If We Only Understood Risk

It’s a damned shame that, as a species, we tend to have a complete shit comprehension of risk. If we did, it would make many collective decisions better.

Consider air travel. It’s staggeringly safer than driving. Whether measured in deaths per mile or deaths per hour, air travel is orders of magnitude safer than driving. But, almost no one fears driving while millions fear flying.

The same is true of violent crime. The violent crime rate is insanely low–measured in a few people per hundred thousand. Historically, risk from violent crime is essentially non-existent. Pre-historic death rates from violence are somewhere around 15%. That’s fifteen out of 100 people. We now see death rates from violence at something more like 0.0005 in 100 per year (about 5/100K/year–I may have gotten the decimal wrong and you have to do more math to figure out the lifetime risk–but, you get the point). And yet, millions are scared of violent crime. Risk of violent crime for almost everyone is vanishingly close to zero. We die of disease and accident, not crime. And yet, fear of crime drives politics wildly out of proportion to the risk.

It’s even more ridiculous when it comes to terrorism. How many people do you know that have died of terrorism vs those who have died of car accidents or at the end of a gun? For me, the first number is zero. I’m pretty sure I don’t even know someone who knows someone who died from terrorism. But I know at least 10 people who died in a car or by gun. Terrorism is NOT A RISK.

Well, that’s not exactly true. There is a very real risk of nuclear terrorism which could very well kill millions to billions. But that, in the parlance of risk, is a black swan event. Like a meteor striking the earth or Yellowstone erupting. The risk of a black swan event actually happening is fairly to very low–but the effect is so enormous that you have to pay attention to it.

That being said, keeping Muslims out of the country has nearly zero likelihood of decreasing such a black swan event.

And yet, the fear that drives national policy more than any other is terrorism–an essentially non-existent risk.

So, now let’s look at the banking industry, which is what sparked this particular line of inquiry.

The banking industry, like the insurance industry, is based almost solely on risk. Banks make investments or loans in order to make money. The likelihood of an investment or loan returning a profit is entirely about the level of the risk a bank takes in making the investment (from here, I’ll call loans investments, because they are).

If the investment is almost sure to return a profit, it has very little risk. Investing in US Treasury bonds has very little risk because the US government has a near-perfect history of repaying its bonds. Because the risk is low, the return on investment is low. Because it’s much safer to invest in treasury bonds than, say, what might be next Facebook or might be a a pile of crap, the treasury can borrow money and pay little interest (interest is essentially the amount a borrower pays back to the lender in addition to principal for the courtesy of having kept the money for some period of time).

So, knowing this, banks, like other investors, seek investments that have higher yields than the safest bets. Fair enough. That’s their job.

Here’s where the problem of humans not understanding risk becomes utterly poisonous.

Most individuals and companies take risks according to their appetite for failure. You might give your cousin Joe $1000 for his new business idea, hoping that he’ll turn it into something great and you’ll get $10,000 back. But if Joe *doesnt* pay you back, you’re out $1000 and that sucks for you. The same is true of most companies. If they fuck up, sucks for them.

This is NOT true of banks. And that’s for two reasons. The first is that up to $100,000 of their depositors’ money (per depositor) is insured by the FDIC. That means that depositors (you and me with bank accounts below $100,000) don’t need to pay attention to the soundness of their bank. Depositors get their money back if the bank fails. That’s good. Most people don’t know how to judge risk and can’t tell the difference between a bank that’s in sound health and a bank that’s about to fail and take all the money with it.

Or, it would be good if the banks weren’t allowed to gamble with the money that their depositors invest. The Glass-Steagal act–the one from the 1930’s that Bill Clinton repealed, was enacted to stop banks from making risky bets with depositor money. When it was repealed, it allowed retail banks (the banks you have your checking account in) to also act as investment banks (banks that have an incentive to take larger risks with your money with the hope of larger returns).

If the Glass-Steagal act had been repealed in a way that removed FDIC protection of depositors from those banks that wanted to take big risks, that would have been sort of fair. Banks could forego FDIC insurance to invest with more risk. People like you and me with a higher appetite for risk might be tempted to invest in such a bank, even though our deposits would be at risk should the bank fail, because the bank would offer higher interests rates to us because the risk was higher.

But, that’s not what happened. Banks with FDIC insurance are allowed to make risky bets on federally insured money. They still had the existential risk of making so many bad bets that they failed, but they make those bets with money you and I put in–and they don’t have to pay a higher cost for that money because it’s insured by the federal government–that is, you and I don’t demand a fat interest rate on our deposits because they aren’t at risk (because we’re guaranteed to get that money back no matter how badly the bank fucks up). No other business that isn’t subsidized by the government has that kind of freedom from the cost of risk (ok, well, there are a fuck-ton of government-subsidized businesses, including much of agriculture, sports, I could keep going, but that’s another topic).

Ok, so that’s really bad. It means that the banking industry is allowed to discount their risk of failure because the government insures its depositors.

But it’s so many times worse than that, as the 2008 financial crisis exposed.

The banks, not content with an already ridiculously unfair advantage, ratcheted up their appetite for risk to delusional heights with a nationwide shell game.
American home loans have traditionally been very safe investments because Americans tend to pay their mortgages before they pay any other bill. That has a lot to do with how Americans feel about their homes, but also who banks have traditionally decided to lend to. Traditionally, banks don’t lend to people who aren’t likely to pay them back. That’s why home loans are traditionally rated very highly by the ratings agencies (Moody’s, etc. ). The rating agencies are supposed to give a rating on an investment based on how risky it is. The lower the risk, the higher the rating.

HOWEVER, in the years leading up to 2008, all of that went to shit. The banks (along with pure investment firms like Goldman Sachs, Lehman Brothers, etc) developed a towering appetite for new home loans because there was a housing bubble. That caused an army of mortgage brokers to scour the earth for anyone who would sign loan papers. The banks wrapped up those loans into “tranches” and sold shares in them (“securitized” in the parlance). The rating agencies stamped them with the standard high rating of traditional home loans even though they were actually piled of shit, again utterly discounting the actual risk.
When risk is severely discounted, it causes people to make bad decisions. The bad decision was to keep extending credit (which wasn’t priced properly because the risk was discounted), and the entire country gorged on real estate, sending prices into the stratosphere based on nothing but cheap, risk-discounted credit.
In addition to discounting the risk, the same banks invested in credit default swaps which is a complicated way of ensuring against risk. I don’t fully understand how these worked, but I know that they are responsible for taking down AIG, the largest insurance company at the time, which was essentially insuring huge quantities of bad loans far too cheaply because the risk wasn’t priced properly.

When the shell game finally came to an end, there was plenty of carnage. Lehman Brothers was allowed to fail over a weekend in September of 2008 (the same weekend I saw Bernie Sanders on the Senate floor for the first time, ranting in his inimitable way). Other institutions were failed or reached the brink of failure.

Instead of letting the whole system crash, the Bush Administration, under the guidance of Hank Paulson, former CEO of Goldman, pushed through the trillion-dollar TARP bailout (ok, $900 billion, but who’s counting at this point) which SAVED THE BANKS (and AIG and General Motors, etc.) FROM FAILING.

The government eventually got most of its money back, but the giant travesty is that the very institutions responsible for massively discounting risk were left standing, essentially unscathed.

Congress passed the Dodd-Frank Act, which is a pale shadow of the Glass-Steagal Act, but at least it was something.

But, the biggest banks got even bigger because they were forced to buy weaker banks (BofA bought Countrywide, JPMC bought Bear-Stearns, etc.). Jamie Dimon and company got to keep their companies.

And here’s the lesson they learned: risk is free because when the shit hits the fan, the Federal government will bail them out.

Now, the banks are gunning hard to repeal the Dodd-Frank act and Trump and the fucking GOP are gung-ho to do it for them.

If 1) your cousin Joe asked you for $1000 to invest in his steal-all-the-underpants business and 2) the upside was you get $10,000 if he succeeds and 3) the downside was you get your $1000 back if he fails, you’d give him the one-large every time, even if you suspected he might be buying and smoking crack with the money. You’d do that because the risk was free.

So, back to humans and how we don’t understand risk.

The world is dangerous. Risks abound. But, accurately assessing risk is fundamental to making good decisions.

Violent crime is not a risk worth noticing, compared to all the other things that can hurt and kill you. It shouldn’t drive national policy.

Terrorism is even less worth noticing than violent crime. Certainly not worth spending trillions of dollars on war and giving up the freedoms we relinquished with the Patriot Act and the creation of a national security state. Terrorism is as risky as tetanus. Maybe less. And yet it drives national and foreign policy and has turned us into a nation of fucking cowards.

The real risks–the risks that should drive national policy–are the risks of going bankrupt from a health problem and the risk of the banks crashing the economy again because they are immune from risk.

Those risks are being deeply discounted by the GOP RIGHT FUCKING NOW. Those are risks you will feel and pay for.

In the meantime, enjoy the beautiful border wall we’re planning to build.