Jan 072016
 

Learning About Incentives From The Big Short

An incentive is something that motivates us to do something. The study of incentive structures can help determine economic activities. If our goal is to have money then we are motivated to work and get paid. 🙂

Understanding how incentives and disincentives work is important to analyzing the financial markets. The subprime mortgage crisis of 2007 in the U.S. was largely predictable for anyone who understands the incentive structures in the world of high finance. 🙂 In the early 2000s the banks started to securitize riskier and riskier mortgages. They sold these mortgages to other investors and claimed the loans were safe when in fact they were filled with toxic and sub-prime mortgages. Sub-prime refers to a borrower with poor credit history and has a relatively high probability of not paying back their mortgage. Around 2007 the entire house of cards collapsed which lead to a global financial crisis. All of this happened because of incentives.

  • Bank executives made a lot of money by underwriting risky mortgages. They lacked the incentive to guard against such risks because they were protected from the negative consequences thanks to insurance and the high probability of government bail outs.
  • Mortgage brokers earned higher compensation from selling variable rate loans than fixed rate loans, even though floating rate loans were more risky.
  • Potential homeowners were motivated to apply for variable rate mortgages because the introductory rates were lower than fixed rate loans.
  • People who didn’t even have jobs or steady incomes still received home loans because some mortgages offered a delayed payments program.
  • The credit rating agencies who were suppose to assess the financial risk of these mortgages gave these funds triple “A” ratings despite the high probability of default because rating agencies are funded by the banks who put together the mortgage funds. That’s like if a health inspection agency was paid by a restaurant to conduct a health and safety inspection on that same restaurant. What are the chances the health inspector is going to write up a negative report? lol. If a credit rating agency such as Moody’s decided to not comply with the bank’s self interest, then the bank will just pay some other agency such as Standard & Poors to rate their mortgage funds instead and Moody’s will lose out on that paycheque.

So in every part of the system people were motivated to take unsubstantiated risks due to the incentive programs that were in place. There’s a book called The Big Short written by Michael Lewis which explains how the sub-prime mortgage crisis unfolded. Lewis says that people see what they’re incentivized to see. If you pay someone not to see the truth, they will believe your lie. Wall Street is organized in a way where sometimes people will pay to see something other than the truth.

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The handful of individuals who understood how financial incentives work were able to predict the great recession. In 2006 a trader from Deutsche Bank paid $11 million to insure against $4 billion of triple A rated bonds from a U.S. bank. About 11 months later his bet paid off to the tune of a mind-blowing $3.7 billion! Holy ham sandwich! That’s an annualized return of more than 30,000%.

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