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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.

Like millions of Americans who invested their retirement accounts in the stock market, I was relieved that the mere suggestion of a governmental bailout of $85 billion for the insurance giant AIG reversed the market arrow up for two days. Relief turned to despair the next two trading sessions, however, until Washington bureaucrats promised another $700 billion for the financial industry in general, leading to another couple of happy trading days and sleep-filled nights. When the plan was scuttled the market crashed again, until it was finally passed, at which point I thought we were headed for greener pastures. Alas, it’s been red-filled days on the iPhone stock ticker ever since. (And all of this market anguish and elation happened before Congress approved the allocation of even a single dollar. That’s the mind of the market for you — it is as much psychology as economics.)

But then it dawned on me: since when is the government in the business of protecting corporations from self-inflicted high-risk losses? The whole point of capitalism is risk taking to make a profit. Low risk taking typically results in slow and steady growth, whereas high risk taking historically produces both high profits and steep losses. By entering the business of risk protection, the government is sending a clear signal to the market: don’t worry about taking big risks with your own and investors’ money; we’ll bail you out. In profits we’re capitalists, in losses we’re socialists.

Welcome to the Welfare Queens of Wall Street. This is corporate welfare, and once the $700 billion are allocated every employee of all the corporations receiving our money will be on the dole. (Don’t believe the caveats that this is a one-time fix for a once-in-a-lifetime catastrophe — precedence is everything in government handouts, and nearly every government program began as an emergency fix.)

The CEOs and COOs of AIG and all the other Wall Street financial giants in receipt of this corporate welfare will be welfare queens. And like the welfare queens during the reform movement of the 1990s, they should all be put on a very public welfare-to-work program in which their salaries (I recommend that they be paid minimum wage to start) are tethered directly to the amount of money paid back — with interest — to the people who earned the money in the first place (us taxpayers). The corporate leaders could be even be featured in a new Fortune 500 list, ranked by how much of our money they have returned.

Contrast the Bernanke/Bush plan with the actions of billionaire investor Warren Buffet, who put his money where the bureaucrat’s mouth is by committing $5 billion of his company’s assets in Goldman Sachs stocks. This investment gave the company’s stock a bump of nearly 20 percent in three days of trading, and boosted investor confidence in the market as a whole. This is different from what the feds did in two important ways.

One, the $5 billion is Buffet’s property and as such he can do whatever he wants with it. Two, we are confident that one of the greatest investors in history is basing his risk assessment on sound fiscal reasoning. Contrast this with Ben Bernanke’s comments to Congress, in which he called the $700 billion “not an expenditure, it is an acquisition of assets.” No it isn’t. You cannot acquire assets with other people’s money that you’ve confiscated without their permission. That’s called theft. When Warren Buffet invested in Goldman Sachs he was doing so in order to make a profit for his company. That’s called investment. It is fully moral because it is his money and his risk. You can voluntarily join Buffet in the risk by purchasing stocks in Goldman Sachs (or any of Buffet’s other corporate holdings), but Warren Buffet will never compel you to contribute to his holdings.

A short lesson in economic civics: the primary job of government is to protect our private property from being plundered by foreign powers and domestic criminals (through the military and the police respectively), to resolve disputes over property (through the courts), and to protect our civil liberties (another form of property) by enforcing the Constitution and Bill of Rights (through legislation). The government does not produce property, so in order to pay for these services (military, police, courts, legislature) it taxes us. According to the Oxford English Dictionary, a tax is “a compulsory contribution to the support of government”. A “compulsory contribution” is an oxymoron. It is compulsory confiscation, and we are all about to have $700 billion confiscated from us. For what? For protection from foreign plunder or domestic crimes against our property? No. For resolving property disputes? No. For defending our Constitutional rights and civil liberties. No. For covering the losses of corporations suffering from taking undue risks? Yes.

So, we are all about to have $700 billion confiscated from us in order to buy homes and mortgages (and the financial instruments tied to them) that are so worthless that even our most stable and endowed financial institutions could not retain their value. At least Bernanke recognizes the risk, as he told Congress: “That does expose the taxpayer to significant risk, there’s no question about it.”

Behavioral economists have demonstrated experimentally and experientially that humans are normally very risk averse. Specifically, the research shows that losses hurt twice as much as gains feel good. That is, in order to get someone to invest their hard-earned money you have to convince them that the potential gains are twice as much as the possible losses.

Why didn’t risk aversion work in the housing industry? Two reasons: short term thinking and reduced risk signals. First, potential home buyers and investors mistakenly assumed that the increasing trend line in housing prices would continue unabated indefinitely. Two, loan officers and their financial institutions intentionally and deceptively reduced the normal risk signals sent to potential customers in hopes that the artificial bubble would not burst. It did, and here we are.

Like everyone else, my emotional brain would love it if the government bailout program drives the market back up and my retirement account recovers. But that’s just greed and short-term thinking on my part. My rational brain knows that such a bailout program sends the wrong risk signals to the market. Why? Because the government is not in the business of risk management because only the people who produce the wealth can properly assess how best to risk it in future investments.

The Buffets of the world can do that. The Bernankes of the world cannot.

How randomness rules our world and why we cannot see it, Part 2

Imagine that you are a contestant on the classic television game show Let’s Make a Deal. Behind one of three doors is a brand-new automobile. Behind the other two are goats. You choose door number one. Host Monty Hall, who knows what is behind all three doors, shows you that a goat is behind number two, then inquires: Would you like to keep the door you chose or switch? Our folk numeracy — our natural tendency to think anecdotally and to focus on small-number runs — tells us that it is 50–50, so it doesn’t matter, right?

Wrong. You had a one in three chance to start, but now that Monty has shown you one of the losing doors, you have a twothirds chance of winning by switching. Here is why. There are three possible three-doors configurations: (1) good, bad, bad; (2) bad, good, bad; (3) bad, bad, good. In (1) you lose by switching, but in (2) and (3) you can win by switching. If your folk numeracy is still overriding your rational brain (continue reading…)

Why our brains do not intuitively grasp probabilities, Part 1

Have you ever gone to the phone to call a friend only to have your friend ring you first? What are the odds of that? Not high, to be sure, but the sum of all probabilities equals one. Given enough opportunities, outlier anomalies — even seeming miracles — will occasionally happen.

Let us define a miracle as an event with million-to-one odds of occurring (intuitively, that seems rare enough to earn the moniker). Let us also assign a number of one bit per second to the data that flow into our senses as we go about our day and assume that we are awake for 12 hours a day. We get 43,200 bits of data a day, or 1.296 million a month. Even assuming that 99.999 percent of these bits are totally meaningless (and so we filter them out or forget them entirely), that still leaves 1.3 “miracles” a month, or 15.5 miracles a year (continue reading…)

Are markets moral? Is our hunter-gatherer brain geared for modern capitalism, and do economies work like evolutionary organisms? The rise of neuroeconomics, the extinction of Homo Economicus and more…

Those were the topics discussed in last week’s ABC Radio National show All in the Mind, a debate recorded for National Science Week in Australia, with outspoken founder of the Skeptics Society, Dr Michael Shermer, and shareholder activist and Crikey founder, Stephen Mayne.

LISTEN to the debate