“Regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.”
Alan Greenspan, Senate Agriculture Committee testimony – July 30, 1998.
BP’s Hayward conceded that his giant oil company had been unprepared for this disaster. “What is undoubtedly true,” he said, “is that we didn’t have the tools you would want in your toolkit.” Tony Hayward, June 4, 2010 interview with the Financial Times
A powerful and controversial precept in economics is the “Tragedy of the Commons.” University of California biology professor Garret Hardin introduced the concept in a 1968 paper published in Science:
The tragedy of the commons develops in this way. Picture a pasture open to all. It is to be expected that each herdsman will try to keep as many cattle as possible on the commons. Such an arrangement may work reasonably satisfactorily for centuries because tribal wars, poaching, and disease keep the numbers of both man and beast well below the carrying capacity of the land. Finally, however, comes the day of reckoning, that is, the day when the long-desired goal of social stability becomes a reality. At this point, the inherent logic of the commons remorselessly generates tragedy.
As a rational being, each herdsman seeks to maximize his gain. Explicitly or implicitly, more or less consciously, he asks, “What is the utility to me of adding one more animal to my herd?”
The tragedy is overgrazing:
…the rational herdsman concludes that the only sensible course for him to pursue is to add another animal to his herd. And another; and another…. But this is the conclusion reached by each and every rational herdsman sharing a commons. Therein is the tragedy. Each man is locked into a system that compels him to increase his herd without limit–in a world that is limited. Ruin is the destination toward which all men rush, each pursuing his own best interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.
We do not have a problem with herdsman. Unfortunately, we have evolved to deadlier pursuits which threaten us all. Let us examine the cases of the post-1999 financial world and the BP Deepwater Horizon tragedy.
The World of Modern Finance
Modern finance was born in 1999 with the passage of the Gramm Leach Bliley bill, ironically named the Financial Service Modernization Act, which repealed the Glass Steagall Act of 1933. Glass Steagall among other reforms required a separation of commercial and investment banking activities. Further, a commercial bank could not hold a brokerage firm. With the passage of the Gramm bill the line between traditional and investment banking was obliterated and permitted the merger of commercial and investment banks, brokerage and insurance firms. The financial “commons” was now open for all to graze in. The result:
- Excessive use of leverage.
- Large scale subprime lending.
- Exotic mortgage products such as interest only, adjustable rates, and ALT-A.
- Securitization of everything from mortgages to car loans to credit card debt.
- Expansion of consumer lending facilities such as home equity line of credit, automobile leasing and mass issuance of credit cards to anyone who could fog a mirror.
- Predatory private equity corporate takeovers amplifying leverage with “pick or pay” payment options.
- Conflicts of interest between credit rating agencies and issuers and the ultimate purchasers of securities.
- Credit derivatives wherein firms could bet on and simultaneously attempt to engineer the demise of other firms.
Before being distorted beyond their original purpose, these practices started from a rational base. Take for example housing. The reigning ideology supporting aggressive lending practices was that housing prices would always rise and homeowners would do everything possible to avoid foreclosure of their homes. Banks armed with AAA ratings from the credit rating agencies and sophisticated models predicting default rates could bundle mortgages, create securities and sell them to “confident” investors.
The tragedy of this commons was that loose credit increased both real estate prices and supply to the point where incomes could not support repayment. In turn, the packaged securitized mortgages did what no one unpredicted, failing at an alarming rate in excess of mathematical projections. Soon the “housing commons” was littered with foreclosed homes, plunging prices, impaired bank balance sheets and the ultimate failures of Bear Stearns and Lehman.
Each participant: banker, builder, lender, appraiser, credit agency, and homeowner was merely pursuing his own economic interest. If this was merely private participants losing money, it would create economic difficulties but not a financial crisis. Unfortunately, two of the major players in the mortgage market were Fannie Mae and Freddie Mac, government sponsored enterprises with an implicit guarantee from the Treasury. These entities are sporting losses which will exceed $1 trillion or more. We the taxpayers through TARP and government guarantee programs are subsidizing these losses. See Shredding the Social Fabric. We are still paying the price for this disaster with 8 million unemployed and countless millions more underemployed.
Part II will examine BP’s ill-fated sojourn into a “common” otherwise known as the Gulf of Mexico.
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Related posts:
- The Tragedy of the Commons Part II: Modern Finance and BP
- From Under-Reaction to Over-Reaction
- Populism and the Modern Cross of Gold
- Are We a Socialist Country?
- Is the Administration Determined to Make the Elderly Poor?
Tags: Alan Greenspan, Alt-A mortages, Bear Stearns, BP, credit derivatives, Fannie Mae, Freddie Mac, Glass Steagall, Gramm Leach Bliley, Lehman, Tony Hayward, Tragedy of the Commons
