Understanding Incentives

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.

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%.

Michael Burry, who ran an investment company, believed the mortgage market was propped up on bad loans and he shorted the U.S. real estate market before the crash. In the end he made $100 million personally, and earned more than $700 million for his clients.

I recently watched a movie called The Big Short, based on the book. (spoilers ahead) It follows Michael Burry and several other investors who predicted the financial crisis and made a lot of money betting against the U.S. economy. The cast is filled with talented celebrities such as Brad Pitt, Steve Carell, Ryan Gosling, and Christian Bale (who plays Burry.) I learned a lot about the incentives in the banking world from this movie. 🙂 It addresses a lot of interesting topics such as mortgage backed securities, credit default swaps, and collateralized debt obligations. Yes, sometimes finance can sound like a foreign language. Luckily the movie features real world celebrities who explain directly to the audience all these complicated financial terminologies. For example, there’s one impromptu scene where Hollywood actress Margot Robbie candidly explains how sub-prime loans work while drinking Champagne. Wow! It’s so educational right? 😀 I enjoyed this movie more than The Wolf of Wall Street.

Understanding incentives is just a matter of doing the proper research and learning about how a business or industry functions. By knowing about the incentives we can better predict the outcomes of an economic system. Doing this will help us become more efficient at allocating resources and potentially earn higher returns from our investments. 🙂 The great recession resulted in $5 trillion being wiped out from savings and pension funds. 8 million people lost their jobs and 6 million lost their homes in the U.S. alone. The reason for all of this calamity began with incentives and people’s predictable actions of responding to them. By being knowledgeable about incentive structures we have a better chance to protect ourselves when the next recession hits. 😉

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Random Useless Fact:

It’s impossible to throw a shot put without making a funny face.