lenders (and securitizers and ratings agencies) left to their own devices will be too “risk adverse” or “self enlightened” to do the wrong thing. The data is in (this crisis) and that hypothesis is thoroughly disproved at this point. Not that this crisis was needed for that. Most of the cutting edge work in the economics profession has already shown that idea to incorrect.

    On to Alan Greenspan. He is certainly a libertarian. He worked with Ayn Rand for years. He wrote for her newsletter and even wrote a chapter in one of her books. He argued for deregulation and carried that philosophy to his role at the Fed where he refused to act to contain the housing bubble preferring a hands off approach.

    Markets. I have nothing against markets. They have their place and a central place at that. However, the notion they are especially efficient and lead to the best outcomes due to enlightened self interest has been seriously called in to question by the bulk of recent work in the field of economics. At the very least we can say such blind faith in markets does not meet the standards for ideas that skeptics should be pushing.

    Like another on the thread I have to wonder why folks such as Shermer and Penn Jillette feel the need to use the skepticism platform to push their unestablished personal political and ideological beliefs. I’ll never forget when I saw Penn on BullSh!t holding up the Time magazine with the Global Cooling headline that is so popular among Climate Change deniers. Now, I realize that at the time he did so the
    Bulletin of the American Meteorological Society had not yet published their study that showed even back then more thought their was going to be warming than cooling. At any rate there certainly was no consensus about cooling or warming at the time. Still, you would think someone claiming the mantle of skeptic would bother to do a little research instead of apparently confusing Time magazine with scientific journals. I guess when someone wants to believe something bad enough skepticism goes out the window. Ironically, a good place to learn some the reasons why is in Shermer’s book “Why People Believe Weird Things” (like libertarianism for instance ;-0 )

  36. Erik Eklund says:

    Americanos… You Guys…

  37. J.F.Soti says:

    Einniv

    You’re missing the point!

    Economics is a science and that is why it belongs on skeptic.
    Some people take economic facts (is statements) and apply moral (ought to) characteristics to it. They conclude that government should regulate the market. Wrong conclusion! Legislators end up corrupting the market and the market corrupts the legislators. Legislators go into it with good intentions but are overridden by the law of unintended consequences.

    The market did exactly what it had to. Companies that failed need to go away, not get propped up. It’s painful, yes, so what? Grow up, learn from it and move on. It’s not the end of the world. Stop fantasizing about a utopia.

    If you want justice, take those who committed fraud to Civil Court and strip them of there ill-gotten gains.

  38. tony says:

    It is refreshing to read someone accurately describing what drives me, as a banker.
    It is absolutely the case that we are competing to be the best, to move ahead of the other guy.
    The money is certainly nice, and makes life pretty comfortable, but it’s primary value is just for keeping score. Most of my colleagues were scientists before they were traders, and many seem to have moved, at least in part, to stop collaborating, and start competing.

    It is the same in all manner of jobs. It just happens that in ours, success is very easy to quantify.

  39. Max says:

    If we put aside morality and “ought to” for a moment, then the question “How did this really happen?” is perfectly legitimate for skeptics to ask. Assigning blame is less legitimate, because it requires moral judgement. When the situation is understood, we can ask, “How can this be prevented?”, but that’s hard to answer without taking morality and values into account.

  40. Economics is a science? LOL. As a financial analyst, my wife carefully analyzes companies financial results, builds models, and once she has where she thinks things will go … she finds the “story” – the story that will justify her predictions and sell it to portfolio managers or hedge fund guys.

    In short, people need stories and economists are the novel writers of finance. Some of what they may say might be true, but mostly it is retrodiction and myth making. The biggest challenge they face is regardless of how well they may or may not predict a status quo economy with cycles etc., they do not and cannot effectively predict the rare event like 100 year floods taking out corn fields and tainted food supplies killing the demand for tomatoes. Suddenly, the price of your taco has doubled and then someone tells the story.

    Are some better than others? Probably. To the extent that an economist or analyst uses the numbers to come up with a story rather than the other way around, they are paying more attention to underlying trends; however, it again assumes that past performance will accurately predict future returns.

    But don’t take my word for it, I’m just a skeptic who married into finance. The most convincing, reasoned, and skeptical treatment of financial markets that I’ve come across have been “Fooled by Randomness” and “The Black Swan” both by Nassim Nicholas Taleb. He comes at things as a skeptic and former financial quant. They are worth a read.

    PS This is why we need government regulations – the financial system is not a games theory system filled with rational actors or a reasonably predictable game of dice. Unexpected transformational changes can and do happen and systems ought to be in place to prevent the large scale destruction of capital and livelihoods that result. It is why New Orleans has levies. We just need to make sure they are big enough. Or should every neighborhood decide for itself the probability of another hurricane?

  41. I’d also note that I’m somewhat skeptical of the practical applications of the behavioral economics study of risk aversion. In my experience, it appears as though finance people go through a mental shift in which hypothetical losses from untaken opportunities have negative emotional effects (i.e. one guy will see his colleagues’ real estate appreciate substantially and will see their own underperformance in another area as a loss). I suspect this helps reinforce the herding behavior in finance; however, its just a hypothesis … if anyone wants to test it, I’d love to find out the results (of course, it may have already been tested and I just don’t know about it). Cheers.

  42. Sundeep says:

    Mark,

    You’re conflating finance, which uses economic tools for predictions and analyses, with economics itself. While there is some overlap between them, they are not the same.

    Also, if economic predictions are made and turn out to be wrong, it does not mean that economics isn’t a science. Meteorology lends itself to understanding climate as a whole, but also to making predictions about the weather in the near term. Does that mean meteorology is no longer a science? Medicine can be thought of in the same way.

    The normative uses of a science do not mean that it is no longer a science.

  43. Sundeep,

    I take your points, but the economists (and yes, they call themselves economists) I tend to meet are those in the financial industry that are attempting to use “applied economics” with incomplete predictive tools. I’d further suggest that if Taleb is to be believed the theorists have little interest in what the few experimenters who are out there have to say. To the extent that economics can and is subjected to experimental rigor, call it a science – fine, but if theorists and practioners aren’t interested in what the experiments have to say then it becomes hard to differentiate it from pseudoscience (again, to the extent that theorists ignore evidence).

    Have you read Taleb? If so, I’m open to a critique of his work and his concerns about economics and finance. Heck, I’d even go in for a cordial conversation about it.

    Finally, I would suggest that economics as I read it is prescientific as medicine and psychology had been in the mid 19th century (probably later with psychology). Given there are multiple schools or paradigms competing for position suggests to me that it hasn’t measured up to the Kuhnian definition of a “normal science” which is the definition I prefer to use.

  44. Sundeep says:

    Mark,

    I haven’t read Taleb yet (though I do plan on it). There are economists in the finance industry, and, I concede, they do use economic tools or applied economics.

    We, however, can distinguish between micro- and macro-economics (not to mention behavioral, neuro- and other heterodox economics). The different schools tend to be focused on macro-economics. For this, experiments are harder to conduct since most cities, states and countries aren’t interested in falsification and so on.

    So, indeed, economics isn’t entirely scientific. It is, to a certain degree. This is the problem with all social science. Just to be clear, I, too, believe that medicine (evidence-based, not all that other nonsense) is far more scientific than economics. I was just trying to point out that not all economic work is non-scientific.

  45. Sundeep,

    Fair enough. I think can agree. It just seems the folks who get on Bloomberg are mostly narrative with no experimental evidence. Regards.

  46. Max says:

    Mark, you realize that Taleb is a Libertarian, so he might not agree with you about government regulations.

    And, oh yeah, he’s skeptical of medicine too.
    http://money.cnn.com/2008/03/31/news/economy/gelman_taleb.fortune/index.htm
    “Sometimes you need to say, ‘No model is better than a faulty model’ – like no medicine is better than the advice of an unqualified doctor, and no drug is better than any drug.”

  47. John says:

    Sundeep, I could not agree more on what you say about the reporting on Bloomberg. My friends and I often send each other stories from there showing what we call the “Bloomberg Fallacy”. An example will be when USD/GBP has moved up a half a cent. This is noise, pure and simple, yet Bloomberg will have a story saying “Pound drops on fears for housing market” (the “cause” will seem to be whatever piece of economic data is out next in the UK, irrespective of people’s expectations. Every move has to have its story, even when it is overwhelmingly likely that te shift was caused by the normal brownian motion (in he true scientific sense of the myriad hedges being done by real customers sometimes adding up to slight buying pressure, and sometimes adding up to slight selling pressure).

    That is not to say that economics is useless. There must be some relationship between scarcity and cost, and between demand and inflation, for example. The fact that it is very much a social science means that it will often only be able to deal in probabilities or generalisations, but that does not make it any less valid.

    In fact, you could even compare it to medecine, in that you are trying to work out a cure given a set of symptoms, often.

  48. Max,

    If Taleb disagrees, he disagrees. I just find his assessment interesting and insightful. Regarding government regulations or market imposed standards, I want transparency so risk can be reasonably evaluated (people in finance have been terrified lately because the information of credit swaps and stuff isn’t public and the uncertainty has been a killer) and firebreaks so that some of the piling on/herd behavior is mitigated (after BS people asked who’s next and started betting against Lehmans – who knows whether they might have survived if speculators weren’t trying to ride them into the ground and get rich doing it). I’m not interested in regulations just to regulate.

    As for Taleb’s comments on medicine, I’m not familiar with them so I can’t evaluate his position other than the line you offered. Frankly, I’d agree with him to a point on it (and if you swing a stick in my family you are likely to hit a doctor). His analogy suggests that sometimes a doctor who doesn’t know what he is doing makes things worse … which I believe is true. My father was in radiation oncology and while most physicians he knew and worked with were competent, he knew a number that for ego, money, or ignorance left patients worse off than they were when they came in the door. Not many. Not often. But enough.

    Also, I don’t get the sense he was advocating for alternative medicines – just reminding us of our own incomplete knowledge and faulty understandings – in finance, medicine, and everywhere else. But heck, if you can show me where I’m wrong, please do.

  49. I find it interesting that high risk home buyers are largely blamed for this. My realtor offered me the opportunity to purchase revenue housing with zero down mortgages. While my wife and I would have qualified to purchase a 250k duplex, we could never have afforded the payments in the long term. But there were banks/mortgage companies willing to lend. In my view it was not the working poor trying to get their first and likely last house, it was more overinflation from speculation by buyers without the necessary assets. Once the boom busted the house of cards fell.

  50. [...] 9, 2008 這個 blog post 的主旨是提供這個 link 給有興趣的人. 這是 Michael Shermer 的短文, 叫做 “Gaming the market”, [...]

  51. Rafe Furst says:

    One point I’m surprised nobody brought up is this seemingly obvious piece of faulty logic: “Now, there’s nothing wrong with corporations taking higher risks… as long as they adjust for it by charging more. The higher price acts as a risk signal to keep the market in balance.” No, you don’t charge more for higher risk loans to “signal” anyone. You charge more for higher risk so that you can still turn a profit when an inevitable portion of them default.

    I have to agree with those that feel that this Shermer’s market posts smack of ideology, contrary to his generally unbiased and rational writing.

    One thing that seems counterproductive for a skeptic (and the skeptics movement in general) is for a blog author to never respond to any of the comments. It’s not really a rational discussion if it’s Post From On High, Then Let The Masses Argue Amongst Themselves. Apologies if I’ve mischaracterized what’s going on here.

  52. 1. I think the topic has a valid place here – as was mentioned above, economics IS A SCIENCE in the context of professors at universities publishing research, peer review, etc.

    2. This post is more about economics than polictics

    3. There are fanatics on both sides, so it makes no sense to call one of them an ideology or religion when both can be, and both can be analyzed rationally

    Personally, I commend Michael for having the guts to post it – I’m sure he realized he’d alienate some readers – but when getting to the truth you can’t let offending some people stand in the way. After all, he posts openly about atheism right?

    Finally…I’m surprised more readers have not seen the similarities between evolution (which seems to be highly praised) and free market economics. They are both beautiful and simple in terms of survival of the fittest, the invisible hand, etc. I tend to agree with his analysis here, while keeping an open mind.

    Great job Michael, keep it up!
    Brian Armstrong
    http://www.StartBreakingFree.com

  53. A Reply says:

    For anyone who is late to this thread, Michael has mentioned his support for the idea that the CRA was primarily responsible for the market collapse. In fact, he is not just supporting the idea, but actively promoting that idea.

    This theory has already been debunked, and was circulated by many Libertarians almost immediately after the economic collapse occurred, as an obvious from of damage control. Many people have already debunked the theory, so this link is only one of many sites that discusses what can only be described as an urban legend:

    http://leisureguy.wordpress.com/2009/03/18/the-cra-myth-debunked/

    This is a very important theory for Libertarians to push, because it is the only real defense they have when people question their opposition to current regulations. If they can’t prove that the CRA was primarily responsible for the economic collapse, which they can’t, and they haven’t, then they have a lot more to answer for.

    I find it troubling that Michael has been so easily fooled, and that he is actively misinforming his readers. A simple corroboration of the theory by other commentators would have shown him that it is, at the very least, a controversial claim.

    In the future, Michael might want to refrain from merely repeating rumors told to him by people who he seems to blindly trust. Economics, and politics are much more complex discussions than UFO’s, ESP, Atheism, and Bigfoot.

    Michael is discussing topics that are way out of his league, and he needs to stop. It’s starting to make him look flippant.

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