Monday, January 12, 2009

More Vegas, Less Wall Street

The origins of the recession lie in a systemic collapse of financial institution integrity. Some financial companies have literally gone out of business, and most others have suffered gigantic losses and are only now starting to resume their essential function of providing liquidity to companies.

In thinking about how we got to this point, I ended up asking myself this question: why don't we ever see casinos or bookies collapse?  Casinos and bookies do have bad days. Casinos and bookies have gone out of business before.  But you have never, ever, heard of a systemic collapse of the gambling industry.  It's useful to think about why this is the case.

Casinos make money by taking a percentage of every bet (the vig is the % of your winnings they get on a sports bet, the "vig" on table games is just the built in advantage they have on the odds). They do not charge by the transaction. In other words, one bet of $1,000,000 yields the same profit to the casino as 1,000 bets of $1,000 each. Wall Street got very rich by charging fees.  Your mortgage broker books a fee for every loan he originates. The investment bank books a fee for every mortgage-backed-security they package and sell. Their incentives were to maximize the number of transactions, regardless of the "vig".  Rather than loaning money at a higher rate than they pay on deposits (the boring old bank method of making money), Wall Street focused on maximizing fee income and, importantly, did not maintain a high enough margin on loans to cover losses. 

The comparison would be if a casino charged $1 per bet on the Super Bowl, but did not charge a vig. What would happen in the short run? The bookies would take as many bets as they could, ignoring their net position on the game (that is, they'd offer whatever line on the game that maximized the number of bets, rather than a line that kept their net position zero). That is, they would take 1,000 bets of $1,000 on the Packers (wishful thinking), and 500 bets of $1,000 on the Steelers. If the Packers win (and of course they would), the bookies would lose $500,000.  Prior to the game, though, they would have booked $1,500 in profit on the 1,500 total number of bets.

Wall Street got caught in this kind of trap. They took on thousands and thousands of bets (mortgages), booking a fee each time and earning big bonuses, but ignoring the fact that they were exposed to an improbably upset like the Lions winning the Super Bowl (the housing collapse).  Once the Lions actually won, Wall Street realized they had to pay off at huge odds and couldn't make good on the bets (Lehman goes down).

Casinos don't get into this trap because they do not charge by the bet, they charge as a percentage. They want to maximize the total number of dollars bet while keeping their exposure at zero. It is often mistakenly thought that casino's set the lines on football games like this: "The Packers should win by 7 points. Therefore we'll make the Packers 7 point favorites."  That is wrong.  Casino's set the line like this: "What line will make sure that the number of dollars bet on the Packers will exactly offset the number of dollars bet on their opponent?"  The whole point is that the casino does not care who wins.  They get the vig no matter what.

Wall Street got caught out by taking a huge bet on the continuation of the housing boom.  They had a betting interest in how the game turned out.  Casino's are smart enough to know that they cannot predict the outcome of sporting events.  Wall Street thought they were smart enough to predict the outcome of the economy.  Once the economy turned on them, Wall Street was stuck.

If you want to prevent some aspects of this from recurring, I think it would be wise to consider running Wall Street more like Vegas.


Petey Esdie said...

from what i've been hearing, now's the time to take advantage of these low interest rates and foreclosures. i'm thinking of buying a condo in Madison. i'll be a first-time buyer so i'll qualify for WHEDA and other assistance.

from an economic standpoint, your thoughts?

- David

Dietz Vollrath said...

Mortgage rates are historically low right now. We're looking into refinancing ours at about 4 5/8%. That's ludicrously low.

The housing crash is a bummer for people who were hoping to sell their house in the short term. But it's a huge opportunity for people who want to get into the housing market and who are not looking to just make a quick buck by flipping the property.

It's the same thing with the stock market. The crash is awful for people close to retirement, and a gold mine for people with long time horizons. Stocks and houses are really, really, really cheap right now.

Petey Esdie said...

that's the impression i've been getting. thanks for the feedback!