Proofiness - Charles Seife [32]
Instead of “fire insurance,” use “mortgages,” and all of a sudden you’ve got a (slightly oversimplified) explanation of the subprime mortgage meltdown in 2007. The risk mismanagement involved selling mortgages to people whose income wasn’t sufficient to support one. There are reports of brokers encouraging people to lie on their mortgage application (a federal crime) to allow them to get a nice fat mortgage; in some cases, people didn’t even need to prove that they had an income at all. The recipients of these loans were just treading water financially, and were highly likely to default on their loans. This made these so-called subprime mortgages extremely high-risk, but if you were able to dump them on somebody else’s balance sheet, you could make a killing.
While times were good and the housing market was rising, everybody who traded in mortgages and other monetary instruments based upon those mortgages (such as “credit default swaps,” which were, functionally, unregulated insurance contracts on these loans) made a fortune. Brokers, banks, and insurance companies passed around the bad risks like a hot potato, creating a complicated web of risk and debt. Every time the mortgage potato circled around, CEOs, corporate officers, managers, traders, and brokers earned themselves millions of dollars in bonuses. By pretending that these high-risk loans were actually low-risk, everybody was making themselves extraordinarily wealthy. But when the economy softened and the housing market began to fall, the good times suddenly came to a screeching halt. People began to default on their mortgages in droves; it’s as if an arson craze hit insurance clients all at the same time. There was a giant sucking sound as the bad risk began gulping money away from the firms and other investors who held large amounts of these “toxic assets.” Citigroup. Merrill Lynch. Bear Stearns. Lehman Brothers. Morgan Stanley. J. P. Morgan. Freddie Mac. Fannie Mae. AIG. It’s hard to know just how much money evaporated—how much of the net worth of these companies was based upon understating the risk of these mortgages—but the damage is in the range of hundreds of billions or even trillions of dollars. This is a mind-boggling sum, not far off from the annual budget of the entire U.S. government. The result was a global economic catastrophe of unrivaled proportions.
During the good times, employees at AIG, Citigroup, and other companies made themselves very, very rich through risk mismanagement. They deliberately underestimated—indeed, ignored—the huge risks of these mortgage-based investments, trading them around and siphoning off money from one another’s companies. And when the mortgages blew up, they got to keep their cash. The companies they worked for, though, were saddled with crushing debt, and looked ready to collapse. The government had to step in to save them, at the cost of trillions of taxpayer dollars.
Yet much of that bailout money would wind up in the pockets of those who caused the crisis in the first place. It was almost inevitable—it was an outcome determined by the way humans deal with risk.
The rules that govern the behavior of officers at AIG, Citigroup, and other malefactors in the worldwide economic crisis are the same ones that are causing us to chop down the rain forests, to fill our atmosphere with carbon dioxide, and to overfish the oceans. This phenomenon, known as the tragedy of the commons,30 is everywhere—even at a friendly dinner.
Imagine that you’re at a fancy restaurant with a bunch of acquaintances and you’ve all decided ahead of time to split the bill evenly among you. Even though the restaurant is pretty expensive, the prix fixe menu isn’t too pricy.