In a world of uncertainty it is more important to know the odds than to know the facts.
In a business bet, if you have a thirty percent chance of winning one hundred dollars or a seventy percent chance of winning forty dollars (with return of principal guaranteed) the better bet is the 30% chance. (30% of $100= $30 vs 70% of $40= $28.) What is pertinent is not just the chance of winning but the pay off or, conversely, the risk.
But risk is rarely known so precisely. In real life decisions risk is a combination of probability plus outrage. This is why we are more concerned with the threat of terrorism than swimming pools, which kill more people.
We all know that there is a chance we will die before our time. That is a known unknown. We can assess what the potential costs of that known unknown is with payroll and investment information, and make a prudent investment in life insurance.
In the financial world (as well as the world of politics, public policy, and foreign affairs) we are faced with unknown unknowns; not only are risks present that we are unaware of but the potential outcome is often unmeasurable. This uncertainty is multiplied by the global extension of our financial institutions, where matters such as the likelihood of repayment of bond principle and interest is subject to cultural differences, religious tribalism, diplomatic shifts, political frailty, and economic amateurism.
Small banks in Iceland and German villages took large positions in the American mortgage market with poor understanding of the risks, the interconnectedness of financial assets and institutions and with a false sense of security in the professionalism of our financial leaders. They did not know what they did not know.
Our financial professionals, rational and highly educated, were not immune to this uncertainty and were more blinded than enlightened by their intellect. With complicated mathematical models they deluded themselves with a false sense of certainty; they thought they had considered all the risk factors, but one never knows ALL of the risk factors. The one risk factor they did miss was a decline in real estate and home prices; it seems obvious only in retrospect. Both regulators and law makers grossly misjudged the risk of the vast interconnectedness of our financial institutions. What we thought was a market rich with competitors, was really just a giant company with redundant and interconnected divisions.
We valued math when we needed history. We replaced a philosophical understanding of risk with a delusional mathematical certainty. This emboldened excessive risk taking and leverage, and convinced the financial titans that they had discovered financial alchemy. The huge profits they enjoyed for a while only convinced them of their own genius, and encouraged them to take even bigger risks. They thought they could ignore the risks of poor underlying junk assets and convert them into investment grade securities with mortgage backed securities, credit default swaps, and other derivative securities. They thought they could turn tin into gold.
But as John Galbraith noted, “genius is before the fall.” Every bubble in history has been built on delusional certainty, excessive leverage, and the mistaken association of money with intelligence.
This bubble would have been contained were it not for the political and tax policy that inflated the housing market, going back for several decades. The mortgage tax deduction gives preference to housing over other investments. When Reagan eliminated deductions for consumer interest, it made housing interest even more valuable and equity lines of credit were tapped for boats and vacations.
Franklin Roosevelt opposed the FDIC (Federal deposit Insurance Corporation) because it would penalize prudent banks and encourage excess risk taking. He capitulated in a compromise in 1934 and it grew from the original $2,500 to the $250,000 we have today. The implied government guarantees of Fannie Mae and Freddie Mac was a moral hazard on steroids compared to the FDIC.
The Community Reinvestment Act, championed by Jimmy Carter, Bill Clinton and George W. Bush (as ‘Compassionate Conservatism’) put these moral hazards to political use and eschewed prudent financial policy to gain political favor. Wall Street thought they could make risk disappear with complex mathematical models; Washington thought they could make risk disappear by pretending they did not exist.
The absurd mark to market rules enforced on the banking system by the government regulators only served to accentuate extremes in market behavior, and could not have been imposed at a worse possible time.
Economics is not a science and the intellectuals and elites who pretend it is keep wreaking havoc. Though not a science, there are principles that have stood for centuries and are ignored at our own risk. There is no better teacher of these principles than to watch the results when they are ignored or violated.