Russ Roberts

Roberts on the Crisis

EconTalk Episode with Russ Roberts
Hosted by Russ Roberts
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Russ Roberts, host of EconTalk, discusses his paper, "Gambling with Other People's Money: How Perverted Incentives Created the Financial Crisis." Roberts reflects on the past eighteen months of podcasts on the crisis, and then turns to his own take, a narrative that emphasizes the role of government rescues of creditors and the incentives this created for imprudent lending. He also discusses U.S. housing policy, particularly the Government Sponsored Enterprises (GSEs), Fannie Mae and Freddie Mac and how the government's implicit guarantee of lenders to the GSE's interacted with housing policy to increase housing prices. This in turn, Roberts argues, helped create the subprime market, created mainly by private investors. The episode closes with some of Roberts's doubts about his narrative.

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0:36Intro. [Recording date: May 12, 2010.] In March of 2008, Bear Stearns found itself in financial difficulty. Unable to borrow money to cover the promises they had made. To prevent consequences from that occurring, the Federal Reserve (Fed) and the U.S. Treasury brokered a deal with J.P. Morgan Chase, where, by guaranteeing about $30 billion worth of Bear Stearns's assets that JP Morgan Chase did not feel comfortable with acquiring or finding out quickly whether they were worth acquiring, the government got JP Morgan Chase to acquire Bear Stearns and honor their promises to others. That was in March 2008; unprecedented set of activities by the Fed. Deemed crucial, necessary, and unavoidable--without a lot of evidence; there was a lot of uncertainty and fear about what would happen if Bear Stearns were allowed to go bankrupt and their creditors would not be getting the money that they expected. Fed and Treasury justified that intervention on grounds of stability, which lasted until September 2008. Fannie Mae and Freddie Mac, Lehman Brothers, AIG collapsed. Government stepped in in Citibank as well. The government stepped in in all those cases except Lehman Brothers; set in motion a lot of anxiety and uncertainty in markets. Found ourselves in the middle of what is now called the Financial Crisis of 2008. Watching that crisis, realized--in March 2008 and more strongly in September 2008--that I really didn't know much about modern Wall Street, the housing market, the role that Fannie and Freddie played and the significance of their collapse. Embarked on reading and listening to try to understand what happened. In Sep. 2008, interviewed Arnold Kling on how Fannie and Freddie worked; beginning of my education in what had gone wrong. Since then, 13 or so podcasts, interviews with people on the crisis--insight on how the two worlds of Wall Street and investment markets, and housing markets, Fannie and Freddie worked; and how these two worlds interacted. Could have done a podcast every week, thirsty to find out what had gone wrong; tried to mix up the podcasts with other topics. Wrote a lengthy paper, mini-book, on the Crisis; now available at the Mercatus Center: "Gambling with Other People's Money."
5:52In this podcast, some flavor of the basic arguments; but also want to discuss some of the issues we've been discussing here: the elusiveness of truth, economics as ex-post narrative, the role of bias; will try to weave these themes into remarks. Turn to the crisis: People have proposed a lot of potential causes. A commission over 20 causes. Congressional Research Service listed 26 causes to be investigated. Include mark-to-market accounting, Fannie and Freddie, Community Reinvestment Act (CRA), monetary policy, tax policy, deregulation, misregulation, too big to fail. Tendency to have the blind man and the elephant problem--blind men around an elephant and ask "What's the elephant like?" One man with arms around the legs says it's like a pillar, someone else holding the side says it's like a wall; like a rope if holding tail. There is a tendency to take the thing you are most knowledgeable about and blame that. There are a lot of competing narratives; all relevant. But curious about more fundamental causes: Is there a cause that without that, it wouldn't have happened at all--not just that it wouldn't have been a little worse or a little less bad. First start with a quote from Paul Samuelson, from an interview--quotes are in the paper--"And today we can see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself.... Everyone understands... now that there can be no solution without government." This is a stark view, widely held--underlying cause of the crisis was capitalism. Even so-called market economists such as Alan Greenspan have been sympathetic to this view. Greenspan, when he testified the first time before Congress in the aftermath of the Crisis, said "I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such as they were best capable of protecting their own shareholders in the firms..." Went on, referring to article in the NYTimes, ideology: "I have found a flaw. I don't know how significant or permanent it is, but I have been very distressed by that fact." In the Greenspan view, we used to naively think that markets, looking out for their own self-interest, would be guided as if by an invisible hand to serve the needs of society; but in fact, as Samuelson claims, that doesn't work. Does not led to stability and good things; leads to collapse, crisis, disaster; and therefore we need government. Fundamental question is: Are Samuelson and to some extent Greenspan right about markets? Is it true that markets can't regulate themselves--not meaning anarchy versus government heavy-handed regulation, but just on this issue? Forget about property rights, contracts--lots of things people on the left and the right could agree on are probably good things for government. Were we wrong to believe that markets are self-regulating or were we right and something else caused the disaster? Not: government or no government, but what should the role of government be? Does it need to be ensuring that there is stability in financial markets--and I would add in housing markets, where we saw this enormous run-up in housing before the collapse--which seems to contradict the Friedman view that markets can take care of themselves; certainly seems to contradicts the Hayekian view that prices and markets communicate information rather than just speculative fever and irrational exuberance. What do we conclude from the fact that stuff went haywire? Does it prove that capitalism is fundamentally unstable or does it prove something else?
12:34Some have argued--Jeffrey Friedman, Editor at Critical Review, Bryan Caplan at EconLog--that mistakes happen. People have imperfect information, make mistakes. Every once in a while those mistakes are so large, mis-assess the future in such a way that things turn out to be much worse than they thought. People go bankrupt. In this narrative, every once in a while--Bryan calls it a once-a century mistake, tsunami of mistakes--people make systematic errors and we have an unfortunate set of consequences as a result. This argument really creates stark issue: Did firms make bad bets because they were myopic? overconfident, stupid, careless? Or was there a set of incentives that encouraged myopia, overconfidence, stupidity, etc.? It's clear ex post that a lot of people made mistakes--executives, financial institutions made gambles, took risks that turned out to be much riskier than the Triple-A ratings that these assets were thought to have. Why did they do that? Why did they make such bad decisions? Was it because of the inherent animal spirits, crowd behavior, just didn't understand the consequences? Friedman and Caplan disagree with Samuelson about the policy responses; but put that aside. Is it the case that the fundamental collapse of all of these institutions was because people were stupid and myopic and world is an uncertain place, or were there policy errors that incentivized imprudent risk-taking?
15:57Let's talk about bias. I'm biased. Free-market guy; hostile to Samuelson argument, susceptible to Friedman and Hayek arguments. Easy to figure out which side I'm going to come down on. Going to argue that there were policy mistakes that created incentives. Easy to dismiss my viewpoint by saying "Well, of course the host of EconTalk thinks that markets work well! He's biased!" That's a mistake, not because I'm right--not going to tell you that I don't know the cause of the crisis. Would argue that when we dismiss people for being biased, we are making the same mistake we are claiming the other person is making. If on my side, prone to confirmation bias. Have to be careful on both sides. We are all biased. Significance of bias: you should judge, because I am biased, my evidence. Can't just dismiss my argument. The fundamental question is: Is the evidence I'm providing convincing? Because I'm biased, you should be skeptical about the validity of the evidence itself--legitimate worry. You don't want to dismiss without listening to the argument. Have to evaluate on the merits. Form of the ad hominem fallacy. True for the other side as well. When you hear that deregulation caused this problem or capitalism caused this problem and here's why, can't just say that's coming from Joe Stiglitz. Have to listen to the evidence. Can't dismiss it because the person making the argument has a bias. The other point about bias--it has a virtue: it forces you to look for things that confirm your bias. If they're not true, you are in a dangerous place; if you are ignoring things that are true, you are in a dangerous place. When you have a paradigm, it helps you organize the world. Thinking about Fannie and Freddie forced me to actually discover what they do.
21:32Back to main argument: Why did the decisions made by financial institutions leading up to 2008 lead to such chaos? Why did the people running those organizations destroy them? Why did bad investments lead to death and destruction rather than just a bad quarter or a bad year? We think about other industries--Amazon can have bad sales, but they don't go out of business unless they have losses year after year after year. Why did the losses of these financial institutions lead to bankruptcy rather than just we made some mistakes, we made a bad investment? Put another way: I was someone who said, back in 2006-2007, this whole subprime housing thing is not important. It's a tiny part of the housing market, which in turn is a tiny part of the investment world. People worried about it are Chicken Littles, the sky is falling. People might lose some money, might have a recession--like high tech world in 2001 when tech bubble collapsed but was not a major crisis. I was totally wrong. I didn't understand what was going on in the investment world was the role of leverage, and the reason that this crisis turned out to be so bad is because of the way they were financed. Through leverage--meaning, through borrowing--through using a lot of borrowing rather than very much of one's own money. Questions: why did firms make such bad decisions and why did the decision-makers make decisions so bad that they led to the end of investment banks and institutions? Was it because of an inherent flaw in capitalism or something else? Related question: such a small part of the investment world--why would that lead to bankruptcy, insolvency, rather than just we lost some money on subprimes so our earnings will be down this year? The answer has to do with leverage. Then the question is going to be--why did people borrow too much money? Capitalism or policy that distorted incentives? We're talking about very high leverage here: If you want to invest $100, you put in $3 of your own money, and borrow $97. That's about a 32:1 ratio of borrowed money to your own assets. This gain, this activity of taking risks with $97 of someone else's money for every $100 you invest, is being played by every single player in this market. What's elegant and frightening about what happened in advance of the crisis is that everyone was leveraged about 32% or more, as we'll see. We'd start with the homeowner: you'd go buy a $100,000 house, you'd put $3000 down and borrow $97,000. You'd have very little skin in the game--just $3000 of your own money. The person who lent you that money would then sell that mortgage either to Fannie and Freddie or an investment bank like Lehman Brothers, Bear Stearns, Goldman Sachs--who was bundling those mortgages up together and then selling them or holding them. If you were holding them, as Bear Stearns did--held many of these assets backed by mortgages, along with Lehman and Goldman Sachs--they too were highly leveraged. So, they would buy $100 million worth of mortgage-backed securities, using $3 million of your assets plus $97 million borrowed to purchase that mortgage-backed security. Acting like the homeowner, acquiring an asset using mostly other people's money. Fannie and Freddie were even a higher ratio of more than 32:1, taking very little of their own assets and the rest borrowing in the open market. Question then is: What are the incentives of the investor who borrows 97 for every 100 and the creditor--the lender of the money, who lends the 97?
28:27Short excerpt from the paper that tries to get at those incentives and takes the puzzle to the next level, poker game metaphor. Originally used dice metaphor; talked to Paul Romer, poker metaphor better. "Imagine a superb poker player who asks you for a loan to finance his nightly poker playing.... You will not get a stake in his winning. You will get a fixed rate of interest...." If his $100 bet makes $103, he has made a lot more than 3%--in fact, he has doubled his money. His assets are now worth $6 after the winnings. "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." We are all lured by the upside; it's the downside that is easy to forget about. If I have a $10,000 stake, $3000 from me, $9700 from you--if I lose 3% on the night, down more than $3000, I can't honor my promise to repay you. Thin margin for you, the lender. If I'm leveraged 32:1 and at the end of the night I'm only down by 95%, I can't keep my promise to you. I'm insolvent because I need 97 to pay you back. So it's nuts for you to lend to me 97:3. Why would you ever do that? Your friend--me--is an extremely skilled and prudent poker player who knows when to hold 'em and when to fold 'em. Might lose a hand or two because it's a game of chance, but by the end of the night I'm always ahead and can always make good on the loan. Let's say this poker play has never had a losing evening. You feel great lending to him: fixed return for you. As a creditor--the person who lends the money--that's all you care about. Don't care if he makes a little or a lot. Only care that the gambler stays solvent so you can get back your principal plus interest. The gambler cares about two things. Doesn't want to go broke, wants to stay solvent. Also cares about the upside. As a lender, you don't care about that upside. You don't care about how much he makes; you just care about his making good on his debt to you. If there's a chance to make a huge amount of money, the gambler may be willing to take a very big risk. The downside is small for him--he only has his $300 at stake. Maybe he'll take a chance on an inside straight. As a lender, you wouldn't want him to take that chance. The gambler will take a lot more risk than you would like. You keep an eye on him. Suppose the gambler becomes increasingly reckless. He's playing mostly with his own money. How would you respond? You might stop lending altogether. Or, you might look for ways to protect yourself: might ask for a higher rate of interest, or ask that the gambler put up his own assets as collateral; might introduce a covenant that legally restricts his behavior, barring him from drawing to an inside straight. 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 taking place in a natural state. Off in the corner is Uncle Sam, keeping an eye on the game, making comments, 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 makes good on the debt of players who borrow and go bust, taking care of the lenders. After all, Uncle Sam is loaded. He has access to funds no one else has. He also likes to earn the affection of everyone in the room by giving out money. Everyone knows Uncle Sam is in the room and knows there is a chance he will cover the debts of players who go broke. Nothing is certain. The greater the chance that Uncle Sam will cover the debts, the less likely you are to restrain your friend's behavior at the gambling table. Uncle Sam has changed your incentives. You will keep making loans even after his bets get riskier. You won't charge more interest. You will continue to lend. You won't require that your friend put in more of his own money. Your friend will respond by taking more risks than he normally would. Why wouldn't he? He doesn't have much skin in the game in the first place. Capitalism is a profit and loss system. The profits encourage risk-taking; the losses encourage prudence. When public policy reduces the chance of losses, it isn't surprising that people are more reckless.
37:50Then the question will be: would it be reasonable for creditors to think about that possibility in the last crisis? Did the rescue of creditors in the past increase the chances of future rescues sufficiently that creditors were careless? Did the rescues of 2008--the rescues of the creditors of Bear Stearns, AIG, Fannie and Freddie, Citibank--not all the firms got rescued, some went bankrupt, but the creditors were rescued. In almost all the cases, with the exception of Lehman Brothers, the creditors did not pay a price. Would it be reasonable to anticipate that if you were an investor in 2004-2007? Would your behavior be influenced? Before turning to that question, a side-issue: what about the equity holders? They were wiped out. Greenspan point: equity holders were wiped out; why didn't they monitor the risks of institutions whose shares they were holding? Fundamental understanding from Gary Stern's book, Too Big to Fail--podcast. Book with Ron Feldman, 2004--ex ante, before the fact description of the problem: argue that past bailouts of creditors had reduced creditors' incentives to be vigilant. More important incentive point relative to share-holders: in a capitalist system like ours, creditors are the watchdogs of carelessness, not equity holders. Equity holders don't want to get wiped out; but they are typically diversified, and they want a lot of risk-taking by some of their investments so they can make high rates of return on the upside. But because creditors don't share in the upside, they only care about the downside, making sure the firm stays solvent. So, it's creditors that monitor solvency, not equity holders. Creditors who monitor prudence and recklessness. But executives of these firms held millions of dollars, hundreds of millions, sometimes a billion dollars in the firm--they didn't want to get wiped out! Why didn't they act more prudently? Seems to lend credence to the mistake theory--myopia, unstable markets. Obviously not a problem of credit rescue--they shouldn't rationally have taken such risks and saw their nest eggs wiped out. Financial and psychological aspects discussed in the paper--the fact that the CEOs of Bear Stearns and AIG were humiliated. Bottom line: surely they paid a price! Think that argument is wrong because it fails to account for the incentives and pay structure on Wall Street, set up to make sure that even when they lost a lot of money, they still ended up with an enormous amount: "Tails they win an enormous amount; heads they win a ridiculously enormous amount." Not like in one case they get wiped out. Jimmy Cayne was left with a mere $500 million dollars. True he lost a billion, but he was left not exactly in poverty. Cayne, Fuld, Blankfein not wiped out. Their ability to borrow other people's money allowed them to take a lot of money effectively out of taxpayers. Fannie and Freddie--who also had highly paid executives, but that's another story--were typically borrowing money from a whole bunch of places--a lot from the Chinese, a lot from institutional investors, a lot from individuals buying their bonds: borrowing money to buy up these high risk mortgages. Russ's Dad. Those investors who invested in housing lent money to Fannie and Freddie at very low rates, even as Fannie and Freddie got involved in riskier and riskier loans. They should have found it harder to borrow. Why didn't they? Why didn't the interest rates they offered have to go up? Between 1998 and 2007, Fannie and Freddie invested in riskier and riskier loans but the rate of interest they paid stayed very low, barely above what the Treasury paid. The Treasury has the faith of the United States behind it. Turned out that Fannie and Freddie had the faith of the United States--taxpayer money. Playing with my money as a taxpayer. Without that promise of taxpayer money, they couldn't have made those bets.
47:37As an aside: don't think Fannie and Freddie were the cause of the crisis. Although they were involved in subprimes, they were not deeply involved. What is true is that between 1998 and 2003, even 2006, they got involved in riskier and riskier assets. Summarize before we go forward. Why did Wall Street and other financial institutions collapse? Because people were careless and made bad bets? or because of public policy that encouraged people to take on too much risk? The next level of cause is leverage. But why would lenders lend money to firms knowing a small change in the value of the assets would leave them unable to cover the value of their debts? Why would lenders take on so much risk? Were they just myopic? Or was Uncle Sam incentivize lenders to be less cautious? Is it plausible that firms anticipated the bailouts or was it simply that they were just careless or over-exuberant? To answer that question--which cannot be answered without a shadow of a doubt--we can get some evidence on it--drawing on Stern's book and additional readings described in a few pages of the paper. Talked about in interview with Barry Ritholtz podcast, Bailout Nation. Sometimes this gets called "too big to fail." We do let large firms fail. The problem is the rescue of their creditors. Semantic distinction. How much creditor rescue has there been of large financial institutions over the last few decades? Was it reasonable for those creditor rescues to influence how creditors behaved in the run-up to this crisis and the ultimate bailout that they received? History goes back to 1984, Continental Illinois, which at the time was the seventh largest bank in the United States. They got into trouble along the exact same lines--made risky investments with borrowed money. Eventually lenders got spooked; Continental Illinois went into insolvency; and the Treasury made sure that all the creditors got all their money back. Even above and beyond what was covered by FDIC insurance. That was the beginning of a whole series of creditor rescues: the Savings and Loan Crisis being an obvious example. That was depositors into savings banks--in that case creditors were promised their money back, which is the nature of FDIC insurance, but as Stern and Feldman point out, they actually got back all their money even when they weren't promised, even if their deposits were above the limit. Other examples: the so-called Greenspan put--the idea that Greenspan would always bail out financial markets, pumping liquidity into markets to make sure markets wouldn't fall, making creditors not have to worry about bankruptcy. Ritholtz gives examples in his book how Greenspan intervened. Another example: 1998 Long Term Capital Management, a hedge fund, did the same thing--convinced a lot of people they would never lose money, or maybe the government standing behind them convinced people. When they couldn't pay back their creditors, the government called a meeting of their creditors to try to orchestrate a rescue rather than a collapse. The government didn't promise any money--they just forced the meeting and tried to find ways to get them to allow Long Term Capital Management to keep going. But it is an example of how vigilant the Fed and government generally were to make sure creditors don't lose all their money. An example that doesn't get talked about so much is the Mexican peso crisis of 1995. Mexico suddenly found they couldn't continue to borrow money--very similar to what is currently happening in Greece. Lenders were very wary; Mexico was about to default on its promises to pay back those who had lent them the money. Those lenders were frequently large Wall Street institutions. Government orchestrated a bailout of Mexico where they guaranteed the loans to Mexico that would allow them to continue borrowing without defaulting. This is called a rescue of Mexico, but that's a mistake. It was a rescue of the people who lent them money. Important to keep your eye on the ball when thinking about what's going on with Greece. It's not the institution that gets bailed out--it's the creditors. Keep your eye on the creditors. In the case of Bear Stearns, think J.P. Morgan Chase was their biggest creditor. Allowing J.P. Morgan Chase to buy them was not a bailout of Bear Stearns but of its creditor, J.P. Morgan Chase. The failure to bail out Lehman Brothers wasn't just a punishment of Lehman, but a punishment of those Lehman owed money to. A lot of those were foreign banks, Asian banks, Korean banks--not J.P. Morgan Chase. Have to keep in mind who wins and who loses. Mexico in 1995, crisis, about to default. United States steps in and puts together a $50 billion--large sum of money at the time--package to guarantee new loans to Mexico so that they will not default. Turns out apparently great, called a success. The Treasury doesn't lose money, no default, Mexico goes forward. Incorrect reading of what actually happened. Willem Buiter quote: "This is not a great incentive for efficient operations of financial markets, because people do not have to weigh carefully risk against return.... That makes for lazy private investors who don't have to do their homework figuring out what the risks are." That's the essential part of what has happened in the last few years. Creditors don't have to do their homework; no one else to monitor the risk. All profit and no loss makes Jack a dull boy. If you don't have to worry about the downside, pedal to the metal on the upside.
59:38That was an ex ante warning. Two examples where the government did not rescue creditors of a large financial firm in the last 30 years. Drexel Burnham, criminal organization so not that surprising. Lehman Brothers. Lehman Brothers looks a lot like Bear Stearns; Bear Stearns's creditors get 100 cents on the dollar; don't know for Lehman Brothers because still in bankruptcy proceedings. In these creditor rescues, instead of giving less than 100 cents on the dollar, give full 100 cents on the dollar. AIG, fall of 2008, threatening default--according to Bloomberg--went to Goldman Sachs and started negotiating to pay less than 100 cents on the dollar. When the government took over, the New York Federal Reserve, under Tim Geithner at the time, said they were going to honor 100 cents on the dollar. When asked why, a number of explanations given. Not a good idea.
1:02:05One time we didn't do it: Didn't do it for Lehman. Their balance sheet looked a lot like Bear Stearns when Bear Stearns went bust in March of 2008. Lehman Brothers was the obvious candidate for "who's next." Plenty of fraud in this story as well--no doubt that firms did dishonest things; not chronicling the magnitudes. We do know that Lehman tried to hide the magnitude they had, more than they revealed. But in the run-up to the Lehman collapse, Lehman credit default swaps--that is, if Lehman goes broke, you get money, insurance against Lehman going broke. When Bear Stearns went broke, the cost of buying insurance against Lehman going broke spiked--went up, because people said they are like Bear Stearns. But when Bear Stearns got rescued, the credit defaults went down to a much lower level--people reasonably thought that if Bear Stearns got rescued, Lehman would as well. Creditors will get their money. Didn't turn out to be true; unexpected. Markets went haywire. People concluded Lehman should have been bailed out. A different interpretation--mine--people said "The government's not going to bail out everybody like we thought?" That's what caused the turmoil. Not the consequences of the Lehman policy but that people learned about government policy. Short-lived because they then proceeded to bail out every other creditor; but it sent a frightening signal that changed expectations about what government is going to do. Suggests that there was an expectation established possibly by Bear Stearns and previous examples. Another example in the paper of how firms had anticipated rescued and behaved imprudently: Haldane, with Bank of England: what's the worst case scenario? Stress test. Haldane was struck by how small the stresses: Why aren't you looking at really big stresses, really big turns of events? One banker said, If it really is horrible we know you will bail us out, so we don't worry about that situation. Response was that we wouldn't bail you out; but when it came time, they did. They bailed out the Royal Bank of Scotland and honored their promises. Role of creditor rescue: I don't argue that the executives at Bear Stearns, Lehman, Fannie and Freddie, etc., who both lent the money and who invested in risky assets with other people's money sat around and said they don't have to worry because the government will bail us out. Mainly what we are talking about here is psychological. The natural cautiousness of a creditor was eroded by the continual rescue of the creditors leading into the collapse of 2008. By consistently bailing out creditors at 100 cents on the dollar they reduced the incentives for prudence. Not paying attention. Other point: Bailed out almost every creditor at 100 cents on the dollar. Maybe people anticipated it; maybe they didn't. Maybe irrationally exuberant. But if you are doubting the power of this incentive, ask yourself how this has changed things going forward. Do you think that the persistent rescue of creditors of large institutions has made them any more prudent? Don't you think it's made them a little less cautious? Reasonable for them to believe they will be bailed out again, so that as a lender you don't have to worry so much? A lot of reform bills on the floor of Congress right now. When you read about them: what you ought to look at is how much discretion policy makers still have to bail out creditors. If they still have that discretion, they haven't solved the problem; we still have continued to encourage recklessness. Don't know that we can solve the discretion problem. Ben Bernanke wants to be able to use discretion for a hundred reasons that should be obvious. Think we have made it easier for creditors to count on being rescued; we have transferred hundreds of billions of dollars to Wall Street and we have allowed them to finance those bonuses that they will continue to receive. Destructive for democracy and for capitalism.
1:10:32Housing market. Some on the right argue that Fannie and Freddie are the cause of the crisis. Don't think that's true. Think they have something to do with the crisis, mostly Fannie and Freddie, CRA not so much. There are plenty of investment banks that did really stupid things that were privately run, and any explanation has to deal with that. Bear Stearns, Lehman, Goldman Sachs, J.P. Morgan Chase, and others took very risky bets that turned out to be riskier than they said they were and did that with other people's money. Housing market: starting around 1992, Fannie and Freddie were encouraged increasingly to finance more and more mortgages to disadvantaged people. These are not the same as subprime loans. They can be, but not the same. Fannie and Freddie were encouraged through the '90s and through the 2000s, both both Clinton and Bush, that a larger and larger percentage of their loans went to low-income borrowers. They purchased loans from mortgage originators, making it easier for mortgage originators to finance those loans. Mortgage originators--Countrywide, Wachovia, WAMU, etc.--were intermediaries, the middlemen, essentially filling out the paperwork for Fannie and Freddie. Because Fannie and Freddie had a guarantee implicitly which turned out to be explicit, Fannie and Freddie could only invest in safe mortgages--20% down, income-to-debt ratios, etc. But starting in 1992, public policy from the Clinton and later the Bush administrations changed the restrictions that Fannie and Freddie operated under so they could make riskier and riskier loans. They moved away from 20% down loans, or loans that had good documentation about income, and also moved into subprimes. On the right, some say Fannie and Freddie is the whole thing; on the left some say they had nothing to do with it. I think both wrong. They had a significant amount to do with it but not the whole thing. Two things: government requirements that they invest in riskier and riskier assets; and the implicit guarantee they had that allowed them to fund those with borrowed money at a very low interest rate. Fannie and Freddie data not very good; always some question about whether they are telling the truth; they had an accounting scandal in 2003-2004. Bottom line is that with the data we do have, starting around 1998, Fannie and Freddie started to invest in mortgages with little or no money down. With less than 5% down. Allowed it to be easier for mortgage originators to offer loans to borrowers with very little skin in the game. Between 1998 and 2003 Fannie and Freddie go nuts. They have an incredible explosion in activity with a parallel explosion of loans to low income borrowers--below the median. Sub-requirements, sub-mandates; but just keeping to below the median, that amount goes through the roof. Chart in the paper. The profits they earned for both their shareholders and their managers; continued to borrow at very low rates. That pushes up the demand for low-income borrowing. The availability of easy credit from Fannie and Freddie starts to push up the price of housing through normal demand factors. Lots of quotes from their executives about how it is making it easier for people to buy homes; they are going to be more aggressive, partner with Citibank. Public campaign under pressure, which they enjoyed or didn't oppose--liked buying low income loans, let them make more money and more highly compensate their executives. Same thing the investment banks are going to be doing in a few years in the story. Able to finance it because of the implicit guarantee. Price of housing, particularly in low-income neighborhoods, have the biggest appreciation during these years. That in turn makes subprime imaginable--imaginable to lend someone money to buy a house, someone who has got very bad credit. Think: they've only got 10% down, but if the house goes up only 3%, they've suddenly got skin in the game. Suddenly not so bad; can imagine a firm taking a chance on lending to someone with low income and bad credit or no documentation. Monetary and tax policy also plays a role. Pushed by Congress and by the Clinton and Bush administrations start to cause a rise in house prices which makes the subprime market more attractive; starts to explode in the 2002-2003 period. That in turn makes it profitable for the investment banks to get into the subprime mortgage-backed security market.
1:20:26A lot of people, Paul Krugman for example, say Fannie and Freddie had nothing to do with the crisis because the crisis was 2004-2006 and Fannie and Freddie were not very involved in housing and not involved in subprime. Had to withdraw from housing because of accounting scandal and they pulled back. Turned out to not be true--they pulled back only a little bit. Where the left is right, where Krugman is right, is that it is true that the bulk of subprime investments came from the investment banks, not because of any implicit guarantee to Fannie and Freddie, but because of the implicit guarantee to those investment banks. They knew investors could expect the possibility of creditor rescue.
1:21:33Go on to show in the paper how regulations called Basel II which were supposed to go into effect in 2008 were actually put in place much earlier on commercial banks and investment banks--how they made Triple-A investments, highly leveraged. What Basel II did--if you want to invest in Triple-A you can leverage 60:1--because they're safe! Triple-B requires much more of your own capital. The regulations that drew on Basel II in the United States drew on that. Triple-A, you don't need very much capital at all because that's Treasuries and other safe things. But what that did was create an enormous demand for Triple-A. There isn't much AAA to go around. Financial markets created some new Triple-A--they created the tranching system of new mortgage backed securities. But that wouldn't have mattered if there weren't creditor rescue. There would have been some prudence, some oversight; but because of creditor rescue that monitoring disappeared or was reduced.
1:23:40Doubts. What might be wrong with my thesis. It could just be myopian greed. James Hamilton post, shows how in 2008 there was a sudden panic. Short-term lenders said Whoa! This could be a mistake. They could go out of business. Could be consistent with my story. Musical chairs--creditor rescue is like the government adding another chair every time. But maybe that's wrong: maybe they just weren't paying attention and when they did they realized it was much riskier than they thought. The other possibility: monetary policy. Maybe that's the whole thing. Maybe without the low interest rates of 2002-2004 that John Taylor talks about in Getting Off Track, it wouldn't have exploded--podcast. In the paper point to a lot of examples of Fannie and Freddie pushing up the price of housing in low income areas. Maybe the magnitudes are not there. Maybe Fannie and Freddie were involved--they were a nontrivial part of the subprime market, maybe 20-30%. But if they hadn't bought them, maybe others would have bought them. Finally, maybe there is stuff we just haven't discovered. The Abacus deal under investment with the SEC--very complicated, moral and legal issues. Magnetar story. There's going to be a lot of research in the next 10, 20 years. We will never know. If my story is correct what we really have on Wall Street is not capitalism but crony capitalism. Quote: "An unpleasant but unavoidable conclusion...." Ponzi scheme. Almost everyone made money except the taxpayers. We'll find out over the next decades.

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COMMENTS (76 to date)
floccina writes:

The way I look at is economic freedom is flawed because people are flawed but Government is also flawed because people are flawed but Government has worse incentives and is excessively powerful and so can do more damage.

1. The part of the podcast where you address your own biases and why people should still consider the evidence that you present is excellent.

2. The evolution of money and banking was cut short by the creation of a single national currency and then a central bank. The banking system is plagued by free back and has no built in fail safe.

3. Bad things happened because free people make mistakes but people in government make mistakes too. I still think freedom comes out ahead. I think that one of the silliest things about housing and finance is that Government wanted more people to own homes and so people in Government tried to make it easier for people to borrow more money rather than trying to to make homes cheaper. Seems strange to me.


LuizdoPorto writes:

Prof. Roberts, try this on for size.

Capitalism is progressive in fact, not just in name. A capitalist actor seeks improvement, making more money by finding ways to get more output out of the same old inputs and poketing the diference.

Of course an innovative system is unstable. It is the nature of the beast.

The tottering political economy of the Developed World, especialy in finance, public and private, is the real problem in Lehman and in Greece.

It's always the damned debt.

Marty writes:

Great podcast and paper. I love the free education I am getting. Thanks.

Couple of ideas on the analogy and personal reflections.

1. What would the ideal game look like?

No uncle Sam. Or a more vigulent Uncle Sam?

2. Should there be a game at all? If not whats the alternative.

3. Does Uncle Sam being there lower transaction costs...I am thinking about liquidity and the benefits of trust overall to the economy. Also where do the rating agencies fit in?. Also the concept of security for my loan and collateral seems absent.

Thanks again

Nick writes:

Dr Roberts,

In the poker analogy you lay out, you enumerate a list of things which creditors could do, if they were concerned about excessive risk taking by the firms. The list includes many things which did not happen (higher interest rates, lower leverage ratios, etc..) but it does not include the very thing which did happen, hedging.

If you could buy insurance to protect yourself in the even of your poker playing friend's default, then your concern about his risk taking would be less.

Of course this still comes back to the argument of government failure, but i believe its a much weaker argument, because it was the failure of government to understand and control the actions of those selling the insurance. I also think this kind of government failure may not sit well with you because it was the free market ideologues of the 1980s and 1990s who opposed controls and oversight on these type of insurance contracts.

Mads Lindstrøm writes:

It seems that the financial storm is moving eastwards - towards Europe - at an enormous speed. Thus it would be very interesting with a podcast about Europe's financial difficulties. I am European myself, which obviously fuels my interest.

One interesting part is the role of the Euro. I am from an EU country, which are happily not member of the Euro zone. Still, to my surprise, some Euro proponents thinks the current crisis would have been a lot worse without the Euro.

Another interesting aspect could be the role of private and public debt. And of cause the role of housing.

I realize that this is an American podcast, but still sometimes it can be educational to look at other countries. And it can be educational for countries to be looked at by outsiders.

Russ, I hope my sales pitch is convincing. Either way, thank you for an interesting and educational series of podcasts.

BZ writes:

Nick -- awesome point about hedging. The bundling of gamblers to offset risk does seem viable, and seems to accentuate the role of the Fed in influencing the outcome. With all gamblers bundled together, how can investors lose? The answer: if someone is feeding the gamblers chips to keep in the game, but the "pots" don't doesn't actually gain in worth, only in chip size. That's a stretch for the analogy though, equating home values with chip values...This is making me dizzy.

TrentWhitney writes:

Russ,

Liked the content of both the podcast and your paper.

A stylistic suggestion: Ask one of your colleagues (or even a regular Econ Talk guest) to read your paper and then interview you about it. I think that would be a lot more effective to have some "live" give-and-take, as with the other podcasts, instead of a 90-minute monologue. I realize that could lengthen the podcast, but you could always divide into two 60-minute podcasts.

Tom Dubis writes:

In the longer, first part of your analysis and
commentary when you discussed investor motivations
I kept waiting for you to mention the ratings
these 'investments' received. Michael Lewis in
his book "The Big Short" gives a great deal of
emphasis to this as part of the explanation for
why investors bought these instruments:AAA ratings.
So Moody's and S & P had a lot to do with providing credibility for this stuff being created by the 'financial engineers' on the bond desks of the Wall St. firms.
Another point he makes is that no one--or almost no one--seems to have understood what was really in these instruments, how they were constructed, or how they worked.
Nor,apparently, was it understood what the underlying leverage might mean if default rates
on housing rose. Recall that for an extended period of time there was an almost universal belief that housing prices could only go up reducing any possible default risk.

NormD writes:

Thoughts:

1. I am deeply concerned about something you dismiss blithely. If no one really owns more than a small piece of any corporation then no one has an incentive to insure that the corporation survives. Incentives matter. But incentives apply to people not corporations. If the CxOs, traders, etc of a corporation can make a huge amount of money for themselves by putting the corporation at risk, they will. And a capitalist should fully expect this behavior. Its completely rational. The check-and-balance on their behavior is missing.

2. You have said repeatedly that people who loan money need to take more care about who they loan to. This sounds so nice, but in the real world, is totally impractical. When you put money into a savings account at your bank, how can you possibly check out what the bank is investing your money in??? How many frugal Germans realized that their saving accounts were being lent to Greece? And even if you spent weeks researching your bank before you invested, whose to say that tomorrow your bank might not roll your money over into something more risky. Refer to item 1. I wonder what my home/life insurance companies are investing in?

3. Something I would love to see more discussion of is timing and capacity, specifically:

3a. Investors. You are China. You just had a $100B of Tbills mature. What do you do with the $100B? You cannot spends months thinking about things, you need to purchase something NOW. What is it?

3b. Bankruptcy. We all want organizations that screw up to fail, but if a series of interlocked banks fail, how do we deal with all the failures? Do we have enough courts, judges and experts? How do we even audit the books of Bank of America? What do we do for the years that bankruptcy may take?

3a. Regulators. Regulators don't have years to consider regulations. They have to act. For example, what should be done (if anything) about High Frequency Trading?

4. Its already been mentioned before but you ignore hedging and the fact that hedging is done privately hides from other investors the actual risk of an investment.

Somehow we have to create system where at every step in the chain some person who has authority will benefit from a profit and lose from a loss. I want to know that if BofA succeeds the CEO will get houses and cars and planes and that if it fails he/she will lose all the houses and cars and planes so that he/she will have an incentive to keep BofA both profitable and safe.

Thomas A. Coss writes:

Dr. Roberts-

You hijacked my Monday afternoon with an amazing piece of work which I thoroughly enjoyed, and for which I'm very grateful.

Special thanks to you and your team this outstanding effort and the clarity it has provided.

Thank you all.
Tom

xian writes:

awesome podcast....among the best...

maybe have people from diffferent "world views" respond to this (and/or paper) in future podcasts.

above all, i was thrilled to hear the whole problem framed in terms of creditors getting bailed out over and over again....

too often ive watched financial tv or read financial columns refering to "bailouts" while never addressing who is getting bailed out...even worse, they usually imply management or equity holders are getting bailed out.

it drives me wild.

great work. the issue needs to be framed like this for any serious changes.

this all raises the question about how market players and government players interact.

Rick Lowe writes:

Thank you for your careful analysis Dr. Roberts.
You have such a clear way of getting the point across.
Rick

Russ Roberts writes:

Nick,

Excellent point. There were two forms of hedging, I think. There was collateral and there was insurance. Neither proved adequate. The collateral was worth much less than it appeared to be worth and the insurance companies were broke. But it's not like the firms said, hey, anything goes, we're going to get bailed out! I think there was something subtler going on, a culture that generated what was considered OK behavior because it was the norm. That norm was what it was because of past rescues.

Christian writes:

Russ,

You and your podcasts are terrific. Don't be despondent, economists apply scientific rigors to an otherwise messy intellectual endeavor. Their number one fault is reliance on induction. Even a physicist can't say that 'nothing in the universe' travels faster than the speed of light lest another Einstein come along and prove him a fool. All we can say is that 'as far as we know' or 'in the circumstances of my test,' such and such result occurred. What does that mean for the broader world? Unfortunately, it often means nothing. However, that doesn't stop people from extrapolating. They apply analogy (fool's gold by the way) and end up where they want to be without any of the scientific rigors that were used to arrive at the original conclusion.

Also, we need to abandon words like "the government" and "the market." They are meaningless and non-instructive. Markets have rules (I can't steal your stuff) and so do governments (one person, one vote), and humans manipulate those rules to achieve the result that best suits them and their beliefs. Instead, we need to focus on the rules and their incentives, just as you say.

Thanks,

Richard Sprague writes:

Incidentally, I'm not convinced that Greenspan changed his mind.

When the first media reports came out, I studied his original 2008 testimony very carefully and I think the media quoted him out of context. Overall, his comments are what you'd expect from a very pro-market 83 year old man, hard of hearing, being grilled by tough politicians looking for a scapegoat. His famous "I found a flaw" quote relates to his lack of understanding of credit default swaps -- a market that barely existed when he was chairman -- and in context reads more like a curious mind looking for more information, not recanting.

I don't know if he's responded more directly since then. Anybody have more up-to-date information?

Nathan writes:

After most every episode of Econtalk I tell myself, "OK ... because I listen to and mostly understand Econtalk I'm probably in the top 0.01% of people in terms of understanding economics ... therefore, based on this knowledge, what kind of predictions can I make about the future, so I can better prepare myself and my children?" I suppose the honest answer is, "Nobody knows".

A few themes this thinking takes are:

1) The U.S. will rebound from this downturn much as it rebounded from the 1970s. The next few years will be lean but there will be great opportunities within my children's and maybe my lifetime yet.
2) The U.S. will rebound from this downturn much as it rebounded from the 1930s, with an intervening major war, possibly on U.S. soil this time.
3) The center of wealth and opportunity has shifted to Asia-Pacific Rim, and I should prepare my children to consider moving there.
4) The U.S. as we know it has gasped its last breath and there will be no rebound. We have inflation, social division, dictatorship, and war in our future.
5) The general uptrend in living standards worldwide will continue. The relative wealth of the U.S. to the rest of the world will decline, but we will still be living pretty well.

I wouldn't want Russ or his guests to seriously attempt to predict the future on Econtalk. As discussed many times on Econtalk, explaining the past is problematic enough. But I think it would be interesting for Econtalk to routinely consider the question, "Where does all this knowledge get us? Can we make some useful guesses about the future? Can we at least not be surprised when otherwise "unexpected" events happen?"

Paul writes:

Fantastic podcast Russ.

As a believer in Austrian business cycle theory, I'd reconciled the recession in my mind, but something that had nagged was why would those investment banks do such crazy things. I think you've provided the definitive answer (with your usual humility).

EE writes:

Russ,

Great podcast. The best part I agree 100% with - is the conclusion. {wink}

We are witnessing the casino capitalism (quants and crooks) at its best; the winner takes it all since he knows the casino owner who writes the rules for the slot machines and roulettes. It needs not to be depressing knowledge, though.
Au contraire!
When I read the current "superstar economists" pop-articles for the masses, it reminds me the medieval theologians arguing about how many angels can dance on the tip of the needle (Summa Theologica).

Mr. Taleb may be crazy (by an opinion of many experts), but mother Nature doesn't give anyone the second chance; he got that right. The time to fasten the seat belts has arrived. Safe journey!

Mads Lindstrøm writes:

Hi Russ,

From the paper:

"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."

So almost every bank failure results in bailout. This supports your hypothesis, but I would be more convinced if the opposite could be shown. Namely, that not bailing out banks results in prudent behavior. Can this be show, in America or other countries?

Saurabh writes:

I listen to Econtalk regularly but this one was utterly disappointing due to verbosity. I agree with the arguments made but Russ went on and on about bias and leverage. With some extra work, the argument could have been compressed and not leave me with the feeling: Ok, I get it, let's move on.

I hope Russ will improve upon this in future.

Joe2920 writes:

Russ,

Great podcast, I learned a lot as usual. But alas I must give my 2 cents, I have not read the paper yet it just finished in my printer. I was suprised to hear that you didn't consider F&F to be at the root cause of the mortgage crisis. If they did not exist and or have implicit gov't backing would banks today still keep their loans in house. Maybe if the FDIC wasn't around people would research where they put their money for risks. But it all gets numbed down by the GOVT and the free market gets the blame.

I enjoyed your analysis and share some of the same conclusions but also the same biases.

I too believe that Fannie and Freddie were players in the game, although certainly not the only culprits. There is ample historical evidence, including loud warnings that Fannie's and Freddie's actions could ultimately lead to financial catastrophe.

Fannie, Freddie, and You as the Secret Santa
http://soquelbythecreek.blogspot.com/2010/02/fannie-freddie-and-you-as-secret-santa.html

Fannie and Freddie can be likened to metal recyclers. Metal recyclers are not criminals. Metal recyclers do not explicity cause others to steal manhole covers, rip out copper plumbing and wiring from abandoned buildings, or cut catalytic coverters from cars parked on the street--all criminal activities. However, metal recyclers provide a lucrative market to covert such activities into ready cash, which encourage illegal activity.

Congress seemingly abdicated its financial oversight role. There was ample evidence of wrongdoing but necessary reforms were thwarted or delayed. Why? Was it because of Fannie's and Freddie's lobbying efforts? Was it because of associated lobbying by related organizations such as the National Association of Realors and National Mortgage Bankers Association? What about from the large financial firms like Goldman Sachs.
http://www.opensecrets.org/lobby/indusclient.php?lname=F10&year=2008
http://www.opensecrets.org/industries/indus.php?ind=F10++&goButt2.x=14&goButt2.y=11

The mortgage meltdown was not a failure of capitalism. If anything, it highlights the inherent danger of crony capitalism, controlled by corrupting forces and conflicting interests within government.

Like any major catastrophe, there likely isn't a single point failure but multiple cascading failures, including but not limited to the Fed's cheap money policy, China's need to invest money outside of China to avoid creating internal inflation, the lack of oversight enforcement by Congress and the SEC, the lack of visibility on credit default swaps, improperly high ratings for some securities by the various rating agencies, conflicts of interest galore, etc., etc., etc.

Ambi writes:

Thank you Russ Roberts for a very insightful podcast. I especially liked your clarification that the federal government is bailing out the creditors and not the banks. I have surmised that these creditors are politically connected to the Bush and Obama administration and the bailout is a case of friends helping each other. It is sad that taxpayers will ultimately pay for Wall Street's failings in the form of high inflation, higher taxes, and lower living standards.

Schepp writes:

Russ,

Great job, I was not a big fan of your monologs in the past, but this is a wonderful capstone to your other podcasts on the crisis and I think that solo presentation made it better. I liked the way you rolled up so much of what was covered in the past year or so and framed it how you saw it.

I like your simple approach and agree with your assessment. I do think that denial of the othersides' points of view can be rooted in the consistency that is needed to get funded. Academics in market place like everyone else, but just as in minimum wage, the rules of academia restrict how the transactions can occur.

I doubt that you or Ed Leamer from last week are gaining any academic fans, but this is great info for me.

Ralph Buchanan writes:

Russ:
Great podcast, but I think you provided a better, more succinct synopsis during one of your earlier interviews on the subject. I like the poker metaphor; although, perhaps it's more like video poker where the system has been programmed and doesn't really perform statistically like a 52 card deck. The house wins - too big to fail. Play again?

I was expecting a new book from this material, which I would have bought and read with glee when it appeared on the best-seller list.

Keep up the good work. Thanks Russ.
Ralph

James writes:

I really enjoyed this podcast in particular (even more than most of your interviews, which I also enjoy). Not that you need to hear it from me, but it was interesting and understandable.

One quick question. You talked about confirmation bias and the importance of hearing different perspectives. Are there any free podcasts or blogs put out by people who hold different viewpoints that you'd recommend? This question is open to any fellow commenters as well. I ask because, as a non-economist, I'm not familiar with many people in the field. Of course, I could search for them myself, but it's so much easier to ask you (I kid; it's probably taken me longer to write this).

I should note that I'm aware that it's probably not the best the idea to ask the person for whom you want a different perspective to recommend those alternatives. I will, however, rely on my belief that you seem like a pretty straight shooter and the fact that I too have a brain (or at least something of a similar size and consistency, situated in the corresponding location of my body).

I look forward to the next podcast.

- James

Carl writes:

Great podcast.

I hadn't realized that I was part of the problem. Basically, I am a creditor because I have a savings account. I don't really care where I put that money because I know that if the bank fails, I will still get all of my money back. So I put my money into a bank that ended up failing, namely Washington Mutual. I gave them money to gamble with, but I had no incentive to do any research on them. If I had to worry about losing the money, I would have put it somewhere else. What that tells me is that as long as we have a bailout culture, maybe there is justification for separating investment banks and commercial banks.

Chris Koresko writes:

Russ,

Enjoyed the podcast very much, but have a couple of questions. One is fundamental: in your poker example, you say,

"If I have a $10,000 stake, $3000 from me, $9700 from you--if I lose 3% on the night, down more than $3000, I can't honor my promise to repay you. Thin margin for you, the lender. If I'm leveraged 32:1 and at the end of the night I'm only down by 95%, I can't keep my promise to you. I'm insolvent because I need 97 to pay you back."

Okay, you are making the argument that high leveraging amplifies risk. What I don't understand here is that the poker player still has $95, which is enough to repay around 98% of what he owes (neglecting interest on the loan). So why is his insolvency such a big risk to the lender? Is the law written such that if he can't repay 100% then his debt is null and void? If so, is that law the real cause of the crisis?

Second point: When I saw Nick's first post about hedging by buying insurance, I thought you were going to respond by saying that to first order it doesn't impact your story, because the company selling the insurance is presumably taking into consideration the likelihood of a bailout just as the lender himself is. This is reflected in the price and availability of the insurance. Is this not correct?

Third point: I am coming to suspect that the risky behavior on the part of Wall Street firms was more or less an inevitable product of the fiscal, legal and regulatory environment in which they operated. Trillions of dollars were being injected into the system as a result of Fed policy and housing policy. That money had to go somewhere. Wall Street had to process it somehow. The money was problematic, because some of it wasn't securely backed by hard assets. Wall Street adapted to the new environment in ways which were innovative and unforeseen, and which might have made the system more vulnerable when it became clear that the debt was "toxic".

You allude to the demand for Triple-A and how firms responded by creating it by packaging together lower-rated assets, and the ratings agencies went along with this. This strikes me as a concrete example of the way Wall Street can be corrupted by Washington. Here I am using the word "corrupted" pretty loosely, since there was nothing immoral in bundling assets this way if there was genuine reason to believe that the bundles deserved their Triple-A rating. But it does illustrate how the regulations created incentives to do things which added risk, or at least obscured it.

If I understand the history correctly, the pressure from Washington on the banks to make bad housing loans was increasing over the decades leading up to the crash. If the banks had resisted harder, they might have delayed the creation of the housing market bubble, but only for a while until the Federal pressure got high enough that they found it prudent to yield.

So I'm leaning toward putting the blame mostly on Washington, though with some reservations.

John Berg writes:

Having the benefit of the time, (It is 10:50 cst on 19 May.) I know the results of the Tuesday elections and that the current DOW is down 150. Apparently the American public is aware of Russ Roberts thoughts and are "throwing out the bums in Washington." At the same time they are protecting themselves from the market. Clearly others around the planet will also be affected by the American public's knowledge.

John Berg

kebko writes:

It is sad how much economic opinion is pre-determined & narrative based. Two examples that came to mind while listening to the podcast:

1) Status quo bias - If you suggested new rules for IRA's & that those rules were: You aren't allowed to save at all, but any investments you made on margin were tax-free and the interest deductible, and you were only allowed to invest those tax-free funds in one single equity (no diversification allowed). People would rightly conclude that your plan would be an outright disaster for the American economy. This is exactly our policy on homeownership, and is only one of many horrible public policies. Yet, if you suggest that government policy is largely to blame, you are likely to be scoffed at as a market fundamentalist. But any scoffer offered the same policy, as stated above, absent the status quo bias, would likely predict consequences at least as bad as what we've seen in housing.

2) Try to suggest that finding the facts in the BP incident might be useful before embarking on the "market bad/regulators good" narrative to explain the issue. Will this make you look more reasonable, or like a "wingnut"? I can't imagine the most reasonable guest possible going to any public forum of note & making that point without taking a hit to their reputation.

BrianO writes:

Spot on! Love the podcasts.

I know you are not a prognosticator for the markets, but I wonder what you would see as the implications, assuming you are completely correct, for future market growth, besides obvious instability. Those in power keep drawing the same wrong conclusions, effectively doing the same things and getting the same results (Einstein called that insanity).

Robert Kennedy writes:

The impact of Basel II is mentioned as contributing to the value of AAA ratings and therefore the incentives to obtain such ratings.

What I have not heard here is any mention of the New Deal era requirement by the Comptroller of the Currency (J.F.T. O'Connor) that required banks to only hold investment grade bonds. As I understand it, when foreclosures started to rise in 2008 and the rating agencies responded by downgrading many CDOs, this requirement forced to banks to sell off. And also because of this requirement, other banks could not buy these CDOs, even at a discount.

I would think that this requirement, along with everything else mentioned here, is another contributing factor. In the absence of this requirement, the banks could have held the CDOs on their books or sold them at whatever discount the market would bear, potentially significantly reducing the losses of various players. And then the various CDSs might have not come due. And the end result might have been just a bad quarter or two for Bear. Lehman, etc.

Does this make any sense?

bshupe writes:

Hello Russ,

Excellent podcast! It was really rewarding to hear the culmination of the previous podcasts on these issues and to hear just you the whole time. While I do like the guests most of the time it is great to hear from you like this as well.

One thought I had about your little gambling/poker player story is this. While Uncle Sam may be sitting in the corner watching the game, the lender who is lending money to the player(s) is not being entertained by the game but rather is moving his chair over by Uncle Sam. While the game is going the banker is getting drinks and snacks for Uncle Sam and discussing the morally superior economic philosophies associated with player bail outs, to big to fail etc. etc.

This I think is a grand moral hazard where some of the players are manipulating the rules and or players in the game to make sure that the ultimate outcome is in their favor regardless of who has to suffer to make it happen.

Thanks again for the podcast, I look forward to it every week.

Bob

Buckland writes:

Dr. Roberts,

One thought I'd like to add. And of course since I want to add it's obvious that with my vast education in economics I was forced to take in the late 70's (3 hours macro and 3 hours macro, mind you) I've found a point you've overlooked.:-)

One piece that I think is undervalued in the reconstructions of the crisis is the role of business expansion in the 80's and 90's. Beginning in the early 80's US businesses went on a tear. Smart guys made fortunes in lots of fields, not just on Wall Street. Leading figures in just about every industry had their day to cash in big on the relentless upward rise of the stock market.

Name an industry, and sometime in the 25 years beginning in 1982 someone made a name (and fortune) by transforming that industry through applying modern management techniques. Consolidation, JIT inventory systems, invention, advanced product distribution systems, various creative financing methods and a dozen other techniques transformed whole swaths of the landscape into profitable, cash spinning machines that drove stock prices ever upward.

Sure there were failures. Some dinosaur companies disappeared during this time, and some silicon valley startups didn't take hold. But the trend was upward. And putting smart guys in control was a near guarantee of profits.

What this created was a generation of business folk that had never known a deep recession. The rules of business had changed. The business cycle had been outlawed by the sheer genius of today's deep thinking managers.

And the best of the best were the guys on wall street. Everything they had done for a generation turned to gold. How could finding a way to create securities from American real estate be any different?

So, my view is that guys on Wall Street knew they could increase profit by increasing leverage. And since they were the smartest guys in the room nothing bad would happen. After all, anybody getting paid what they were was too smart to lose large amounts of money.

In my view, there were lots of people willing to take outlandish risks, not (entirely) because of the possibility of government support if things went wrong, but because things can't go wrong, not to somebody this smart. This attitude permeated the investment banks themselves, the government actors (Fannie and Freddie), bond holders, and other players forgotten.

Many of the Greek tragedies begin with the idea of hubris -- a pride in one's ability that in the end precipitates the downfall. This is why the leverage was high in virtually all of the players involved -- banks, government agencies, non bank investors, etc. No one could conceive of it turning out badly because it never had before, at least not in modern times.

With smart guys in charge, what could possibly go wrong?

emerich writes:

An excellent analysis and ordering of the likely causes of the crisis. I've listened to all the podcasts of the last three years and read many of the books and articles about the crisis and I think your podcast (I haven't quite finished the paper) gets the balance just right and puts the spotlight on what has mostly been overlooked: the moral hazard problem has been building during at least 30 years of bailouts. That fact puts a gloomy spin on the outlook for our economy and the world's because it would be painful, and probably politically inconceivable, to reverse the bailout psychology. Reversing inflation psychology in the 1980's was a walk in the park in comparison. We're probably stuck with crony capitalism.

TheRidge writes:

Truly one of your best shows. The most academically honest presentation of the 2008 financial crisis. There are only two parts I would slightly depart or address is

1) I am with the crowd that the GSEs had a larger role in pushing the "liar loans". I live in Southern California and during that time everyone seemed to be a mortgage broker doing whatever they could to get a loan to someone who could not afford it so they could sell it off to the GSEs.

2) I never hear about the issues with the refinance loans. The folks who sold their equity to party and buy toys and later end up foreclosing on their house. Yes, I saw plenty of that in So. Cal. also.


Chris writes:

You are missing the underlying issues that actually caused this crisis in your analysis in my opinion. To even call this a financial crisis is a complete misdiagnosis of what is actually going on and this is the key reason most economists completely misunderstand what is happening.

The financial crisis is visible, stock market crashes are readily observable but deep rooted economic problems like the decline of the manufacturing sector can be easily ignored by academics in their ivory towers or stock jobbers on wall street.

The real cause of this crisis is the following;

After the death of JFK LBJ came in and increased social spending and military spending while giving out tax cuts at the same time. This predictably lead to large fiscal deficits and money printing.

This money printing broke down the monetary system leading to Nixon defaulting on gold payment, this then opened the gates to raging inflation during the 1970s. Wages for American workers peaked in 1973 if you actually use accurate inflation numbers to calculate them.
According to the economist John Williams the wages for average American workers is 30% their 1970 level.

This is clearly true if you consider how today you need 2 bread winners working noticeably longer hours than the 1970 worker did and still they cannot pay the bills without resorting to excessive borrowing in most cases. Workers often are forced to take on multiple jobs for this same reason where formally a single job was more than adequate infact a middle class worker could buy a house pay the bills and have money to spare working a single job and less hours. Clearly this is not a positive economic development but why did this happen?

The 1970's saw the Government increasingly neglect new infrustrucure projects, institutional investment and preserving public services. Almost every major capital work in the US was constructed from the 1930's - 1960's with virtually no real Govt investment in the areas that actually are helpful after that time.

When Raegan came to power he began implementing dramatic and disasterous economic reforms, he cut the top income tax rate from 70% down to 28% in one fell swoop and increased defense spending at the same time (like LBJ only far far worse) this then exploded the budget deficit, Raegan trippled the national debt. To compensate Raegan declared war on the American middle class, slashing entitlement programs, increasing regressive tax rates, looting the social security fund, cutting states funding and generally undermine all these crucial aspects of the economy.

Raegan also began to ruthlessly destroy the trade union movements. Today the hard line right wingers complain about those damn unions with their high wages and decent working conditions and how 'unfair' it is they have decent paying jobs while non unionised workers struggle to get by. It is not the unions that is the problem but rather the lack of unions (unionisation in the US today is at its lowest level since 1929 uncoincidentally). Britain under thatcher did the same madness and unsurprisingly their economy lies in ruin today as a consequence.

The destruction of unions and the attack on public institutions and services lead to a terminal and continual decline in real wage levels disguised by the manipulation of inflation numbers starting in 1980. Raegan transferred atleast 3 trillion dollars of wealth out of the hands of the middle class using these policies (according to Dr. Ravi Batra). The infamous trickle down economics.

This then lead to continual declines in the level of economic demand and therefore the natural level of economic activity but instead of allowing the economy to slide into depression at that time Greenspan and the Fed began to carry out expansionary monetary policy to cover the problems up.

Rather than allow the erosion of the foundations of the economy its self (the middle class and public institutions) to drag the economy down instead a debt bubble was grown ontop to cover the problems up.

Instead of workers earning less and spending less they would earn less but spend the same and borrow the difference with the Fed lending the money to facilitate and encourage the process.

Clinton largely continued these same policies however his free trade policies decimated the manufacturing sector and lead to further collapses in wage levels. Not because the US manufacturing sector was less competitive (measured in output per worker per time unit) but rather because of being forced to compete with slave wages.

The economy again threatened to fall into a depression around the year 2000 but instead of allowing it to do so Greenspan dropped the interest rates to 1% pumping a new bubble on top of the economy to keep it ticking over for longer while still the underlying problems continually grew worse.

The housing bubble gave people the impression of increasing wealth so they were willing to borrow and spend more and more to create the illusion of prosperity.

Finally the middle class was so indebted that they could borrow and spend no longer. Even people with no income and no job were given large housing loans to keep the bubble growing for the maximum possible time.

When people could no longer spend beyond their means and instead cut back demand in the economy dried up leading to the economy falling off a cliff into depression. The low interest rates had also lead to large borrowing by wall street and other institutions. Then the banking crisis and financial crisis broke out as a consequence rather than a cause of these problems.

People are living beyond their means not because of living so extravagantly but because their means have fallen so much. The myth that people are spending beyond their means due to extravagant living is a horrific myth that argues in direct contradiction to what one must understand to frame a solution to this problem.

The US could easily have the strongest economy in the world, all it takes is good economic management. But this will not come from esoteric concepts that are trumpeted by most economists but rather must come from returning to real world physical economics as dictated by history.

Quick rundown of solutions:
1) Total debt moratorium for all mortgage creditcard, business and government debts for 5 years or the duration of the crisis.
2) Large increases in Government spending on education, health, and social services to support the economy, permanent not temporary increases. The new deal stimulus pumped up the economy not for years but for decades.
3) Large medium and small scale infrastructure projects nation wide including high speed rail and nuclear power, also upgrades in telecomunications
3) 0% credit issued from the Fed to the manufacturing sector and small business directly to support the economy, 0% credit for the states and federal government for above spending
4) Large increases in taxes on the rich and cuts in defense spending to restore fiscal balance including a toben tax on banks and agressive crackdowns on tax havens and evasion generally.
5) No austerity measures under any circumstances lest the economy be destroyed
6) Re unionise the labor market to increase wages
7) Protectionist trade policies to defend the economy from slave wages and facilitate reindustrialization in combination with 0% credit. Protectionism alone will not necessarily bring manufacturing back but along with 0% credit it will.
8) Large Govt investment in R&D, do not forget that the Govt invented computers, the internet, Jet engines nuclear power and more clearly it is useful for tech development.

This outlines the causes and solutions to these problems. Perhaps now you can see how far off the mark current policies really are and how iladvised most solutions I atleast hear advocated are, some people say the only solution is to 'shrink government' that will necessary completely destroy the entire economy and probably cause hyperinflation (ironically). Doing the same things that caused the crisis in the first place will not help!

Questions comments criticisms feel free to email me at choros22@yahoo.com.au. I would like to hear your views on my analysis.

James M writes:

Prof. Roberts,

I began listening to you podcast over a year ago to help me transition from one career (public education) to a new one (accounting). I'm a big fan and really appreciate the service you provide.

Your analysis of the financial crisis was excellent. I'm looking forward to reading your paper as well.

John Mininger writes:

Professor Roberts:
I guess I’m one of those people on the “right” who believe that while Fannie and Freddy were not the sole cause of the crisis, they really started the race to the bottom.

Any possibly of having Peter Wallison or Mark Calabria on EconTalk? They are at least as qualified to talk about the recent financial unpleasantries as Judge Posner.

Wonderful podcasts; every week. Keep up the great work.

Jean McGrath writes:

Russ,
this was a great podcast. All your podcasts are great, but this one was particularly insightful. I started out with my own set of thoughts about what caused the cricis. But you won me over completely. Not 100% sure that the creditors took all those risks mainly because they thought that they would get bailed out by the Gov. That was a big factor for sure. But I think mainly they were riding the wave, just like everyone else. And few people ever see the crash until it happens. Giving the creditor responsibility for ensuring that he invests his money wisely is such a basic, even old fashioned concept. And hugely wise and insightful in this context. Well done, yet again.

John Berg writes:

As much as I have enjoyed these podcasts and I agree that a review of them since March 2008 provides a useful review of factors that affect our current economic crisis, I find the statement about "crony capitalism" just not sufficient. The big issue was the assumption of much corporate debt by the Federal government with the quiet agreement of Congress and the Executive branch.

John Berg

Raja writes:

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Tom H writes:

Hi Russ,

A first time commentator but a long time listener (you and the MP3 player are the best inventions of the age).

It is logical that an expectation of bailing out creditors leads to inefficiently high risk taking by the organisations borrowing from those creditors. By implicitly guaranteeing creditors the Government effectively subsidises risk taking by the borrowers because borrowers do not pay a price for the expected cost of the Government guarantee.

It seems plausible to me that such an implicit subsidy to risk taking played a central causal role for in the global financial crisis.

If we assume that you are right then I think there are some obvious next questions that you didn't focus on in your podcast but that are critical for thinking about creating a better policy. These are:

i) What are the forces that drive the Government to provide these implicit guarantees to creditors to large financial firms? Or, put another way, why are creditors to these firms sufficiently confident of being bailed out?

ii) If the forces that drive governments to act in this manner (for good or ill) can't be altered then what is the (second) best 'financial regulation' policy that can be put in place? For example, if we know governments will always prefer a bailout to the collapse of a major financial institution how does this change the optimal regulation of the major financial institutions?

I ask the second question because I think it is important and interesting enough to be worthy of a podcast (at least to me). It would be especially interesting to hear you arguing about the best form of government intervention (even if it was intervention required to fix a problem that stems from another government failure - we have to get you arguing for bigger government somehow!).

Heidi Keene writes:

Dr. Roberts,
You are exactly correct. I hope you are able to read and dismiss the ridiculous commenters who are unable to see the real equations being played out here. It is interesting that it is exclusively fluctuations in markets that are thought to be caused by human action. No one ever seems to blame the latest tsunami or hurricane on greed or the imperfections of the weather system in general. Heaven help us if government ever gets the notion of intervening there.
I thought you channeled yourself clearly and precisely, judiciously and economically. No pun intended. You are a joy to listen to and a wonderful defender of free markets. I believe your mentors must be beaming.
Heidi Keene

Jeff morse writes:

Nice wrap up of many of the issues, but I think we still need to look at "agency" issues: if powerful actors are willing to risk the company to enrich themselves (or even for ego) and companies have structures/rules that allow this then the companies are not acting as rational long term market players. I think that all the models with nice smooth curves fail to work when agents get too much power. I think this was also key in the debt market "freeze" since behind the models are folks that not only are free to be overly cautious to protect their jobs (won't buy anything at any price) and if a company allows this, then others will follow to a new norm. We end up with extremes up and down when when these folks exceed a certain % of market power.

Per this podcast I agree that the presence of a high probability bailout helps to create the conditions within companies that allow for more free agents to collect power.

Tom writes:

Just wanted to say how much I always enjoy your podcasts - have been meaning to say so for a while, but this one is about the best yet.

I'm an economics novice: before listening in to your stuff I knew nothing* about the subject and having been following for about a year now I really feel like I've been given a grasp of some of the basics.

There does seem to be a question raised in your analysis on this topic - although you've got me convinced on your general thrust.

Your main argument is that governments caused the crisis by removing the loss part of the profit/loss motive - it seems very hard to argue against this. You also say yourself that the people operating within the financial institutions such as Bear Stearns also had a very one-sided motivation (i.e. they could make a fortune in bonuses but stood to be left only very rich, and not stinking rich, in the event of failure). But why put so much emphasis on the former cause and so little on the latter?

Both sides imply a degree of state interference in the market (it is limited liability laws that prevent the CxOs, traders and shareholders from suffering the penalties of undue risk)... Perhaps limited liability laws could be amended in some way so that they don't cover people who are "gambling with other people's money"?

regards,

Tom


*although possibly enough to realize there's another side to be put on some of these stories!

Seth writes:

I enjoyed the podcast, Russ.

You may have mentioned it and I might have missed it, but I think there's more to the bailout anticipation than previous bailouts.

I think that the near groupthink among elected officials that it was a good idea to increase the percentage of homeowners sent a strong signal to folks that these guys wouldn't let it fail. They had a horse in the race.

It seems that the Fannie/Freddie participation in subprime sent the same signal to investors and lenders.

Christian writes:

To Everyone:

Stop anthropomorphizing! If you say something like "the government" or the "the market" or "investors" or "the Fed," you have already made your analysis useless because you are assuming that these abstract entities (which are creations of your own imaginations by the way) acted independently of the individual human beings of which they comprise.

Therein lies macroeconomic's greatest failure. The most recent perpetration of which is the false dichotomy between "the government" and "the market." Do yourselves a favor and focus on specific rules and the human beings they effect. If we all stop talking about the "causes" of anthropomorphic entities and all start talking about human beings and the incentives to which they respond, then we might just start getting somewhere.

Don't believe me? Let's just start with one example: "markets" CANNOT exist without "government." For instance, why should I buy something from you if I can just shoot you in the chest and take it? Well, I guess we can all agree that shooting and taking should not be allowed. Uh-oh, we just created "government," whatever the hell that means. So, stop kidding yourselves, and abandon the childlike tendency of anthropomorphizing so that you can blame somebody and start thinking about rules and incentives.

Thanks,

Julien Couvreur writes:

Great podcast.
In terms of format, I appreciated how you recapped a few times as you progressed through your story.

In terms of content, I think you're asking the right questions, by trying to dig deeper than "they are greedy bastards". Much government intervention ultimately changed the incentives towards higher risks, as you described.
The next question is how could the government make those explicit and implicit guarantees?

There is probably more than one factor, but there we see the FED surfacing again, as Austrians are keen on pointing out. The government cannot afford to make such guarantees if it were not for its ability to inflate...

EPZEN writes:

I enjoy your podcast if only for the fact I disagree with many of the comments made on it.

I don't recall exactly but I believe interbank lending during the crisis fell from $110 billion dollars to $5 billion. One cannot say this supports your thesis that institutional lenders weren't worried about solvency because they knew they would be bailed out. If the banks were not worried about the solvency of each other then they would not have cut the loans to each other.

Furthermore, if the banks were not worried about each other, then the LIBOR rate would not have risen to 6.88%.

These events occurred DESPITE previous bailouts.

Furthermore, the Canadian banks which are more heavily regulated than the American and European banks did not suffer the same problems.

As much as I love your podcast, I feel your thesis is an example of a fresh water economist attempting to fit a square peg into a circle. You mentioned personal bias and my own is that I have been very frustrated by the exclamations and solutions offered by fresh water economists in relation to the latest crisis as they don't ring true to me.

Having said that, I generally view myself as a monetarist. Personally, I feel that if governments had not pursued quasi Keynesian policies to justify debt during the last 60 years and relied more on monetary policy then we would all be much better off....if only for the fact that when the liquidity trap hit Keynesian government spending would not have been as limited by previous debt loads.

In any case, thanks for all the work with the podcast, one cannot refine one's views unless challenged by someone of a differing opinion.

Andrew writes:

I listened intently to this podcast, but have to admit I was a little confused regarding the poker player analogy. In what real-world situation would a lender give a poker player (or equivalent) so much money to play with, without there being some mechanism in place to guarentee some or all of the money will be repaid should the poker player fail? If banks lent money to homebuyers to invest in real estate, they did so, at the time, with the belief that if the borrower defaulted the bank would take possession of the property, hence returning some or all of the borrowed funds (hopefully).

That quibble aside, I agree that markets eventually right themselves. We can see it happening now. I just don't think that it's ideal that entire investment banks need to engage in behaviour so risky that it can cause them to fail, before the invisible hand steps in to pick up the pieces. To me the problem is fundamentally that the individuals who make the decisions stand to gain from a company's success, but seldom lose. Wall Street bankers are paid such high sums that if they made a dud investment choice and the company went bust, they'd still have their nest eggs and bank accounts to fall back on. The incentives to make riskier and riskier decisions do not seem to be outweighed by measures to punish them for doing so. Perhaps if directors and managers and staff were held individually and collectively liable, and punishable, for the damage they are causing to society, they wouldn't put entire economies at risk.

Capitialism will always seek to maximize risk, as it tries to maximize profits. I don't mind so much when manufacturers of clothing or gourmet food or pet accessories engage in risky behaviour, and occassionally go bust as a consequence, as I will inevitably benefit from their entreprenurial spirit. But when financial services companies do this, the risks to the economy seem to far outweigh the possible benefits as we as 'little people' are generally excluded from reaping any rewards.

Jim Labbe writes:

Great podcast.

A couple thoughts and questions and an idea for a future show.

Why did freddie mac and fannie mae become a primary strategy for federal goverment's affordable housing policy in the early 1990s?

The politics of freddie and fannie are probably very complex. But part of the impetus was the cut-backs in direct public subsidies to housing and the need to respond to the failure of the private housing market to supply adequate affordable housing where there was a community need. For better or worse, the idea that private home ownership is an essential element of the American dream probably also played into public-private hybrid solution that was freddie mac and fannie mae.

But if the feddie mac and fannie mae model of promoting affordable home ownership via cheap credit is flawed, how can we how do we make sure people have affordable housing?

There are probably lots of answers to this question from a "market-based" and "goverment-based" perspective.

One creative alternative approach was forged at the local level in response to the same cut-backs in federal housing subsidies that drove the mac/mae strategy: affordable housing community land trusts.

While not a new concept, the affordable housing land trust model emerged in Burlington, Vermont as a direct response to the need to provide secure housing to people who could not afford to participate in the traditional private market. Local social justice advocates under the leadership socialist Bernie Sanders then the mayor of Burlington, pioneered the land trust model in the 1980s.

Affordable housing land trusts have grown steadily since the 1980s and interestingly land trust homes have had a much lower rate of foreclosure than the private market subsidized with cheap credit.

I would like to see Econtalk explore in more detail the successful and unsuccessful models of providing affordable housing. What are the economics and/or institutional successes or failures of different approaches to providing affordable housing in a community, region, or nation?

In the wake of the the failure of Freddie Mac and Fannie Mae and the housing crisis it is likely that government will take a renewed role in addressing the need for affordable housing. Econtalk could play a valuable role in helping inform the policy debate that will most certainly ensue.

It would be quite provocative and interesting for Econtalk to invite someone like Bernie Sanders (who clearly doesn't share Econtalk's enthusiasm for the adequacy market-based solutions) to talk about these issues.

Thanks,
Jim Labbe

Jack writes:

It would be great if the financial crisis was caused by public policy and altruism (helping people own homes). Altruism is easy to discourage. Unfortunately, the financial crisis was caused by greed and greed is impossible to discourage.

If you go back to 2004-2006 when the bubble was expanding, several economists identified it and warned investors. Stiglitz, Krugman, Roubini, several others and almost all of them are either on the left ideologically or at least served in a democratic administration. The free market guys (Cochran, Roberts, etc) all said there was no bubble. Now they admit there is a bubble but the blame goes on public policy. Wishful thinking.

gulliver writes:

Russ--regarding your introductory note that Alan Greenspan started to falter in his belief in free markets, that is not entirely the case. Below is an exchange between he and ABC White House correspondent Jake Tapper awhile after that comment, which would at least clarity his true thoughts:

JAKE TAPPER: You'll be testifying about the financial crisis on Wednesday before the financial crisis inquiry commission. When you testified before Congress in October, you said that you finally saw a flaw in the way that you looked at markets, that markets cannot necessarily be trusted to completely police themselves. But isn't it more than a flaw? Isn't it an indictment of Ayn Rand and the view that laissez-faire capitalism can be expected to function properly, that markets can be trusted to police themselves?

ALAN GREENSPAN: Not at all. I think that there is no alternative if you want to have economic growth and higher standards of living in a democratic society to have competitive markets. And, indeed, if you merely look at the history since the enlightenment of the 18th century when all of those ideas surfaced and became applicable in public policy, we've had an explosion of economic growth, and especially in the developing countries where hundreds of millions of people have been pulled out of poverty, of extreme poverty and starvation basically because we have competitive markets. So it's not the principle of competitive markets, which really has no alternative which works, it is a strict application as I presented in a Brookings paper fairly recently in a somewhat technical area. The major mistake was assuming what the nature of risks would be, and the reason it was missed is we have had no experience of the type of risks that arose following the default of Lehman Brothers in September 2008. That's the critical mistake, and I made it. Everybody that I know who works in this business made it, and it means that basically we have to work our way back to understanding what we're under, and as I argue, what we need is far more required capital for financial institutions than we've had.

[Taken from ABC's Jake Tapper page]

Russ Roberts writes:

Lots of great comments here. Wish I had had more time this week to respond in more detail. But I do want to respond to a couple of important points.

Chris Koresko--great observation. If I borrow $97 and I have $95 at the end of the night, I'm "barely" insolvent. Another type of insolvency might be that I actually have $97 worth of assets but they are hard to sell quickly. In either case, I am not able to honor my contractual obligation. If I have one creditor, we might be able to work something out. He might float me another loan. Or I might be able to borrow money from a second creditor (different rate of interest, probably!) to stay in the game. If I have lots of creditors then there will be a fight over who gets what. Suffice it to say that not being able to honor my obligations completely is usually a big problem even if the gap is small, though there can be some stopgap measures.

A number of people raised the questions of credit default swaps. Yes, that was another way to reduce your risk as a creditor. And as someone pointed out, that just pushes off the reliability question to the counterparty on the CDS. Did Goldman Sachs think that AIG was reliable? Did GS think that the government would back up AIG in the event that they were not?

Epzen correctly points out that bank lending dried up very quickly. I think I pointed that out in the podcast, making reference to posts by James Hamilton at Econbrowser. But why did it happen suddenly? Once people realize that there is not enough money to go around, then people do panic. They cannot rely on the certainty of a rescue. It is not certain. But was it probable enough that it induced inadequate prudence leading up to that point? That is the question. Read my paper and look at Fannie and Freddie. As their loan portfolio got crummier, their CDS should have gotten more expensive and the rates they were borrowing at should have risen. Neither happened for years until suddenly it looked like they were going broke. And then, because there was some uncertainty about whether the government would stand behind them, creditors did get very wary. But why didn't it happen before?

Jack, I appreciate your thoughts on prediction and the inaccuracy of free market economists vs. others. I actually never said there wasn't a bubble. What I did say, mistakenly, was that the increasing home ownership in America was a sign of prosperity. It actually was a sign of government subsidies of various kinds. I wasn't paying enough attention to the range of programs that the government put in place to artificially inflate the rate. My mistake. I was wrong. But interestingly you mention Stiglitz. I did not mention in the paper or the podcast that in 2002, Stiglitz was commissioned (with the Orszags) by Fannie Mae to study the probability of Fannie Mae going bankrupt under their new capital levels. Stiglitz and the Orszags estimated the odds of Fannie Mae defaulting on its obligations were 1 in 500,000 or maybe as low as 1 in 3,000,000. That was a bad prediction. But I don't cite that paper because I'm pretty sure their analysis presumed that Fannie kept the quality of their portfolio at the same level as they had before. Given their assumptions, default was unlikely. But that doesn't make their story of what actually happened good or bad.

As for all those people who "knew" it was a bubble, I'd like to hear their theory of how the bubble got started. But either way, being good at predictions does not prove that they are right about what caused the crisis.

EPZEN writes:

Thanks Russ. I did read your paper and still remain skeptical. Why didn't the Canadian banks suffer the same fates? They have securitization, they have CEO's with stock options, their creditors have implicit backing of the federal government, they have down payments as low as 5% (although a premium has to be paid in the form of a mortgage default insurance) and the Canadian Central Bank's policies have been similar to the Fed's. I would argue it was successful regulation where Canadian regulators will attend bank board meetings to discuss each bank's risks.

American regulators were forced to abandon their duty by a deregulation movement which now claims that regulation is the problem. Friedman felt safety regulations were not needed because the risk of being sued would be enough. Thanks, but I'll keep my building codes so that the electrician wiring my house doesn't create a fire hazard. I would prefer not to have to sue him after the fact. Likewise, I want bank regulators who prevent the fraud not a hope that pure capitalism carries significant enough disincentives.

Subprime mortgages are fraud, approving loans with no evidence for ability to pay is fraud, putting those same mortgages into bonds and rating them as AAA is fraud. Canadian regulators were able to prevent all of that and regulators elsewhere should have been able to do the same. I'm not saying Canadian banks won't someday be gob smacked like the rest of the world's banks but at least they have thus far avoided the current crisis.

Bad regulation led to the start of the savings and loans problems (e.g. limiting the interest paid to depositors) but the abandonment of regulation allowed the S&L's to become vehicles for fraud. A healthy balance needs to be followed. I think Samuelson's quote in your paper was right.

In any case, you are much smarter than me about economics and I do appreciate your perspective. Perhaps someday I will see the light:). Thanks again for a great podcast.


Nick writes:

Jim Labbe,

Israel has a system similar to what you describe. The land is almost completely owned by the state, and leased on 99 year renewable leases. In your mind you are thinking that this would probably increase minority home ownership and decrease discriminatory practices. However from Israel we can learn this policy can potentially have quite the opposite effect. Specifically if there is some particular ethnic minority that the government finds undesirable (lets say Arabs for instance), well it's going to be very hard for them to buy property.

It's a great system if the people running it are benevolent.

Scott S Todd writes:

Brilliant. I learn a great deal from your podcasts, and find the introspection pointed and amazing.

You last point about Capitalism vs. Crony Capitalism is telling, I think, but confusing. Because, if true, I have never lived in a meaningfully capitalist system, and despite 30 years of hobbyist reading am left uncertain what it would be to live in a Capitalist system, and where an example would be.

Can you think about a podcast that would point to several examples of nations which are Capitalist? Or, defining which part of American life (or any modern developed national life) are Capitalist?

Thank you for all you do,

Scott Todd

Will writes:

Professor Roberts,

Thank you for the great podcast. You mentioned in your podcast that you were not sure whether people wanted to hear these sorts of podcasts or more podcasts on the Great Recession, but I would like to say that I greatly enjoyed this podcasts and would welcome more podcasts exploring this issue. Additionally, please continue to create podcasts like this where you try to provide an overall view of large economic events as best as you can understand them. Your insights are very useful and edifying.

I do have a several questions that I was hoping I could get your response to:

1. Rating agencies – What are your thoughts on the failures of rating agencies to correctly rate financial instruments (i.e., rating mortgage backed securities as AAA when they were much riskier) and why do you think this occurred? Was it simply a race to the bottom with people choosing agencies that rated instruments as they wanted them to be rated? Or was the problem that the rating agencies incorrectly assessed the risks because of fundamental flaws in the assumptions they made to rate the instruments (i.e., that they could diversify their risk to housing downturns by aggregating housing securities or that they could adequately judge a default risk based on only 20-30 years of data). You suggest that creditors did not do their homework, but if anyone failed to do their homework it appears that it was the rating agencies on which creditors relied. One could argue that people outsourced their own risk assessment to rating agencies, but isn't that the more efficient result. Is the alternative (that everyone reviews financial instruments and rate them themselves) feasible or desirable?

2. Bailouts – You are strongly against bailouts of large interconnected financial institutions because of the long-term moral hazard problem. But what is your suggested alternative? Is it simply to let these institutions fail and essentially impose short run harm to the economy with the idea that it will be a better functioning economy in the long run? Is this expectation realistic given the fact that what you are asking is for the government to not send out firemen when there is a fire so that in the future everyone will practice good fire prevention techniques and self insure? I am afraid that the risks and benefits to the current economy are obvious while the long-term benefits are non-obvious, and the voters will punish politicians for short run failures (even though they made a correct decision in the long term) and will not reward politicians for being so forward looking. If it really isn't politically feasible for the government to not have bailouts for large financial institutions when they collapse, then what should be done? If the answer is that there should be no large institutions (a la Nassim Taleb), is that feasible given that large institutions may help solve large problems that smaller institutions cannot? Perhaps bailouts are the most efficient solution to the current set of incentives in the world.

Lastly, I have a suggestion. I think it would be useful and entertaining if you just had a podcast where you responded to the questions posed by this podcast (and other podcasts) in more detail.

Thanks,
Will

Brian writes:

Russ,

Bravo, it is satisfying to see your growth on this topic. You are almost there. Now you need to learn how the game is played so you can understand how elected governments are no longer in control of their national finances, but are pawns in a game played by central banks and other financial institutions. You might start by talking to James Rickards at Omnis, Inc. in McLean, VA.

I know I sound like a loon, but those who say I am are the ones who will be left wondering "What the hell happened?" when the global financial collapse hits - not me.

David writes:

Russ -

As always, a point of view well articulated. One thing I think deserves a bit more attention is the role of direct involvement of financial institutions and their creditors in setting these implicit and explicit bailout policies. You correctly point out that we don't have capitalism in America, we maybe have some form of a crony capitalism paradigm. But given that the influence of these corporations (our version of Smith's Glasgow Merchants) is fundamentally ingrained in American institutions, I'd be interested in you and Don discussing what is the path forward from where we are to a more classical liberal paradigm.

'Small' government politicians today are only small government advocates in a very narrow way that will just result in more of an unfettered corporatocracy than we have now. And the corporate lobbyists are certainly not interested in changing the institutions that give them so much influence. So my question remains the one of transition - how do you get there from here? And if you can't, what's the second best set of policies?

Lenny writes:

Prof. Roberts:

Excellent podcast, as are most episodes of Econtalk. I appreciate your clear and succinct explanations of the history that shaped the motivations and beliefs of the lendors and loanees in the run up to the crisis and thought your arguments against complete bailouts to the banks were compelling. Nonetheless, I was left wanting for a more complete explanation of what motivated the Fed to act the way it did. Was it as simple as political cowardice (a belief that tens of millions of Americans getting a small fiscal trim would not scream as loudly as several large institutions getting scalped) or would the consequences of lettings things take their course have been unthinkable as we've been led to believe? The impression I get is that you believe the Fed acted somewhat like a "helicopter parent" and over-intervened, but that the Fed could not responsibly have stood idly by either. In other words, am I correct in assuming you believe it was not a question of whether the Fed needed to step in, but how much (enough to stave off a larger crisis and discourage irresponsible behavior in the future and not so much as to encourage the cycle of destructive behavior that has shaped the unhealthy belief that the government would always act as a backstop?

Rajan Chopara writes:

Russ

Thank you for an excellent podcast on this topic.

Is it possible that the structure of the markets and institutions were also part of the problem?
(a) the creditors thought they were being prudent by lending to rated institutions.
(b) it is probably not possible to disband the ratings institutions and hand back the job of assessing credit risks to individual investors (no matter how sophisticated) because of the difficulty involved in assessing the true financial condition of the large financial institutions and the cost involved in undertaking such an analysis would be very high for individual investors
(c) the credit spreads cannot under the present structure reflect the increase in systemic risks that build up when everyone decides to leverage up to the maximum possible

I find it difficult to assume that managers act only as passive agents responding purely to external stimuli (bad regulations) and don't have the character/skill/judgement to realise that they were taking unacceptable risks (in one of your earlier podcasts one of your interviewees mentioned that Jamie Dimon didn't enter the CDO market(?) even though the bank he was the CEO of JP Morgan) invented the product because his modellers told him that the market prices didn't reflect the inherent risks. So bad regulations cannot be blamed for fraud/bad judgement/myopic behaviour. And if we cannot prove that this behaviour was somehow aberrant then it does mean that some form of rules or regulations are required to, at the very least, minimise possible damage to the economy.

Another issue seems to be the ease with which money can be put to different uses. You may think you are lending to an institution that lends to (take your pick) but the borrower can decide to change its lending policies and strategies at very short notice due to the nature of money. So when investing in financial institutions the investor needs to have a lot of confidence in the managers. Which will again mean that if managers cannot be trusted to act in a sensible manner then we have a problem that markets cannot solve.

I really liked the point you made about "too big to fail" being a proxy for bailing out creditors. But size can be a problem because it limits the ability of the market for corporate control to get rid of bad managers.

Finally, I do remember your earlier podcasts where you said that we should allow the financial institutions to fail, just like we allowed the telecom firms to fail earlier. And I found that to be a very compelling argument. What I have also since learnt is that there is a fundamental difference between the financial institution and any other firm in any other industry. In another industry if a firm fails, its competitors are generally very happy because the level of competition has gone down and they can now sell to a whole new set of customers. In the finance industry, the degree of interconnectedness is such that if one firm fails, all others are affected (to varying degrees). And again, too big to fail becomes relevant in the finance industry unlike any other industry.

Richard W. Fulmer writes:

You stated that Freddie and Fannie were able to continue to borrow at low interest rates despite their increasingly risky investments because they were implicitly backed by the federal government. Might another reason be the Fed’s credit expansion?

James Roane writes:

Like many I enjoyed your recent podcast. I do wonder about your example of the poker game. You seem to make the point that "Uncle Sam" is affecting the game without input from the players but in real life, both the lenders and the insurers are spending large sums of money to put in place policies that benefit them. Maybe that's your point about government and if so I definitely agree. It's just that it seems that so many anti government folks leave out the part that corporations, in my opinion, have too much influence in how they are regulated and rig the system so that it's heads they win, tails they win. While it's true that what comes out is government policy, that policy is not made out of whole cloth

Jared writes:

Thanks, Russ and team, for another great show!

Ralph Buchanan writes:

Great Paper!
Thank you.

Basel - Faulty.
Nice.

Chris Koresko writes:

Russ,

First off, thanks for your kind response to my previous post, and especially for taking the time to answer my question about your gambler story.

I was in fact one of those who predicted that the housing market would suffer a sudden and large decline. Partly that was the result of coming across an article which mentioned that a very large proportion of houses were second houses (I think it was 40%, but I can't remember the article, the market, or the date). That suggested to me that they were being bought as investments to take advantage of the rapid price inflation. That being so, it seemed reasonable that as soon as that rapid rise slowed, a large fraction of the housing stock would get dumped onto the market as those investors tried to cash out. That ought to cause the price to decline precipitously, I thought.

That the rate of inflation would slow seemed obvious simply because it was clearly going to price housing out of almost everyone's reach soon. Here "soon" refers to the math: an exponential rise in the price (fixed percent per year) means that the time to reach the breaking point -- whatever point that turned out to be -- depended on the logarithm of time. That means the timing was relatively insensitive to the inflation rate and to the exact price level at which large numbers of buyers would hesitate.

Anyway, it kept me from buying before the crash. And it's like macro: I have a nice story to tell that may or may not be a façade over a bit of dumb luck.

Chris Koresko writes:

Russ,

Just realized my post above failed to answer your question.

I am no expert but I do have a version of the story. In essence, it goes like this:

* Federal policy encourages home-loan borrowing, including borrowing with little money down, starting some time in the 1990s (actually it started long before that, but the strength of the encouragement rose around that time if I understand correctly)

* The Fed holds interest rates very low following the 9/11 terror attacks. This triggers something like an Austrian business cycle, except that the long-term investments are directed into housing stock instead of capital equipment

* Local policies in some heavily populated areas hold back housing construction, causing prices to rise rapidly with demand

* All seems well as long as the bubble keeps inflating. Is this a kind of Ponzi scheme?

* Eventually the prices reach the breaking point, housing speculators scramble to unload, and the market tanks

* The collapse of the bubble has not been anticipated by many of the investors holding the mortgage debt, or those who sold them guarantees on it. (I thought this was mysterious, but your podcast seems to have made it less so!) Institutions which did not believe themselves to be at risk are suddenly insolvent as they discover that the insurance they'd bought is inadquate. There is a mad scramble to figure out who owes what to whom, and whether that debt can or will be paid.

* Critically, most of the apparent chaos is not much more than money flowing around, rather than real wealth being lost. The loss of real wealth mainly occurred earlier, during the malinvestment phase. I'm not sure what the magnitude of that loss is, but it's probably a few hundred billion dollars (a fraction of the trillion or so in toxic mortgage-based assets).

* Another loss came in the form of the bailouts of Fannie, Freddie, and AIG. This loss is hard to estimate because the long-term consequences are mainly things like moral hazards and their impact on the size and scope of future financial problems.

* A similar (probably somewhat larger) malinvestment and loss of real wealth occurred in the form of the stimulus package. I say probably somewhat larger because one effect of the stimulus law is to lock in higher spending by the states, exacerbating their own fiscal problems.

* A nearly simultaneous increase in the federal minimum wage, coupled with the onset of Higgs-style regime uncertainty, deepens the recession and drives up unemployment. This tends to exaggerate people's impression of the impact of the original crisis.

* The biggest economic damage is yet to come in the form of the financial reform package which is nominally designed to ensure that this doesn't happen again

TGGP writes:

The blogger at Economics of Contempt argues that AIG could not have "renegotiated" a lower payoff to its creditrs, and so Geithner deserves no blame.
http://economicsofcontempt.blogspot.com/2009/11/geithner-vindicated-in-tarp-watchdog.html

He has also argued that Goldman Sachs was not exposed to AIG because it had fully hedged itself.

Scott Sumner (and I think Bryan Caplan) have argued that the timing of market swings does not support the interpretation that the failure to bailout Lehman caused the panic.
http://www.themoneyillusion.com/?p=1822

Allen Cogbill writes:

Russ,

I thought this podcast was great. I'm late with my comments because I often stockpile the podcasts for cross-country driving.

There's one aspect of the U.S. [and other] economy that I think seems neglected by your choice of topics. Virtually all economists despise price controls, as do most people who have lived through such (Tricky Dick's wage and price controls are the most recent, obvious ones in U.S. history). Why then, do economists tolerate the Federal Reserve, which rather arbitrarily sets the price of money? The Fed represents a cartel of banks; we know that this is inefficient and can (and does) lead to serious economic errors -- why is there not more outcry from economists?

My 2 cents

Allen Cogbill writes:

Another comment, on a somewhat different topic. I've listened to many of the EconTalk podcasts for the past 3-4 years, and truly I have benefited. One of the subjects that strikes me is that the CEOs of major public corporations, even when they have major assets at stake, often walk away from a bankrupt (or virtually bankrupt) company with truly gobs of money. In other words, they win big when things are good, lose some when things are bad, and walk away with beaucoup bucks. One of the better examples of such is Jimmy Cayne, former CEO of Bear Stearns and now a very rich professional bridge player (personally, I would love to trade places with him, as I love playing bridge).

I think this is a flaw of the corporation system. This system exists only as a legally-defined entity, and careful modifications to a creation of such seem to be in order.

Glen writes:

While my "world view" is completely aligned with the podcast, I have a difficult time accepting the idea that the stock market fall following the bankruptcy of Lehman Bros. was a reflection of the market's sudden uncertainty over the federal govt's response to the crisis. The problem I have with that is, if it were true, that means that the stock market is telling us that govt bailouts are GOOD for the economy. I could understand if only the financial sector stocks dropped, but I don't think that was the case. (Full disclosure - I don't really know whether that was the case.) I'm in a quandry over this because I just can't buy into the idea that govt bailouts are good for the economy...and yet I believe that there is no better barometer for the health and wellbeing of the U.S. economy than the NYSE.

Dr. Duru writes:

Wow, Professor Roberts! I thoroughly enjoyed this podcast. I think you did an excellent job summarizing the fundamental issues and causes of the last financial crisis. I also appreciated your introduction regarding bias; it set a proper context for the discussion and debate to be had about your ideas. I also loved your conclusion characterizing Wall Street as a hotbed of crony capitalism. I can't wait to dive into your paper.

I also have to say that you were very wise in taking your time with this piece and listening and studying the opinions and analysis of others first.

Kudos!

Raili writes:

Thank you for this podcast and others that have examined the sources of this economic crisis. While I agree with you in doubting that more government regulation will avoid future crises and bubbles, I disagree with your final analysis that the current one was caused by government intervention in the form of implicit or explicit protection for the too-big-to-fail institutions, which then allowed them to continue their imprudent lending practices. In my view, your line of argument fails in the following points:

1. Incentives of the investment bank executives: Your argument is that while they stood to lose a great deal of their personal wealth should their institutions fail, they were still left with such a bundle that they did not care if the organizations they ran went bankrupt. Working in publicly traded institutions, it is clear to me that while the CEOs and other leaders earn tremendous amounts of money their main motivation in their positions is the power and prestige they hold. Stan O'Neal, Jimmy Caine or Dick Fuld did not run their banks expecting to be kicked out in infamy but rich after a government takeover. They ran their institutions to the ground because either they did not know any better, i.e. that the risks that they were taking were excessive, or they did not know how to stop the train before it ran off the rails. If you are deriving a large portion of your earnings from bundling loans and driving the ROE by increasing your leverage, when do you make the call that enough is enough and disappoint analysts by saying that the party is over? Some organizations such as Goldman Sachs were able to pull back at the brink and while requiring some government support, turn around and remain independent. Others, such as Citi, Lehman, and BearStearns, hurtled forward and were left with such amounts of toxic assets on their books that bailouts, takeovers, and bankruptcies were their only options. The outcome is the same, but I believe these executives were not looking at Uncle Sam hovering over the poker table but at the folks who determined whether they could stay at the table playing in their positions. The board members or analyst/investor communities appear to have had no inkling that the game would come crashing down and thus were expecting the players to come forward with outsized winnings quarter after quarter even though their ability to extract value from the housing loan packaging had to come to an end at some point in time.
2. Why were the creditors not more prudent in their lending practices? Why did they get paid off 100 cents on the dollar rather than something less, which would have encouraged greater scrutiny over the creditworthiness of the institutions they were backing? Three words: Global Liquidity Crisis. Those creditors have tremendous power within the financial system, because if they stop lending, the whole economy comes to a halt, which it appeared to be doing back in 2008. While it would have been right to teach the feckless lenders a lesson in prudence, the government officials making the calls at the time did not appear willing to run the experiment of what would happen if the bailouts did not happen. The teeter-tottering of the financial system during September after Lehman failed seems to pretty much guarantee that no government officials are going to try to run such an experiment in the near term.
3. Difficulty in assessing and managing risks. The current crisis-du-jour, BP's leaking oil well in the Gulf, exemplifies how a series of slightly bad decisions can lead to an unmanageable catastrophe. The global financial system is an increasingly interlinked ecosystem whose management has proved equally challenging for the participants. While I, like you, have serious reservations about government officials' wisdom in regulating market activity, leaving market forces to manage the system will also create outcomes, such as bubbles, that create significant collateral damage. Different individuals and cultures have differing views on how to balance freedom and security with one another, which makes a complex global system even harder to negotiate across to make the rules clear and fair, align incentives, and minimize the role of governments.

There is still lot to be examined, debated, and learned about the causes of the financial crisis and I applaud your podcasts in bringing these issues out in an interesting and accessible fashion. For future podcasts, I suggest bringing in Michael Lewis whose recent book, The Big Short, tells the stories of individuals who identified the risky underpinnings of the financial mortgage loan instruments well ahead of the actual crash. The book highlights the role of the market participants who blindly follow the crowd and either due to financial self-interest or laziness continue perpetrating investments that lack underlying value, as well as the dilemma of the few who do not. It would be also interesting the hear from Karl Weick, professor at University of Michigan's business school, whose research and writings focus on managing risks in various organizational contexts. Regarding state of global markets, it would be interesting to hear from Ian Bremmer, who has recently published a book on the emergence of state capitalism.

John Ratelle writes:

I have listened to this podcast twice and you are spot on. Government just needs to set the rules, make it a fair game and there will be winners and losers. We are in for a rough ride if the crooks and cronies are only able able to win and not lose.

I cannot get our of my mind when you said when you are at the poker table and you are wondering who the sicker then it is usually you! Keep up the faith.

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