The financial crisis, bad loans and bailouts

The doomsday, broken incentives and moral hazard

Published October 25, 2019Updated May 7, 2021

Give a man a gun and he can rob a bank, but give a man a bank, and he can rob the world.

Tyrell Wellick, “Mr. Robot”

During 2007–2008, the world experienced the biggest financial crisis since the 1930s Great Depression, often referred to as the 2008 financial crisis. What was so crazy about the crisis? And is there a relationship to sound money?

What caused the 2008 financial crisis?

The financial crisis was caused by too many people borrowing too much money. The banks were happy to help and repackaged the bad loans and sold them to someone else, for a nice profit. When there weren’t enough loans the clever banks conjured new ones, keeping the money machine rolling. This eventually blew up and brought the global economy to it’s knees.

This explanation is naturally very simplified. There were for example two bubbles that popped: the housing bubble and the much bigger bond bubble (based in large part on mortgage loans). The complex financial products (for example the mortgage bonds or the CDOs nobody really understood) appeared to be low-risk but were high-risk. And of course the “heads I win, tails you lose” incentives at play all the way from top to bottom in the system.

It’s not important to understand exactly how the complex financial products, such as CDOs, work; the important thing to know is that experts didn’t understand them either.

A lot of ink has been spent on articles, books and movies explaining the events better and in far more detail than I could hope to do. I particularly like the explanations given in the Oscar-winning movie The Big Short (2016). Just look at how they describe subprime mortgages and CDOs:

Basically, Lewis Ranieri’s mortgage bonds were amazingly profitable for the big banks. They made billions and billions on their 2% fee they got for selling each of these bonds. But then, they started running out of mortgages to put in them. After all, there are only so many homes and so many people with good enough jobs to buy them, right?

So, the banks started filling these bonds with riskier and riskier mortgages. That way, they can keep that profit machine churning, alright? By the way, these risky mortgages are called “subprime.” So, whenever you hear the word “subprime,” think “shit.”

Margot Robbie, “The Big Short”, (youtube)

OK, I’m a chef on a Sunday afternoon, setting the menu at a big restaurant. I ordered my fish on Friday, which is the mortgage bond that Michael Burry shorted. But some of the fresh fish doesn’t sell. I don’t know why. Maybe it just came out halibut has the intelligence of a dolphin.

So, what am I going to do? Throw all this unsold fish, which is the BBB level of the bond, in the garbage, and take the loss? No way. Being the crafty and morally onerous chef that I am, whatever crappy levels of the bond I don’t sell, I throw into a seafood stew. See, it’s not old fish. It’s a whole new thing! And the best part is, they’re eating 3-day-old halibut. That is a CDO.

Anthony Bourdain, “The Big Short”, (youtube)

A pitch of humor sure makes for memorable explanations. But if it’s too much Hollywood for your taste I recommend the book the movie is based on: “The Big Short: Inside the Doomsday Machine” by Michael Lewis. Or if you’re short on time maybe this 11 minute video might suffice.

The effects of the crisis

The crisis began with the collapse of the bank Lehman Brothers, marking the start of the Great Recession. In the U.S. alone the crisis meant $18 trillion disappeared, millions of jobs were lost and more than a million people lost their homes.
(Alan S. Blinder, “After the Music Stopped”)

United States GDP growth rate between 2005 and 2012.
United States GDP growth rate surrounding the years of the financial crisis.
It bottomed out at -8.4% the fourth quarter of 2008.

Although the crisis originated in the U.S., the crisis spread globally. For example, in only the first quarter of 2009 the GDP rate was -4.7% in Germany, -4.8% in Japan and -3% in the Euro area. There are many details to dig into here, such as the unemployment rate or stock market valuations, but I’m content with just noting that the crisis was indeed a global disaster.

The bailouts

Although bad, the crisis could have been much worse. The U.S. came close to a complete financial meltdown, but without crossing the line. Partly thanks to the bailouts, where the Federal Reserve bailed out banks and other private companies. The extremely risky assets—too risky for anyone else to touch—were bought up to rescue the banks which were “too big to fail”.
(Alan S. Blinder, “After the Music Stopped”)

The bailouts started when the government guaranteed assets of the investment bank Bear Stearns and encouraged J.P. Morgan to buy them for a knockdown price. Then the mortgage lenders Fannie Mae and Freddie Mac collapsed, promptly rescued by being nationalized coupled with a $200 billion government investment.

While the investment bank Bear Stearns was saved, the investment bank Lehman Brothers was allowed to go bankrupt. At first the Treasury and Federal Reserve claimed they allowed Lehman to fail to send the signal that recklessly managed Wall Street firms did not all come with government guarantees. But when they saw the fatal effects the bank’s collapse had on the economy they changed their tune and claimed they lacked the legal authority to do so.
(Michael Lewis, “The Big Short: Inside the Doomsday Machine”)

Then followed massive new efforts to bailout banks and other private companies. The Federal Reserve, for the first time in history, took control over the private company American Investment Group (AIG) while giving them a $182 billion loan. The laws allowing them to do this, but not bailout Lehman Brothers, must be very interesting. (Lehman Brothers was an investment bank, which isn’t a real bank. Other investment banks later converted to “commercial banks” in order to receive bailouts.)
(Alan S. Blinder, “After the Music Stopped”)

In September 2008, U.S. Treasury Secretary Henry Paulson persuaded the U.S. Congress for $700 billion to buy subprime mortgage assets from banks.1 Once handed the money they abandoned the promised strategy and instead essentially gave away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and others. For instance, the $13 billion AIG owed to Goldman Sachs was paid off in full by the U.S. government.
(Michael Lewis, “The Big Short: Inside the Doomsday Machine”)

The government guaranteed $306 billion of Citigroup’s assets. They didn’t ask for a piece of the action, change in management or anything of importance. The $306 billion guarantee—nearly 2% of U.S. GDP, and roughly the combined budgets of the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development and Transportation—was presented undisguised, as a gift. No explanation was given, just that the action was taken in response to Citigroup’s “declining stock price.”

When it was clear the money wasn’t enough, the Federal Reserve started buying bad subprime mortgages directly from the banks. By early 2009 the tax payers were stuck with more than a trillion dollars of risky assets and, if things went sideways, would end up eating a huge loss while the banks were in the clear.

For the taxpayers, it’s like betting all on red on a roulette wheel—you risk a very big loss. In this case American taxpayers got a good outcome, they even made money on the bailouts, but the Irish taxpayers for example weren’t so lucky.

A message from Satoshi

After having released the Bitcoin whitepaper in 2008, Satoshi mined the first bitcoins and launched the Bitcoin network January 2009, just after the financial crisis. Little is known of the ideals of Bitcoin’s creator, but Satoshi did leave a message in the first ever Bitcoin block:

The Times 03/Jan/2009 Chancellor on brink of second bailout for banks

Satoshi refers to The Times issued the 3rd of January, 2009 with the title “Chancellor on brink of second bailout for banks” and the subtitle “Billions may be needed as lending squeeze tightens”.

Which you might see as a sign that Satoshi wasn’t a fan of bailing out the banks (if developing an alternative to the banking system wasn’t enough of a hint).

Life is unfair

In medieval Europe, a banker who couldn’t pay depositors was hanged. Today, that same banker would get bailed out, paid bonuses and enjoy some tax benefits, too.

After the dust settled, it’s easy to think the guilty got punished—after all the U.S. loves to dish out harsh punishments—and the system was reworked to prevent a similar crisis from ever happening again. The reality is often disappointing.

The bankers weren’t punished for their unregulated gambling or outright fraud. In fact only a single U.S. banker went to jail. Instead they got bonuses and in 2010 the banks were enjoying massive profits—while regular people were still struggling without jobs and houses.
(Michael Lewis, “The Big Short: Inside the Doomsday Machine”)

Remember the $182 billion AIG bailout? Shortly after accepting the bailout they paid out $165 million in bonuses to their executives, those responsible for the biggest corporate loss in history. As president Obama asks: “how do they justify this outrage to the taxpayers who are keeping the company afloat?”. One can’t help but wonder…

Then, there’s the case of Howie Hubler, which to me exemplifies the mindbogglingly stupid bonuses oh so well. He was responsible for the biggest loss of a single trade in history—a staggering $9 billion—yet when asked to resign (a friendly way to get fired) he received $10 million.

How about the other traders and the “CDO managers” who sold junk disguised as safe assets to their customers? They became rich too.

It’s all about incentives

Never, ever, think about something else when you should be thinking about the power of incentives.

What really caused the financial crisis, and made the crisis so large? It’s easy to point the finger at people who borrowed money they couldn’t afford, at the bankers who helped them (or tricked them) and at the rating agencies who didn’t really know what they were rating. But the greed of Wall Street shouldn’t be surprising—it should be expected.

The blame should be placed on the incentives that enabled the greed to flourish. They made the rating agencies not look too closely at the assets they were rating—otherwise the bankers would go to another rating agency and take their money with them. The people taking loans were incentivized to loan more since the house prices kept rising, making them more money. And the people giving out loans were encouraged to give out as many loans as possible, because they would get a cut of every loan they gave out.

What are the odds that people will make smart decisions about money if they don’t need to make smart decisions—if they can get rich making dumb decisions?

If you exploit and gamble, but instead of a prison sentence you’re rewarded with a fat bonus check, you will not change your actions. In fact you’ll be more likely to continue. It’s exactly like a child who wants candy: if he screams and cries until he gets candy, what will he learn? He’ll learn that you get candy when you cry—so now he’ll cry to get the candy.

Indeed, as investor extraordinaire Charlie Munger says: if you want to predict how people will behave, you only have to look at their incentives. This is why the bailouts, while helpful in the short run (the child stopped crying), made the fundamental problem that enabled the crisis worse (the child will cry more in the future). Bad behaviour by banks and the people working at banks are even more likely now since they’ve learned that if they fail they will just get bailed out, and keep their bonuses. They even passed laws to make it even easier for the Federal Reserve to step in and rescue whatever they deem “too big to fail”, without the unnecessary overhead of going through congress.

I find it interesting to compare the incentives for banks with the incentives for cryptocurrency miners. While banks are incentivized to gamble, exploit and cheat as much they can get away with, the incentives for miners are to work in the network’s best interest. While incentives makes the financial industry unstable, it’s what makes cryptocurrencies secure.

Will history repeat itself?

The 2008 financial crisis was a combination of a number of different factors working together. If only one were removed, for example if bankers didn’t give out loans to everyone and their pets or if the rating agencies would rate the assets correctly, then the crisis would never have grown so big. And there were changes to the financial system after the crisis which should prevent a repeat of the crisis.

But as I wrote previously, the core incentives problem is unsolved and even made worse. There won’t be an exact repeat of the 2008 crisis, but we might see similar problems resurface in the future. It’s like “curing” fever by lowering your body temperature, while leaving the virus infection intact.

For example in 2015, several banks began selling billions in something called a “bespoke tranche opportunity”—which is just another name for a CDO (the 3-day old halibut). The banks are also warming up to the same mortgage bonds that burned them in 2008, while housing prices are going through the roof and people are borrowing like mad.

History doesn’t repeat itself, but it rhymes awfully well.

What if we used sound money?

With sound money nobody can manipulate the money supply. For example fiat backed by gold (as long as we trust the backers), actual gold coins or cryptocurrencies. The question is: could the financial crisis have been prevented if we used sound money?

Unfortunately, probably not. The housing and bond bubble might still have happened as the banks can still create mortgage backed securities, CDOs and other complex derivatives. Sound money cannot prevent anyone from creating and selling junk.

But the incentives would be different. Banks can still use fractional banking (create IOUs and inflate the money supply), but if they fail there’s nobody to print money for them to bail them out. The bailouts in 2008–2009 were only possible because the Federal Reserve has the ability to print as much money as they want.2 There’s no upper limit to the size of the bailout—they can always conjure enough. Not so with sound money.

Therefore the unhealthy “heads I win, tails I get bailed-out” incentives would return to the normal “heads I win, tails I lose” incentives we see in any healthy gamble. This seemingly small but important change would force banks to be more careful with their risk-taking, and if they overstep their bounds they will fail. This might have bad effects in the short-term, but would lead to a more robust and healthy risk management in the long-term. The virus infection would be cured, but the fever might worsen temporarily.