In her useful new book, Gillian Tett of The Financial Times writes that the global financial meltdown, which economists estimate could result in total losses from $2 trillion to $4 trillion, was ?self-inflicted.? Unlike many banking crises, she adds, ?this one was not triggered by a war, a widespread recession, or any external economic shock.? Rather, the ?entire financial system went wrong as a result of flawed incentives within banks and investment funds, as well as the rating agencies; warped regulatory structures; and a lack of oversight.?
To put it another way, the crisis was, in the words of the Newsweek business columnist Daniel Gross, ?a man-made product that turned out to be immensely toxic and damaging? ? not, as so many in the ?Smart Money crowd? insisted, ?a random, once-in-a-lifetime thing that fell out of the sky.?
It was also a disaster, he notes, with ?plenty of blame to go around,? including ?poor regulation, eight years of a failed Republican economic philosophy, Wall Street-friendly Democrats who helped stymie reform, misguided bipartisan efforts to promote home ownership, Wall Street greed, corrupt C.E.O.?s, a botched rescue effort? and poor judgment calls on the part of the Fed, and top bankers who in many cases did not even understand the derivatives their firms were trading in.
In short the current global financial crisis is a story about people who thought they were the smartest guys in the room and who turned out to be remarkably na?ve, reckless or, in some cases, downright stupid. It?s a story ? novelistic in its narrative and moral arc ? about hubris and greed and heedlessness, about people, as Fitzgerald wrote in ?The Great Gatsby,? who ?smashed up things and creatures and then retreated back into their money or their vast carelessness? and ?let other people clean up the mess they had made.?
These two new books both tell versions of that story. In ?Dumb Money? (originally published as an e-book several months ago), Gross gives the lay reader a succinct, breezy and sometimes snarky account of how ?the Ownership Society? so quickly devolved ?into Bailout Nation,? how the Alan Greenspan era of low interest rates and ?Cheap Money? (from late 2001 through 2004) begat the ?Era of Dumb Money? (mid-2004 through mid-2006) of growing leverage and debt, and, eventually, the ?Era of Dumber Money? (late 2006 to the calamities of 2008), in which ?large, old-line investment banks waded chest-deep into the subprime? mortgage swamp, processing the debt (bundling it, selling its pieces and helping others trade them) in compulsive pursuit of lucrative fees, even as the housing bubble had started to burst.
Tett was in the vanguard of those who foresaw the implosion in the credit markets. And in ?Fool?s Gold? she provides a much more densely detailed account of how complicated new kinds of derivatives (financial instruments whose value derives from an underlying asset), which had been intended to help control risk, became a means of amplifying it, as ?banks devised a host of new tricks for offering investors better returns, which invariably revolved around creating products that employed more leverage, as well as more complexity and risk.? She does so by focusing on an elite group of bankers at J. P. Morgan, who in the 1990s were pioneers in the world of derivatives, and who later came to regard what other firms and hedge funds did with their creation with dismay.
?Fool?s Gold? is somewhat arduous going for the lay reader. Tett does not write with the narrative ?lan of a Michael Lewis or a William D. Cohan, and parts of her book wander deep into the thickets of Wall Street acronyms and impenetrable jargon. She not only expounds on CDOs (collateralized debt obligations) and CDSs (credit default swaps), which readers of newspaper business sections have become familiar with in the last year, but also employs terms like ?mezzanine CDO of ABS,? ?super-senior risk? and ?inverse floaters.?
In the end, however, the book is rewarding for those readers who persevere. Tett explains how bankers ?delight in swathing the concept? of derivatives in complex jargon (not unlike that employed by deconstructionists in academia a decade or two ago), as ?opacity reduces scrutiny and confers power on the few with the ability to pierce the veil.? And she deftly explicates Wall Street dynamics, showing how falling interest rates and regulatory changes fueled the rush into derivatives and how these derivatives? use of leverage dramatically magnified trends in the market, potentially resulting in huge returns or huge losses.
At the heart of ?Fool?s Gold? is Tett?s portrait of the high-octane culture at J. P. Morgan in the 1990s. She shows the premium that young hotshots there placed on ?innovation? and ?creativity,? and she also conveys the horror that some of them later felt when they saw that their Frankensteinian brainchild had become a ?rapacious scourge,? as other firms monkeyed with its genetic code, moving from the world of high-grade corporate lending into the far more hazardous realm of subprime mortgages.
Tett describes how banks invented increasingly complex derivatives, ?all based upon the fundamental premise that the default risk of bundles of mortgages had been virtually erased by the process of bundling and then slicing them? into so-called ?tranches,? which were supposed to give investors a choice of different levels of risk and return.
And she shows how precarious such bets really were, given the vagaries of rating agencies? assessments and the fact that there was little historical data on mortgage (especially subprime mortgage) defaults to feed into the computer models used by many bankers. Her book starkly illustrates the folly of using mathematical models to predict human behavior and the Las Vegas-like bet-making embraced by many bankers.
Tett and Gross both convey the sheer craziness of the speculation in derivatives ? which, Gross points out, basically amounted to ?debt layered on debt, frosted with debt.? And they illuminate the groupthink blindness that came to afflict much of Wall Street and Washington, with bankers and heavily lobbied regulators ignoring the warning signs of systemic risk, even as subprime mortgages went from being a tiny niche market to a bigger and bigger slice of the mortgage pie.
?With the home ownership rate having crossed 69.2% in 2006,? Gross writes, ?lenders exhausted the pool of creditworthy borrowers. And so mortgage brokers began to market subprime loans (made to people with poor credit scores) and Alt-A (or low documentation) loans with greater intensity. Subprime origination rose to $625 billion in 2005, up from $210 billion in 2001.?
In spring 2006, house prices started to slide, Ms. Tett reports, but the signs of, ?housing strain did nothing to stop the mortgage-based CDO machine. Between October and December 2006 alone, banks issued a record $130 billion worth of CDOs, double the level a year before, and 40% of those were created from asset-backed securities consisting primarily of subprime mortgages.?
Back in the ?90s, Felix Rohatyn, the financier who played a central role in the 1975 plan that saved New York City from bankruptcy, described derivatives as ?financial hydrogen bombs, built on personal computers by 26-year-olds with MBA’s.? It was a prescient remark, weirdly echoed by a banker who talked to Newsweek about working at JP Morgan when the firm was at the cutting edge of innovation in derivatives. ?I?ve known people who worked on the Manhattan Project,? the banker said. ?And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important.?
As Gross observes: ?There must be a secret room in Harvard Business School where irony is vaporised from the brains of MBA?s. For in time, the analogy to the origins of the nuclear bomb would prove all too apt.?
