Too Big to Fail and Risk Compentsation

If you have anti-lock brakes, it is claimed that you will drive crazier than if you don’t. If you drive past a bicyclist wearing safety gear, you’ll give them less clearance than one who isn’t. In short, the existence of factors that mitigate risk tends to lead, not to reduced risk, but rather to increased risk-taking.*

Thus, the real problem with Goldman Sachs and other behemoths of world finance is not exactly that they make too much money – it’s that they believe, at least to some degree, that they and other huge financial institutions are too big to fail. They’ve got government-supplied anti-lock brakes, so to speak. The combination of huge potential profits and the belief that the government will step in to save them should anything go seriously wrong leads to risk compensation of the worst kind.

This is not theory in the case of Goldman – they knew, if anyone in the world did, that once the housing bubble burst (and they had billions riding on it bursting!) that AIG would fail (AIG had billions of exposure to a housing collapse, much of it to Goldman). So, had they not believed that AIG was too big to fail, the prudent business step, starting in about 2003 or so, would have been to refrain from buying credit default insurance on instruments (mortgage bundles) that they knew could not be paid off (AIG’s exposure dwarfed the actual value of these instruments in the market).

What did they do? They loaded up on credit default insurance, above and beyond any ‘insurance’ needs – Goldman didn’t even own the instruments they were buying insurance on! In other words, they made a huge investment in the collapse of the economy – an economic titan put itself in the position of winning if and only if everybody else loses, because they were firmly convinced that the bubble would burst. At the same time, they kept selling mortgaged backed securities to their investors, despite having invested billions that would pay off ONLY if the instruments they were simultaneously selling to their customers failed.

Got that?

The only risk in all this, apart from having angry mobs start stringing them up by their reversible Adam Smith/Karl Marx neckties, was that AIG would fail – which it would have within hours of the initial claims against its credit default insurance had the government not stepped in. A government, as it happens, with dozens of former (and future) Goldman Sachs employees in key positions. Quickly, the argument was made that AIG was simply too big to fail. The Fed effectively nationalized AIG at the cost of $85B – and Goldman’s ‘investment’ was paid off in full.

Note, at the same exact time Goldman was receiving 100% payout on its investments, the people to whom it had sold the exact same instruments whose failure triggered those billions of dollars were trying to sue Goldman for conflict of interest – and being told ‘hey, you’re big boys and girls – you should have known the risks. Don’t go crying to me.’ And the courts, so far, are backing them up.

The top goal for any meaningful financial reform should be the elimination of Too Big to Fail. Government bailouts of private industry should be strictly illegal. Any company that reaches a size where its failure would seriously damage the US economy should be considered by that fact alone subject to anti-trust break-up. The counter-arguments (usually from economic efficiency of some sort) simply wilt in comparison to the reality that our entire government and the tax-paying capacity of our children’s children has been put into the service of one extremely well connected bank.

* note: risk compensation takes place across populations, meaning that it’s not automatic that any one individual will fall prey to it. *I* don’t drive more recklessly because my car is safer! No, really!

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Author: Joseph Moore

Enough with the smarty-pants Dante quote. Just some opinionated blogger dude.

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