Shortlisted, 2010 Victorian Premier’s Literary Awards, Essay Advancing Public Debate
At particular times a great deal of stupid people have a great deal of stupid money... At intervals...the money of these people is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora'; it finds someone, and there is ‘speculation'; it is devoured, and there is ‘panic'.
– Walter Bagehot, ‘Essay on Edward Gibbon', 1856
IN THE LATE 1990s, when I was busily employed writing the history of a bank, one of the choicest vantage points was the foyer of its skyscraper each morning. This would begin filling with employees around seven, while remaining strangely devoid of hurry or flurry; there was a sense of deep solitary deliberation, of people already at work in their minds long before they arrived at their desks. Although the suits were smart and the outfits expensive, there was little ostentation. The standard accessory was not a slimline briefcase but a gym bag: lunch was for wimps; running and pumping iron were preferred.
Business had such a buttoned-down air that the outside world was easy to forget. One morning, late in August 1998, my first appointment was with a veteran fixed-income executive. It happened that, overnight, the Dow had swooned almost a fifth in response to Russia's decision to suspend coupon payments on its rouble bonds; even as we spoke, the default was wreaking havoc on local equity markets. Not that you would have known it. Only occasionally, as he fielded questions about note and bond issues from days of yore, did my interviewee turn to one of his screens and check prices, remarking lightly at the money being lost by everyone, including himself. His sangfroid was impressive; in the span of our conversation, his wealth must have been lightened by a million dollars or so. But, as I learned, he wasn't unusual.
Even as stocks plunged, yield curves contorted and interest-rate spreads blew out through the afternoon, the difference in the trading room from a normal day was difficult to discern. Save for a few more chagrined glances and amused asides, the hum of quiet industry was hardly disturbed. Eleven years earlier, I had watched foam-flecked operators roaring themselves hoarse on the floor of the Melbourne Stock Exchange during the share-market crash; now, it seemed, crisis could be bridged by recalibrating a few models – a hedge here, a haircut there, a little restructuring everywhere.
Perhaps it was different elsewhere – I'm sure it was. Yet it also felt like a motif of an era in which financial upheaval was a routine, while remaining oddly distant and unreal, like an occasional disconcerting thud in another room heard through the wall. Capitalism decorated itself with a daisy chain of disasters: the Tequila crisis, the Asian meltdown, the defaults of Russia and then Argentina, the rout of the dotcoms and then the telcos; the disgracing of Enron, WorldCom, Tyco and even Martha Stewart; Australia filled its own corporate pillory with the likes of FAI, HIH and One.Tel.
Yet, somehow, these misfortunes always seemed to befall other people. Sooner or later, central bankers stepped in, poured money on troubled markets, and the moment passed – until, one unexpected day, 15 September 2008, it didn't. On that day, the 158-year-old Wall Street investment bank Lehman Brothers, driving force behind RCA and the birth of television, patron of enterprises from Pan Am and TWA to Sears, Roebuck & Co. and Macy's, slid into bankruptcy under a burden of debt rendered insuperable by the collapse of the American housing market.
That day, a day we are still living through, and will be living through for some years to come, an old saw was varied. Owe the bank a million and you have a problem, it used to be said; but owe the bank a hundred million and the bank has a problem. To this now add: when millions owe trillions they have no hope of paying back, the government has a problem.
THE CREDIT CRISIS is already quantitatively and qualitatively different to those earlier misadventures, to which we grew so inured. Trading rooms are again subdued, but it is the quiet of paralysis, apprehension about what else might lie in wait on battered balance sheets, anxiety at mushrooming deficits that imperil national credit ratings. Industry is straining to adjust to a world of scarcity, both of credit and of consumption, and global trade is more circumspect for the apparently long-term economic realignments ahead.
Politicians and central bankers have stepped in but their monetary-policy party tricks have so far failed to rekindle confidence, while one bank bailout has followed another and a succession of stimulus packages has been unable to revive demand. Indeed, it's partly the central bankers' solutions to prior problems, their repeated irrigations of illiquid securities markets that precipitated such a promiscuous wastage of credit, in particular the incomplete resolution of the currency collapses twelve years ago in Indonesia, Thailand and Malaysia. Bulwarking themselves against a repeat of events, Asian economies between 2001 and 2007 poured US$5 trillion in savings into funding a yawning American current-account deficit. This allowed the central banks of the OECD to keep interest rates artificially low, and spenders to surfeit themselves.
Booms, too, are usually associated with mirages, speculations, peculations. But the boom we are doomed to repent was as solid as bricks and mortar, involving the satisfaction of that most familiar of yearnings, home ownership, and driven by that uniquely human quality, optimism – the belief, fundamentally, in a perpetually brightening future. The bust, meanwhile, has prostrated an industry, finance, that had prided itself on consciousness and control of risk, on non-stop growth and innovation. The giants of Wall Street have already been humbled; for Europe's banks, which have recognised just a fraction of an estimated US$1.1 trillion in losses, that day is coming. Australia's better-capitalised banking sector has so far absorbed the shocks from abroad, but perhaps a decade's deleveraging lies ahead: according to the Asian Development Bank, global financial assets depreciated last year by roughly $50 trillion – equal to the world's economic output for a year. The interconnectedness of the global economy has for years been a matter of marvel; it has in fact proven more far– and deep-reaching than anyone acknowledged, with Iceland near-ruined by the carelessness of its banks in Britain, the Congo slowed almost to a standstill by Chinese investors repatriating capital, and bank collapses from Spain to the Caribbean.
THE RISE OF finance had earlier seemed irresistible. As recently as the early 1990s the financial sector provided only about a fifth of American corporate profits. By the peak of the boom, however, that proportion had doubled, and the sector was generating almost a tenth of GDP. As the proportion of American workers in manufacturing shrank from a third in 1950 to a tenth today, finance appeared to be taking up the slack, rewarding itself according to that improved station: mean compensation grew from about the average of all domestic private industries to almost twice that, and the top seven American banks dispersed US$95 billion among employees between 2005 and 2007. Increasingly, finance offered the keys to the kingdom. More than a fifth of American CEOs were once chief financial officers, according to a survey last year by CFO magazine – twice the proportion of a decade earlier. Even in Australia, a resources economy, balance-sheet legerdemain was regarded as a passé-partout to success. Heroes of equity investors have been the financial cosmeticians of Macquarie Bank, Babcock & Brown and Allco, whose makeovers have wrung sexy returns from the dourest infrastructure.
Finance, moreover, seemed welcome everywhere it went. In the past quarter of a century almost every advanced economy touted for banking and asset-management business, in order that it might claim to be a ‘financial centre'. Some have been old centres rejuvenated. The City grew to provide a tenth of Britain's GDP, and a quarter of total corporation-tax receipts; at an industry dinner just two years ago, Gordon Brown congratulated bosses for ‘an era that history will record as the beginning of a new golden age for the City of London'. Some have been new. Fostered by huge tax breaks and regulatory incentives, Dublin's International Financial Services Centre transformed a stretch of the Liffey formerly sprawling with dormant docks and shuttered warehouses into a vertical principality of glass and steel. The IFSC is the setting for Ava McCarthy's new thriller, The Insider (HarperCollins, 2009), where it is savoured as 'the place where rich people come to get richer'.
For twenty years, Sydney has promoted itself in competition with Singapore, Hong Kong and Tokyo as a regional financial centre. As recently as last year, the then Assistant Treasurer Chris Bowen was leading an ‘Olympics-style push' for business, abetted by tax incentives, short cuts through bureaucracy and the attention of a dedicated financial-services advisory council within Treasury. Prime Minister Kevin Rudd hosted events for the financial-services industry while visiting the US, China and Japan, while committing Australia to mutual recognition of securities regulation with the US – presumably before discovering he was the dupe of a horrid neo-liberal plot.
For government, the enticements of finance were not far to seek. The regular profit outperformance of financial-services companies in an era of low interest rates tended to disguise slower economic growth elsewhere. Finance does not require major infrastructure development or lengthy lead-times to begin operating, while its apologists argued that competition imposed disciplines which regulators could not. Its assets, meanwhile, as the famous saying has it, go down in the lift every night. That was fundamental: finance provided nice, clean, respectable jobs for graduates, who voted, and whose parents did as well. By 2007, for instance, finance was absorbing more Harvard graduates than any other industry: a fifth of males and a tenth of females. One of the stated objectives of Australia's Bradley Review of Higher Education was to find how universities could produce more finance graduates for local and international consumption.
There were, of course, always refuseniks. Financial services often appeared as the vanguard of globalisation, an incitement to rage on both the left and right of politics. Paranoia about the encroachments of modernity also made it the object of violent expression: when al-Qaeda plotted 9/11, it chose as its target not an old-economy bastion, like the headquarters of General Motors in Detroit, or a new economy symbol, like the Googleplex in Mountain View, but the gleaming spires of New York's World Trade Center, putting them on hegemonic par with the Pentagon and White House. Public ire during the G20's London Summit in April was directed at, among other locations, the headquarters of the profligate Royal Bank of Scotland, sacked by demonstrators in emulation of the anarchists who tried to bomb the venerable House of Morgan in September 1920.
Except that ninety years ago, hatred of ‘Morgan the financial gorgon' sprang from the idée fixe that it concentrated wealth for an unelected elite; anger springs now after a period in which wealth was spread to the edges and borrowers were lent money on almost any terms, for almost any object of their hearts' desire. And while financial calamities are traditionally and proverbially larcenous, with the standard complaint that the big guy made a clean getaway and the little guy was fleeced, the top of town has here taken unexampled hits: l'affaire Madoff, perhaps the greatest fraud ever committed by a single person, was perpetrated at the expense of rich professionals, not poor suckers. Bernie Madoff aside, this has not been a crash accompanied by evidence of widespread malfeasance. Rather, it seems to have occurred in the ordinary course of business, to be a crisis of the system not in spite of it – which is precisely what has made it so intractable. That being so, it is useful to consider the origins of that system, the genesis of the core banking function of credit creation.
IN BILLY WILDER'S delirious Cold War comedy One, Two, Three (1961), Otto Piffl, the headstrong young communist whom the Coca-Cola executive CR MacNamara is trying to convert to capitalism, is surprised to learn that his wedding in the West has already buried him in debt. ‘I've been a capitalist for three hours and already I owe $10,000?' he exclaims. MacNamara, played with sardonic relish by James Cagney, thinks he's finally got it. ‘That's how the system works!' he explains. ‘Everybody owes everybody else!' Quite – and it is this apparent paradox that underpins what JK Galbraith called simply ‘the miracle of banking'.
This year marks the four-hundredth anniversary of the dawn of modern banking, the foundation of Amsterdam's Wisselbank. Established in response to the hundreds of different denominations of gold and silver coins then in European circulation, it issued credit notes based on the weight and assay value of currency presented. But, as the bank kept the physical currency on the premises to cover the paper it issued, this was only half a revolution. The other half came fifty years later, with the establishment of Stockholm's Banco, which took deposits for a fee and issued loans secured against property, a task previously the preserve of moneylenders.
Initially, the acceptance of deposits and the making of loans were separate operations, and the idea of merging them was a stroke of genius for which Banco founder Johan Palmstruch almost paid with his life, being not the last banker to discover that short-term deposits do not always coexist harmoniously with long-term loans: the bank collapsed and Palmstruch's death sentence was commuted only at the last minute. But it was an idea whose time had come, and it is appropriate that banking's emergence coincides with alchemy's last efflorescence: credit creation has about it a touch of the philosopher's stone, even today, for where business prefers martial allusions, from ‘captains of industry' to ‘guerrilla marketing', financiers are still routinely ‘wizards'.
The original banking model has since been stretched numberless ways. Banks began taking deposits from and lending to companies and among themselves, and dealing in every conceivable security of every possible maturity – with a certain amount of creative destruction along the way. The first great ‘banker's bank' devoted to trading bills of exchange, Overend, Gurney & Co., collapsed in ruins; the first great ‘commercial bank' designed for lending to industry, Crédit Mobilier de Paris, collapsed amid scandal. And, sooner or later, everyone is reminded that ‘credit' comes from the Latin credo: I believe. There is faith at every level of banking: in the value of collateral, in the enforceability of contracts, in the solvency of customers and counterparties, in the abiding liquidity of markets. It is a faith that fissures readily, as Walter Bagehot noted in surveying the City of London 136 years ago: ‘Every banker knows that if he has to prove he is worthy of credit, however good may be his arguments, his credit is gone.'
It is a faith that central banks were granted monopolies of issuance over currency to counteract. Yet, if anything, that basis in faith has grown, as markets have grown global and electronic, and finance more reified. The taunt that finance is mere ‘paper shuffling' is nowadays obsolete; it hardly involves even that level of substantiality. Thus the scene in Po Bronson's droll Bombardiers (Penguin, 1996), where the wunderkind trader Eggs Igino causes consternation by asking to see a bond: ‘I've sold billions of dollars worth of bonds,' he explains. ‘I think it's time I got to know what I was selling...I would sleep better at night knowing I wasn't part of some big hoax.' The search that turns the bank upside down to produce a modest certificate is anti-climatic, but when a spontaneous auction breaks out, Igino sells at a profit. ‘You're a fucking genius, Igino,' says his boss. ‘You could sell venom to a snake.' And while reporting of the world of money sticks loyally with the fortunes of stocks, currencies and commodities, it is the bond that is the financial instrument of greatest ubiquity and versatility – again, in name, operating at a level of faith. Any debt with a payment stream can underpin a bond – and, in our lifetime, almost every debt has come to.
WITH THEIR DOLLAR'S giant slalom in the 1980s, Australians fixated on the foreign-exchange trader as their financial cowboy of choice. But the bawling, brawling, braces-wearing blowhards of Tom Wolfe's Bonfire of the Vanities (Picador, 1988) and Michael Lewis's Liar's Poker (Hodder & Stoughton, 1989) were trading bonds: at that stage mainly government securities, US treasuries, UK gilts, with what was politely called ‘emerging market debt' for bigger swinging dicks, and what were unambiguously called ‘junk bonds' for investors with the biggest cojones of all. It was an age of big deficits, big corporate borrowings, and also greater personal indebtedness, for alongside these traditional instruments were soon to be seen other collaterals: bonds backed by auto loans, student loans, credit-card debt and royalty streams, bundled up and rendered fungible by a process called securitisation.
In parallel, there emerged a market for derivatives – again, traditional instruments finding modern applications. Options are known to have been traded in Holland in the 1630s, and futures to have been offered in rice on Osaka's Do-jima Exchange in the 1730s; swaps, more recent, were first initiated in currencies in 1980 (between the World Bank and IBM), in interest rates in 1982 (between the Student Loan Marketing Association and ITT), and in equities in 1989 (arranged by Bankers Trust). Most people know little more than that derivatives are designed to mitigate risk and are often, if not always, very complex, governed by esoteric concepts like ‘convexity' and ‘duration', and relying for evaluation on ‘zero curves' and ‘coupon curves'. But what matters most is who developed these parallel and gradually intersecting concepts, and why.
The Great Depression left a schism in American banking, the Glass-Steagall Act, which split commercial banking, the acts of making loans and taking deposits, from investment banking, the art of underwriting securities for corporates and trading stocks and bonds for private clients and pension funds. Where the anarchists had failed, Senator Carter Glass and Congressman Henry Steagall succeeded. In September 1935, the House of Morgan was rent asunder: most of it became the blue-chip commercial bank JP Morgan & Co., clustered eventually with peers like Citibank, Chase Manhattan and the Bank of America, and guaranteed by the Federal Deposit Insurance Corporation (FDIC); the residue moved a few doors down to constitute the fledgling investment-banking partnership Morgan Stanley, ranking then alongside the likes of Dillon, Read & Co. and Kuhn, Loeb & Co., then later with Goldman Sachs, Merrill Lynch, Bear Stearns, Salomon Brothers, Lehman Brothers – the loose agglomeration of names that collectively and popularly constitute Wall Street.
For the next forty years, both groups enjoyed relatively cosy and discrete franchises. Then, on 1 May 1975, the Securities and Exchange Commission, the Depression's other regulatory outcome, abolished Wall Street's system of fixed commissions for securities trading. Many commentators on present discontents, such as Australia's Prime Minister, deem deregulation to be part of a neo-liberal agenda. Yet the scrapping of the commission structure on Wall Street, widely lauded as busting up its cloistered cartel, is every bit as significant as the eventual repeal of Glass-Steagall, through the Gramm-Leach-Bliley Act, ten years ago.
Investment banks did not enjoy low-cost funds from deposits; they depended on the resources of their partners and, increasingly, on wholesale markets. Consequently they were compelled to earn fees from competing and innovating, pioneering new markets and exploiting volatilities, pushing tolerances of risk. Opportunities duly materialised. With the steady disintegration of the last vestiges of the Bretton Woods system of fixed exchange rates, in the early 1970s, they developed trading expertises; with the vogue for hostile takeovers, they expanded their advisory capabilities in mergers and acquisitions; with the deregulation of finance in foreign climes, they cultivated subsidiaries and joint ventures abroad. Investment banking, in its new varieties and global extent, steadily outstripped the wherewithal of the old partnership structures: competitors needed big balance sheets on which to park securitised assets, and to act as credible counterparties in derivatives transactions. Salomons was the first to go public, and a succession of huge paydays followed: when Morgan Stanley's partners sold out, in March 1986, some reaped as much as US$50 million. The last to go that route, Goldman Sachs, did so ten years ago, by which time the apparent shilly-shallying of the partners had become a talking point; in hindsight, their circumspection was understandable.
With the end of the partnership, Wall Street firms acknowledged that they had lost something – that elusive collegial binding, that sense of loyalty to the franchise. They sought to replicate it by pampering their star earners with increasingly lavish equity-based incentives: options and preferred stock, on hugely advantageous terms where it was not free. By the peak of the boom, American financial institutions were paying their employees sums equivalent to more than half their annual revenues. Their explanation? They deserved it. Wall Street's frat-boy ascendancy passed almost as soon as it was immortalised by Tom Wolfe and Michael Lewis. By the early 1990s, investment banks were plundering universities of their nimblest mathematical minds and most creative computer modellers. When everyone had balance-sheet grunt, the selling differential became structuring capabilities – sheer, unadulterated brainpower. As Lewis puts it in his new book, Panic (Penguin, 2009):
‘A gap opened up between high and low finance. It was the end of anti-intellectualism in American financial life.'
Although derivatives had been devised as a means of reducing or at least redistributing risk, they had also become part of finance's profit-making armoury, and the more complicated the instrument, the greater the fee – although, no less often, the greater the concealed risk to the holder. In his memoir of derivatives trading, F.I.A.S.C.O. (Norton, 1996), Frank Partnoy describes popularising an apparently innocent structured note called PERLS, Principal Exchange Rate Linked Securities, whose marketing documents contained the soothing advice that ‘downside was limited to the size of the initial investment': ‘These words appeared as boilerplate throughout Morgan Stanley's marketing documents and almost always generated snickers from the salesmen...The most a buyer could lose was everything. Morgan Stanley, in contrast, had nothing to lose.' The other appeal of trading securities and originating derivatives was that the activities were unrestricted by the now-antiquated Glass-Steagall Act, so investment banks and commercial banks alike could profit. This was a game everyone could play and,
BUSINESS'S TENDENCY TO migrate to environments of least supervision, however, had a more perverse outcome: a dangerous knowledge gap began to open, between those who ran banks and those who...well, really ran banks. Financial institutions were still ostensibly governed by chairmen, directors, chief executives and chief financial officers, all in their forties and fifties. Yet they were increasingly dependent for the heft of their earnings on the ingenuity and industry of younger executives exploiting market opportunities that were usually fleeting, and using devices generally new and untested. JP Morgan himself was proud to say he could do the job of any man in his firm: ‘I can sit down at any clerk's desk, take up his work where he left off and gone with it...I don't like being at any man's mercy.' A possibly apocryphal story of the early days of swaps is that the chief executive of the firm bearing Morgan's name, Lewis Preston, rounded on his derivatives pioneer, Connie Volstadt, convinced that the US$400 million profit he was claiming should be a US$400 million loss – he had to be painstakingly proven wrong. Mind you, at least Preston had the nerve to issue the challenge; his peers were happy enough to fall further behind with each passing year. For innovation in the financial markets is unlike that in medicine or science. There is no copyright protection, no notion of intellectual property, and little semblance of peer review, except as a means to imitation. If one competitor has success with a zero-coupon structured note or a covenant light bond, the market is soon flooded with lookalikes; unless either very complex or exceedingly risky, products are instantly perishable, and knowledge grows rapidly obsolete.
Some tried to point this out. In a January 1992 speech to the New York State Bankers Association, the lugubrious president of the New York Federal Reserve, Gerald Corrigan, urged bankers to take a ‘very, very hard look' at derivatives: ‘Off-balance-sheet activities have a role, but they must be managed and controlled carefully, and they must be understood by top management, as well as by traders and rocket scientists. I hope this sounds like a warning, because it is.' A wave of derivatives shocks all over the world – Procter & Gamble, Orange County, Metalgesellschaft, Daiwa Bank, Sumitomo – duly culminated in a scandal shocking to bankers everywhere.
Eighteen months after Corrigan's speech, the chairman of Barings Bank, Peter Baring, visited the supervision department of the Bank of England. It was a regular visit, and a cordial one, because Barings, one of the City's most venerable names, had lately reported an impressively robust profit. Minutes of the meeting recorded Peter Baring's honeyed words: ‘The recovery in profitability has been amazing...leaving Barings to conclude that it is not actually terribly difficult to make money in the securities business.' When this transcript was published, a young Barings employee stood on the floor of Singapore's SIMEX futures exchange enunciating the quote in the poshest sneer he could summon. ‘This was a conversation between two experienced bankers who were smugly congratulating themselves on this secret way of making money. And they would have shaken hands in farewell and gone their separate ways thinking what a super chap the other was. They should have known better.'
That they didn't left them acutely vulnerable to the depredations of the speaker, Nick Leeson, who was piling his derivatives losses into an electronic bottom drawer called Error Account 88888, while eluding the lunges of incompetent and half-hearted investigators: ‘The only good thing about hiding losses from these people was that it was so easy. They were always too busy and too self-important, and were always on the telephone. They had the attention span of a gnat. They could not make the time to work through a sheet of numbers and spot that it didn't add up.'
THEN BARINGS VAPOURISED in January 1995, bankers everywhere felt a pang of simpatico with its management and resolved to do a better job, although they did not linger long over its implications, perhaps because a rogue trader could be made a scapegoat. Yet, in some respects, the collapse of Barings was even more a harbinger than the subsequent and far larger collapses of Long-Term Capital Management and Enron. For what has been gruesomely fascinating about finance's recent travails is how little top management was aware of how their banks made money, and therefore of the risks they were running. Some of the strangers in banking's strange land were never hard to pick, like the former retailer Andy Hornby, who ran Britain's HBOS. But there were others, better camouflaged yet just as ill-adapted to the altered landscape. As Gillian Tett notes in Fool's Gold (Little, Brown, 2009), her new account of the false promise of financial innovation, ‘By 2005, very few men running investment banks had extensive experience in structuring and trading derivatives. The field was just too young to have produced many high-level leaders, and many derivatives experts were too cerebral to play the type of internal corporate political games needed to rise to the top at most banks...Citigroup, Merrill Lynch, UBS and numerous others were run by former bond and equity salesmen, lawyers, wealth managers and commercial bankers. Such men had little instinctive understanding of the technical details of managing risk. Moreover, the wider competitive climate provided an overwhelming incentive for them to focus on revenues above all else.'
As the mortgage market deteriorated in late 2007, for example, Citigroup fell victim to an instrument of its own design that allowed investors to return $25 billion of the deteriorating financial products they had been sold. Neither chairman Chuck Prince, a lawyer, nor his successor Robert Rubin, an economist, had heard of the ‘liquidity put', despite having skimmed hundreds of millions of dollars in annual compensation. ‘How did this happen?' asked JP Morgan boss Jamie Dimon of a Citigroup peer. ‘We are not entirely sure ourselves,' came the reply.
Similarly, when AIG began unravelling, chief executive Martin Sullivan was completely dependent on his heavily implicated financial-products group chief Joseph Cassano – the company had for six months failed to fill vacancies for a chief financial officer and chief risk-assessment officer, and Sullivan's background was property. As Matt Taibbi reported in Rolling Stone: ‘That meant that the eighteenth-largest company in the world had no one checking to make sure its balance sheet was safe and no one keeping track of how much cash and assets the firm had on hand. The situation was so bad that when outside consultants were called in a few weeks before the bailout, senior executives were unable to answer even the most basic questions about their company – like, for instance, how much exposure the firm had to the residential-mortgage market. When the growing credit crunch prompted senior AIG executives to re-examine its liabilities, a company accountant named Joseph St Denis became "gravely concerned"...Cassano responded by personally forcing the poor sap out of the firm, telling him he was "deliberately excluded" from the financial review for fear that he might "pollute the process".'
Bosses at Bear Stearns – 2006 Financial Institution of the Year, according to the prestigious Euromoney – appeared to personify Wall Street at its most practical and unostentatious: chairman and CEO Jimmy Cayne was a stockbroker, co-CEO Alan Schwartz a corporate adviser, CFO Sam Molinaro an accountant, asset-management chief Rich Marin an experienced portfolio manager, elder statesman Ace Greenberg a sixty-year industry veteran. But in the most thorough exposition of the crisis so far, William Cohan's House of Cards(Allen Lane, 2009), they are recalled by colleagues as barely able to ask questions, let alone provide answers. At a speakerphone Q&A with banking analysts at which Bear was coming under pressure, for example, the storied Cayne was baffled by the only question posed him: ‘All heads in the room swivelled to Jimmy, who was sitting in the room with Sam, and Jimmy went blank like a deer in the headlights. Sam jumped in to save him and said Jimmy had to leave the room. Our vaunted CEO was incapable of answering a single question...it was pretty much a softball question, too, like "What do you see in the markets?"...It was a nothing question. Jimmy couldn't open his mouth, so he didn't.'
When Cayne fired his senior fixed-income executive, Warren Spector, mainly because he didn't like him, the situation became even more confused. ‘It was clear when Warren left, Jimmy had no idea what we did in fixed income. Unlike Alan, who didn't get it and knew he didn't get it and tried, Jimmy had no clue. He would now come up to the fixed-income floor and wander round and try to find some common ground: "How you doing?" And: "What's going on?" He'd have heard of some customer name – Thornburg, for example, was falling apart at that point – and he'd go: "How's Thornburg going?" It's like, "Fine. Nothing's changed since yesterday"...There was no way he could learn it unless he experienced it. It was sort of hopeless.'
Schwartz was little better: ‘It was like Bonds 101. You're starting with, "prices go up, yields go down. And how do you calculate duration?"...It's not what he did for a living, and he picked up on it faster than most humans could. But he never really got it...It would take you fifteen years to get up to speed on the funky shit that we owned.'
Nobody had fifteen minutes, let alone fifteen years. Here was an industry that had lost its head, so segregated in its complex specialisations as to have become a mystery to itself. A fashionable phrase is that banking institutions had been allowed to become ‘too big to fail'; it is just as arguable that they had become ‘too big to run'.
WHAT EXACTLY DID these top executives fail to grasp? In one sense, the origins of the crisis are disarmingly prosaic. It has become popular to trace it to Bill Clinton's National Homeownership Strategy, launched in August 1994 with a clarion call for ‘new financing strategies, fuelled by the creativity and resources of the public and private sectors', to extend home ownership to more low-income families. But Clinton's was an ancient preoccupation made new. Americans had already embarked on a love affair with home and hearth by the time of their first Federal Income Tax Act, which in 1913 permitted full tax deductibility of mortgage repayments, while their politicians have repeatedly espoused the social efficacy of property ownership, in terms reprising those of Herbert Hoover nearly ninety years ago: ‘The home owner has a constructive aim in life. He works harder outside his home, he spends his leisure hours more profitably, and he and his family live a finer life and enjoy more of the comforts and cultivating influences of our modern civilization.' Hoover's Own Your Home Scheme, an elaborate array of incentives for marginal mortgagees, was the first of any number of well-meant and ill-starred initiatives aimed at encouraging Americans' real-estate dreams; by encouraging dreams at odds with reality, it was also integral to a sizeable proportion of the thousand foreclosures a day at the height of the Great Depression.
Other developed nations, notably Australia, have also fetishised home ownership. But only in the US has the state carved out such a colossal role. The Depression, in fact, fostered both the Federal Housing Administration (FHA) to insure mortgages, and the Federal National Mortgage Association (FNMA, usually called Fannie Mae) to purchase those insured mortgages. Had Roosevelt helped draft the Declaration of Independence, he would almost certainly have dedicated the country to freedom of borrowing in addition to life, liberty and the pursuit of happiness. To the tough-minded Al Stephenson (Frederic March) in William Wyler's The Best Years of Our Lives (1946), it was worth a war to defend. Irked when the Cornbelt Loan and Trust Company, to which he's returned from active service, turns away a poor but industrious borrower who lacks ‘sufficient collateral', and emboldened by a few drinks, he gives a stirring speech at his homecoming banquet: ‘One day in Okinawa, a Major comes up to me and he says, "Stephenson, you see that hill?" "Yes sir, I see it." "All right," he said. "You and your platoon will attack said hill and take it." So I said to the Major, "But that operation involves considerable risk. We haven't sufficient collateral." "I'm aware of that," said the Major, "but the fact remains that there's the hill and you are the guys who are going to take it." So I said to him, "I'm sorry, Major...no collateral, no hill." So we didn't take the hill and we lost the war. I think that little story has considerable significance, but I've forgotten what it is...I love the Cornbelt Loan and Trust Company. There are some who say that the old bank is suffering from hardening of the arteries and of the heart. I refuse to listen to such radical talk. I say that our bank is alive, it's generous, it's human, and we're going to have such a line of customers seeking and getting small loans that people will think we're gambling with the depositors' money. And we will be. We will be gambling on the future of this country. I thank you.'
With the GI Bill of 1944 and the Housing Act of 1949, this promise of future largesse and liberality was steadily fulfilled: over the past fifty years, total mortgage debt in the US grew seventy-fold, with owner-occupiers finally owing a sum greater than the country's GDP. This was despite the curtailment of direct government assistance for low-income borrowers – casualties of the Reagan years. Lately, it was the work instead of a massive, integrated and hugely efficient private-sector machine, albeit with the continued implied support of Fannie Mae and its consort Freddie Mac (the Federal Home Loan Mortgage Corporation), not to mention bipartisan backing from Capitol Hill.
Accounts of the credit crisis seldom do justice to the intricacy of that machine. At the front end was generally a loan broker acting in cahoots with one or more mortgage originators, with the assistance of a valuer. Then there was either an investment bank or a commercial bank to scoop those mortgages up, securitise and sell them to other financial institutions, with the endorsement of a credit-ratings agency, accountants and lawyers, especially after an August 1996 policy change announced by Alan Greenspan, the US Federal Reserve's gnomic chairman. Henceforward, Greenspan decreed, a mortgage-backed security could be held by a bank with less than half the capital required for the equivalent quantum of mortgages. With a quasi-government guarantee from Fannie Mae or Freddie Mac available, it was an invitation to start securitising with both hands; banks did not miss it.
In that machine, however, only the front end, and then fleetingly, had any contact with the borrower and the asset – each step placed a greater distance between the individual who had taken out the mortgage and its eventual holder, which could be anyone from a bank in Scotland or a money-market fund in California to a public-service pension provider in Iceland or a hedge fund registered in Bermuda. Yet each step was also vitally interested in the business taking place; it was how they extracted their fee or obtained their return. So, as homebuyers were pitched in at ever greater extremities of gearing, bankers began performing ever greater stretches to accommodate them, while articulating ever greater self-deceptions to explain them. In October 1997, the first securitisation took place of what came to be called ‘sub-prime' mortgages, those taken out by low-income borrowers, with payments guaranteed by Freddie Mac, and underwritten by Bear Stearns and First Union Capital Markets; Fannie Mae then also agreed to begin purchasing loans made to ‘borrowers with slightly impaired credit'. To assuage investor anxiety, Bear insisted that low-income borrowers regarded owning a home as ‘a near-sacred obligation' and that ‘a family will do almost anything to meet that monthly mortgage payment' – cod sociology and wishful thinking.
In truth, as the economic historian Robert Shiller learned while researching his Irrational Exuberance (Scribe, 2000), nobody knew very much about how housing markets behaved at all. ‘To my surprise,' Shiller wrote, ‘everyone I asked said that there were no data on the long-term performance of home prices – not for the US, nor for any country...Stop and think about that. If the housing boom is such a spectacular economic event, wouldn't you imagine that someone would care if this kind of thing had happened before, and what the outcome had been?...This is at once a lesson in human behaviour and a reminder that human attention is capricious. Clearly no one was carefully evaluating the real estate market and its
potential for speculative excess.'
EXEGESES OF THE credit crisis quickly proliferate with acronyms, from ABS and ABCP to SIVs and SPVs; familiar words in unfamiliar settings, like conduit, mezzanine, synthetic and repo; and just occasionally a cross between the two, such as BISTRO (Broad Index Secured Trust Offering, if you must know). But only two pieces of jargon are genuinely consequential: collateralised debt obligation (CDO) and credit-default swap (CDS).
A mortgage-backed CDO derives its value and payments from a portfolio of home loans, which it borrows money to acquire from an originator. These portfolios are sliced into bonds in different tranches of risk, from super-senior to junior: the super-senior, based on securities of ostensibly higher quality, pay a lower coupon; the junior pay more, in return for the investor accepting greater default risk. At first, because relatively few lenders dared tarry with ‘sub-prime' borrowers, CDOs were constructed only of high-quality ‘conforming' credits. Then that taboo relaxed and, as Gillian Tett reports, everyone got rich: ‘Precisely because sub-prime loans were risky, the homeowners who took out such debt typically paid a higher rate of interest than prime borrowers did, and that meant the "raw material" of sub-prime loans produced higher-returning CDOs than those built of "prime" mortgages. For returns-hungry investors, sub-prime mortgage-based CDOs were gold dust.' With sub-prime lending underpinned by this reassuringly tailored and focused security, lending to low-income borrowers grew 500 per cent over the next eight years. Hedge funds accumulating these CDOs on margin to further juice up their returns, moreover, were often funded by the same investment banks that underwrote the securities.
The CDS, meanwhile, was a credit derivative devised by JP Morgan that allowed investors to bet on, and thus hedge against, the risks of a bond defaulting. After successfully marketing CDSs on European government debt, the so-called Morgan mafia started offering them to banks as a means of ‘cleaning up' their balance sheets: by selling tranches of bonds based on the securitised default risk, a bank could now effectively insure against a corporate loan or an emerging market economy defaulting. This market, too, exploded: by mid-2005, it had a nominal value equivalent to that of the entire American economy. Mind you, CDS protection continued to look like the acme of prudence. When the Morgan mafia sought a way to deal with the super-senior CDO risk that was always hardest to sell, they even wheeled in the world's mightiest insurer, AIG – the ultimate endorsement.
Some side effects were always obvious. If nobody was holding mortgages through to maturity, what incentive existed to make them robust? If risk was to be moved off balance sheets in such quantities, who would end up watching it? And at what point did securitisation shift from being a means of reducing risk, thereby rendering the economy more susceptible even to minor shocks? They were questions without answers. A CDO was a leveraged bet on leveraged bets, destined to flourish only in an environment of low interest rates. A CDS relied on assumptions about liquidity and stability never hitherto tested – indeed, AIG seems to have regarded mortgage risk as like the self-contained risk of house fires or car accidents, which do not affect the probability of other similar events; while banking panics are spontaneous, contagious and sauve qui peut. An old folk-wisdom of the financial market runs: shouting ‘Fire!' in a crowded theatre is a bad strategy – unless you happen to be near the door.
The cumulative and complementary impacts of CDOs and CDSs, then, were to encourage bankers to recycle the capital on their unburdened balance sheets for even further adventures, while also feeling that appropriate precautions had been taken – an effect exacerbated by the industry's involuted incentives. For the assumption on Wall Street had always been that, somehow, the stupendous rewards available to elite workers would protect the industry from mishap; after all, who would willingly imperil an institution on which their future wealth depended? Equally, however, who wanted to retard a machine that in 2006 spun off US$6 billion in investment-banking fees? Lucrative equity-based remuneration packages turned out not to engender prudence; if anything, they exacerbated a predisposition to cut corners and relax credit standards, in order to maximise quarterly revenues, thereby enhancing stock prices and remuneration. In this world, what counted was not deal quality but ‘deal flow' – the number of transactions that could be executed, and thus the number of tickets that could be clipped on the way through. What counted for CDOs and CDSs, indeed, counted every bit as much – in the Australian setting – for the securitised infrastructure in which Macquarie Bank specialised, or the leveraged property schemes of Centro.
Rather than a personal evaluation of worth or even a market certification of value, rewards had become something more like casino winnings – in the gaming vernacular, ‘house money'. Almost twenty years ago, the behavioural economist Richard Thaler demonstrated what had long been thought, that gamblers are far more inclined to stake house money on possible further gains. Because limited liability protected personal downsides, moreover, the costs of failure were vastly incommensurate with the rewards for success. Wall Street had actually never been making its inhabitants richer than at the point it blew itself to smithereens.
SO FAR, SO bad, and so familiar. But from here on, the standard narrative of financial collapse begins breaking down – because, as observed earlier, a striking feature of the crisis was the emphatic flourish with which Wall Street signed its own death warrant, hanging guilelessly on to souring sub-prime securities, gripped by the widespread delusion that house prices could only rise, despite them already having doubled between 1997 and 2005, and that the economy could only grow, even in an environment of trillion-dollar deficits. While the dotcom boom was underpinned by the proverbial ‘bigger fool' syndrome – the belief that there will always be a bigger fool to relieve you of overpriced stock – the biggest fools last year were banks themselves.
For all the rapacity and recklessness on show, furthermore, the ethical standards of Wall Street do not seem to have been more than averagely dubious. Bernie Madoff is like one of those bug-eyed, big-mouthed deep-sea grotesques occasionally dragged to the surface in a trawler's net: a freak of nature, satisfyingly symbolic but not truly representative. For connoisseurs of colourful villainy, in fact, this bust has been a squib, containing nothing like the pleasing perp walks that followed the collapses of Enron or WorldCom, or the satisfying Spitzer settlements. Bear Stearns' terminal error was choosing to protect its reputation with clients and counterparties by standing behind its own disintegrating hedge funds. CEO Jimmy Cayne wanted to let the funds go under: ‘Fuck them,' he told his fellow executives. ‘It's not our money.' But his executive-committee colleagues outvoted him. Ironically, it was Cayne's one correct call of the crisis: when an orderly liquidation proved impossible, the securities turned out to be worth a fraction of their book value, and recapitalising the funds was like emptying the bank's coffers down a capacious drain.
For once, too, it seems, Wall Street more than met its ethical match. While there was certainly predatory lending among mortgage originators, there also appears to have been at least as much ‘predatory borrowing'. Perhaps the most telling research to have emerged from the mortgage markets has been a study by BasePoint Analytics, a Californian consultancy, evaluating more than three million loans from 1997 and 2006 with an emphasis on the most recent. Reporting the findings, the economist Tyler Cowen explained: ‘As much as 70 per cent of recent early payment defaults had fraudulent misrepresentations on their original loan applications...Many of the frauds were simple rather than ingenious. In some cases, borrowers who were asked to state their incomes just lied, sometimes reporting five times actual income; other borrowers falsified income documents.'
Worse still, lenders actually expected their customers to dissemble – even exhorted them to do so. In 2006, more than two-thirds of funds dispersed to sub-prime borrowers were through ‘liar loans', where borrowers were able simply to state their income without providing verification. Borrowers on teaser rates that required virtually no repayments in the first year, furthermore, could afford indifference to the prospect of losing equity in their houses because, as Cowen's colleague Russell Roberts observes, ‘they didn't have any equity in these houses to start with'. This is not necessarily indicative only of ethical elasticities. For all the borrowers trying to game the system, there were probably always more counting on refinancing on more advantageous terms – something seemingly straightforward in the environment of abundant credit. But considered together, the behaviour of financial institutions and borrowers implies a subtle but unusually egalitarian shift in attitudes to risk in the past decade.
IN THIS THEY weren't alone. In June 2001, the five-month-old Bush administration pushed through the first of three personal tax cuts of unexampled extent, leaving the president with less money to work with than any of the previous eight incumbents, just months before he opted to bankroll an ill-defined and illimitable war. But the cuts mimicked, too, the behaviour of an electorate that had – barely – chosen him. Americans' savings rates, which neared a tenth of disposable income in the 1980s, had dipped suddenly in the 1990s and recently tailed off to an average of nothing, while for the first time since such records were kept household debt actually exceeded Americans' ability to pay, even though interest rates were at forty-year lows. Mortgages formed only part of this: credit-card debt alone soared trillionwards, with auto loans and student loans not far behind. Americans, in other words, had settled on a president perfectly in tune with their latter-day thriftlessness; they then carried right on. There had been hand-wringing in the early 1980s when American private debt reached 123 per cent of GDP; by 2008, it had reached 290 per cent without causing anything like the same public discomfort.
Australians were hardly more frugal, household indebtedness spiralling to more than $700 billion, and domestic spending outpacing annual earnings, as against traditional savings rates of about a tenth of earnings. There was not quite the same profligacy in government, the Costello Treasury treating the size of the surplus almost as a measure of manhood: one of the exquisite ironies of budget time, in fact, became the boastings of fiscal rectitude to an electorate fast losing such habits. Yet Canberra also developed a direct interest in high levels of personal spending, the goods and services tax contributing an ever-growing proportion of total tax rake-off. And for all the grumblings about income tax, it is at least levied on money has been earned, while tax based on outlays reflects money that hasn't – and that became increasingly likely to have been borrowed.
A HOST OF explanations advanced for twenty-first century squandermania, from a collective hankering to live in the present due to apprehensions about the future, to sluggish growth in real wages inciting increased reliance on borrowings. Property prices certainly acquired a palliative quality. While worldwide wage growth in 2006 was puny thanks to generally high levels of employment, inflation in house prices made everyone feel wealthier. Indeed, the accent on home ownership in developed nations in the past fifteen years has been, at least in part, a concession of weakness: if true financial security derives from anything, it is from a steady income, which the industrial economies of the West have been faltering in their capacity to guarantee. But exactly why former habits of thrift were abandoned so thoroughly will probably never be known; it may be as simple as individuals, like the CEOs of the banks funding them, no longer fully grasping what they were dealing with.
Surprisingly little is understood about human behaviour with credit. Experiments have demonstrated what stands to reason: that, for instance, people keep better account of cash than credit-card debt, because the experience of acquisition and payments is decoupled and distanced in the latter. What we do know, however, is that between the decoupling and distancing exists a continent of incomprehension. According to a 2007 survey, nearly a third of American credit-card holders were unaware of the interest rate they were paying – and of them a third thought it was less than 10 per cent, when it was usually two to three times that. According to a 2008 survey, two-thirds of Americans had no grasp of compound interest. In a recent episode of The Simpsons, Homer is irrepressibly enthusiastic about his home-equity loan. ‘I borrow as much as I want,' he explains, ‘and the house gets left with the bill!' When the bank forecloses, he is baffled: ‘When I borrowed this money, you said I wouldn't have to pay it back until the future. This isn't the future! It's the lousy stinking now!' Among many borrowers, unconsciousness of indebtedness extended to indifference to insolvency; indeed, among those with no assets to confiscate or wages to garnishee, such indifference was entirely rational.
For while a foundation of credit is the borrower's promise to repay, we have always known that such promises are not invariably met, and that this does not always play out as personal disaster. In the classical depiction of debt and its dangers, Shakespeare's The Merchant of Venice, the dishonouring has dire consequences not for the debtor but for the creditor. This being so, as Niall Ferguson comments in The Ascent of Money (Penguin, 2008), one of the world of money's most intriguing questions is, ‘Why don't debtors always default on their creditors?' The obvious answer would be that credit is usually scarce, and not a commodity to be abused, because one is never sure of needing it again; but when credit becomes as superabundant and debauched as in the past ten years, the temptation is to think of it as permanent, bottomless, blind and even, perhaps, a potential relief from monotony. ‘Could it be that some people get into debt because, like speeding on a motorcycle, it adds an adrenaline hit to their otherwise humdrum lives?' wonders Margaret Atwood in her recent primer, Payback: Debt and the Shadow Side of Wealth (House of Anansi, 2008). ‘When the bailiffs are knocking at the door and the lights go off because you didn't pay the hydro and the bank's threatening to foreclose, at least you can't complain of ennui.'
Whatever the case, nobody seemed to much care: although their economy and they themselves had never been more financially gaseous and distended, investors behaved increasingly as though risk had simply been abolished. Crisis had become normalised, and induced not caution but recklessness: with a widespread belief in America that the Fed would simply douse any financial conflagrations with liquidity, there was a steady narrowing of risk premiums – the extra yield that investors demand for riskier securities like mortgage bonds or low-rated corporate debt. Even as the Fed made seventeen consecutive upward adjustments of interest rates, from the start of 2004 to the middle of 2006, increasing short-term rates from 1 per cent to 5.25 per cent, premiums continued diminishing, hitting record minimums in February 2007. Investors, in other words, were treating tranches of bonds based on sub-prime mortgages as being as secure as a ten-year US Treasury. Alan Greenspan called this ‘a conundrum'. Yet the anomaly points straight back at him as the chief personification of the regulatory apparatus.
Since the abolition of fixed commissions coaxed investment banks into diversifying their businesses, Wall Street has straddled ever wider and deeper conflicts of interest. Investment banks sell stock, issue bonds, execute mergers, perform research. Client companies want high prices and low interest rates; client investors want low prices and high rates; the bank, between them, extracts fees from both, at any time potentially working at odds with one or the other. Perhaps because of this comfort with conflict, the role of ratings agencies passed without comment. For ratings agencies certified CDOs and other mortgage-backed securities allegedly on the basis of disinterested analysis, while actually earning their fees from issuers with a vested interest in the risk being priced as cheaply as possible.
Illusions flourished about the nature of the work these agencies performed. Agencies never read individual loan files: by the time loans reached Moody's, Standard & Poor's or Fitch, having probably been made on the advice of a loan broker through a mortgage originator, then sold to a bank that blurred them into an amorphous mass to be parcelled up as bonds, they had long since been pulverised, concentrated and flattened out into aggregates of data. What the agency did instead was work on the basis of averages, such as of borrowers' asserted incomes, and concentrations, like the geographic distribution of loans, adjusted for other factors, including the proportion of primary homes involved, because of a general rule of thumb that primary homes are less often abandoned. Such modelling as the agencies did, furthermore, was mainly static: Moody's, for instance, did not update the default-rate assumptions of its CDOROM model between 2002 and 2007, despite steepling increases in delinquencies and foreclosures in the last couple of those years. Based on its analysis, the agency might make a positive rating conditional on an ‘enhancement' – usually a thin additional sliver of equity. Or, especially if the client looked like they might ‘ratings shop' and take their business elsewhere, they would not, the standard fee for rating a CDO being in the region of $100,000, and for rating a complex CDO, like those called a CDO-squared and a CDO-cubed, sometimes double or treble that: by 2005, in fact, Moody's was drawing half its revenue from such work.
Evidence presented to the US House Oversight Committee Hearings on Ratings Agencies in October 2008 suggests that raters knew full well the increasingly suspect nature of their work – and were ignoring it. A December 2006 email from senior S&P executive Chris Meyer to colleagues Nicole Billick and Belinda Ghetti ends with a sigh: ‘Rating agencies continue to create and [sic] even bigger monster – the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters. :o)' A droll email exchange between S&P analysts Rahul Dilip Shah and Shannon Mooney in April 2007 might almost have been lifted from Dilbert:
Shah: By the way, that deal was ridiculous.
Mooney: I know, right – model def does not capture half the risk.
Shah: We should not be rating it.
Mooney: We rate every deal.
Shah: It could be structured by cows and we would rate it.
In a Portfolio magazine profile of the maverick investor Steve Eisman, who picked the housing market as overinflated long before most, Michael Lewis recounts an August 2007 conference call where Eisman asked an S&P analyst why he was downgrading CDOs now rather than many, many months earlier. ‘It's a good question,' said the analyst. ‘You need to have a better answer,' replied Eisman. The answer was obvious: fees for rating a CDO were three times as great as the fees on conventional bond ratings, although, because these fees were paid by the seller rather than the buyer, agencies were always essentially granting licences rather than issuing opinions. Why anyone believed in the ratings is more difficult to answer. At the peak of the boom, there were 64,000 issued securities with AAA ratings, compared to only a dozen public companies with the same rating on all the world's stock exchanges – which even then was one too many, because AIG was among them. At its simplest, perhaps, it was the ancient story: Mundus vult decipi, ergo decipiatur. The world wants to be deceived, therefore let it be deceived.
FUTURE HISTORIANS STUDYING this crisis will likewise search in vain for cautionary words or actions from law makers and enforcers. They will see instead 1999 legislation which allowed AIG to choose to be regulated by the complaisant Office of Thrift Supervision alongside other forthcoming disasters like Washington Mutual and IndyMac Bancorp, 2000 legislation which largely exempted CDSs from regulation even as they swelled to a market worth a notional $45 trillion, and 2004 reforms of the Securities and Exchange Commission relaxing net-capital rules on securities firms to increase permissible leverage to forty times equity. Ironically, the consequences of the much-abused Gramm-Leach-Bliley Act have been mainly positive, allowing JP Morgan to bail out Bear Stearns, Bank of America to acquire Merrill Lynch, and Wachovia to kick the tyres of Morgan Stanley before the intercession of Mitsubishi UFJ Financial Group. Lots else, however, in the US and elsewhere, was wilfully wrong-headed.
Above all, those future historians will note the continuance of interest rates at historic lows. The Fed's autonomy is guaranteed by the Banking Act of 1935; it is self-funding and self-governing. Greenspan's dour precursor, Paul Volcker, once received a note from Ronald Reagan asking if the president could pay him a visit; Volcker replied tersely that this was ‘inappropriate'. Yet no governor was so freely and successfully courted by the White House as Greenspan, charmed by the administrations both of Clinton and Bush, whose interests were generally best served by an environment of easy credit and false prosperity. The historians will also note that even while raising interest rates, successive Fed governors remained obdurately bullish, issuing soothing communiqués about the capabilities of the banks they were meant to be regulating, and in doing so sounding more like spruikers than supervisors. Both Alan Greenspan and Ben Bernanke, for example, acted as boosters for the bushwah that credit derivatives like CDSs answered all potential ills. Thus Greenspan in May 2005: ‘The development of credit derivatives has contributed to the stability of the banking system by allowing banks, especially the largest, systemically important banks, to measure and manage their credit risks more effectively.' Thus Bernanke in March 2006: ‘The management of market risk and credit risk has become increasingly sophisticated...Banking organisations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.' In this they were echoed by the International Monetary Fund, in its 2006 annual report: ‘The dispersion of credit risk by banks to a broader and more diverse set of investors, rather than warehousing such risk on their balance sheets, has helped make the banking and overall financial system more resilient.'
At the time, it was actually popular to argue that there was no compelling rationale for the continued existence of the IMF – to which the G20 has now pledged a fighting fund of $1.1 trillion. But, then, the crisis is presenting many ironic saviours. While at the New York Fed, and in collaboration with the fourteen biggest originators of credit derivatives, Tim Geithner, now US Treasury Secretary, oversaw the creation of an electronic network that hugely simplified and accelerated the trading of these instruments. In February 2007, at which time American sub-prime mortgage debt had grown to US$1.3 trillion, a review of risk management at large banks under Geithner's watch concluded that the quality of loans and investments remained ‘strong', and that there were ‘no substantial issues of supervisory concern'.
Remember the cosy chat between Peter Baring and his affable Bank of England interlocutor? Here was an initiative of similar character, the regulator acting as friend, familiar and ally to those it was empowered to police. Some of this can be ascribed to Greenspan's personal philosophies, as perhaps the world's most public and adamantine apostle of Ayn Rand; indeed, one could hardly have a more counterintuitive candidate for a senior regulatory role than a libertarian implacably hostile to regulation. Some can also be sheeted home to the freedom with which bankers in the US move between their industry and its bureaucratic mandarinate, whether that be Hank Paulson and Jon Corzine leaving Goldman Sachs to become the Treasury Secretary and the New Jersey governor respectively, or the journeys of Rubin from the Treasury to Citigroup and Greenspan from the Fed to PIMCO. When AIG came to discuss a bailout with the Fed last September, for example, who should be sitting alongside Geithner but the CEO of Goldman Sachs, Lloyd Blankfein? Why? Not for reasons of expertise or authority, but because no institution was more exposed to AIG's CDSs than Goldman Sachs.
Regulation, being almost invariably in arrears of market developments, can only achieve so much; bad judgement persists in any age. ‘A strong case can be made for stricter regulations and supervision of banks to forestall euphoric lending that may end in a financial crisis,' observed the great dean of financial turmoil, Charles P Kindleberger, in his classic Crashes, Manias and Panics (John Wiley, 2005). ‘Historical fact suggests that such a case rests on a counsel of perfection.' But here, perhaps, was the worst of all possible worlds: ratings agencies reduced simply to endorsement, regulators dedicated chiefly to encouragement, as intent in their own way as the brokers, valuers, mortgage lenders and bankers on the business getting through, yet who by their very visible existence instilled a sense that everything was under close control.
AUSTRALIA HAS BEEN fortunate in its banks. Unlike the fragmented and dispersed American banking sector, the ‘four pillars' were able to spread their risks around markets and geographies; they have run high capital ratios, enjoy low-cost retail funds and, after heavy losses there in the 1980s, have gradually disinvested overseas. Casualties have accumulated in the realm of asset-backed securities, whether property or infrastructure, and the days when Macquarie Bank was referred to as the ‘millionaires' factory' suddenly seem the stuff of nostalgia. But the regulatory system, chiefly the Reserve Bank of Australia, the Australian Prudential Regulation Authority and the Australian Securities and Investment Commission, seems largely to have avoided the phenomenon, famously delineated by the economist George Stigler, of ‘regulatory capture', where market participants coerce regulators into serving primarily their own interests.
America offers a demonstration of what Australia avoided. Simon Johnson, former chief economist at the IMF, has argued persuasively in The Atlantic that the crisis in the US is ‘shockingly reminiscent' of crises of crony capitalism in Russia and Argentina. In the US, as in emerging markets, Johnson contends, ‘elite business interests...played a central role in creating the crisis, making ever larger gambles, with the implicit backing of the government, until the inevitable collapse.' In their deliberations on the crisis, regulators ended up speaking to people exactly like themselves, often old friends too senior to have a sophisticated sense of market conditions and credit quality, but willing participants in mutual disorientation; between them, they then did everything possible to protect their industry's interests, staving off insurrectionary talk of nationalisation. Ironically, American financiers and economists have scourged developing nations for just such coalitions of interests. In the aftermath of the Asian crisis a decade ago, for example, the much-admired economist Rudi Dornbusch deplored the mentality of ‘Dial 1-800-BAILOUT for reckless businessmen, greedy bankers and corrupt politicians'. He told the Davos World Economic Forum: ‘It's important that some people lose a lot of money, important that they be punished for their stupidity and greed.' But nobody enjoys the taste of medicine, least of all their own.
Bankers, regulators and politicians alike have resolved instead to gamble that theirs is a crisis of liquidity rather than of solvency, like those hostages in mass kidnappings who insist that if everyone just sits tight and keeps calm then no one need get hurt. Bankers have rediscovered how important they are to the ‘real economy', reminding whoever will listen that credit creation is integral to all industry; regulators and legislators have taken them at their word, trusting that stability will rekindle optimism. The agreed solution has been to perpetuate the banking system with repeated infusions of taxpayers' money, and indeed to take certain parts of it over: British taxpayers are already majority owners of Royal Bank of Scotland and Lloyds Banking Group; American taxpayers will soon own the largest stake in Citigroup; German taxpayers look like controlling Hypo Real Estate. This has been done, so far at least, without actual formal representation, or the setting of limits and targets, thanks partly to a dread of the repeat of the panic glimpsed last September, but mainly because of an engrained ideological antipathy to such state controls. Barack Obama's modest regulatory proposals of June came with a resigned sigh about ‘the speed, scope and sophistication of a twenty-first-century global economy' – a formulation that could have come directly from the pitch documents of the banking industry lobbyists who have besieged the Beltway these last six months. One area of risk management in which American financial institutions have continued to excel is the area involving risk to their own freedom of opportunity. If asset and securities repricings since last year reflect fundamentals rather than a temporary discount for illiquidity, however, those lobbyists have a great deal more work in front of them.
IF THERE WAS a point at which this crisis metastasised from one of finance into what is sometimes euphemised as ‘the real economy', it was with the demolition of Lehman Brothers, which had had the misfortune to seek regulatory clemency at the same time as AIG and after Bear Stearns. Lehman had a concentrated version of what would soon be identified as a widespread problem: a balance sheet fat with assets that weren't worth their ascribed values, and that were therefore too injurious to sell.
Unlike at Bear Stearns, where investors had some warning, nobody had seen it coming, and there was fright at the tyranny of mark-to-market accounting, which requires more or less instant recognition of fluctuation in asset values, thereby seeming to bankers the acme of common sense in boom times and a diabolical imposition in busts. A colossal broad-based liquidity crisis ensued: banks doubled the reserves they held at the Fed, interbank lending ceased almost altogether, and the market for short-term and asset-backed commercial paper froze as if flooded by liquid nitrogen. The panic was so pervasive and paralysing that you half-expected tales of ATMs refusing to disgorge depositors' cash.
In the preceding years, the relationship between finance and business had appeared an increasingly distant one, reflected in the media's topsy-turvy preferences, reporting the fluctuations of stocks, commodities and currencies as news, while treating the manufacture of physical goods as something arcane and esoteric. Market turmoil after Lehmans' collapse threw everyone into turmoil together, credit creation being next to impossible in an environment where nobody quite knows what anything is worth.
Corporates singed by recession in the early 1990s, and by periodic reckonings in the equity and property markets since, have actually only been averagely wasteful in recent years. Some leveraged buyout funds and venture capitalists have tended their reputations for daredevilry – in KKR's $26 billion acquisition of First Data in April 2007, interest payments were set to absorb the target's entire cash flow – but business conditions had not been so buoyant as to cajole companies into over-borrowing. General Motors perished of pre-existing wounds, decades in the seeping.
The calamity in private consumption, however, reverberated. Flush with credit, American consumers have accounted for more than two-thirds of the country's economic growth since 2000, and more than a third of worldwide growth in private consumption since 1990. Now, like a deep-sea diver hurriedly yanked to the surface, they were decompressing dangerously, and in intensifying anguish. Certainly they were too busy dealing with existing borrowings to incur more, which hurt the economy at every level: retail sales, corporate profitability, capital investment, dividends and distributions, consumption and personal-tax revenues.
Goldman Sachs' balance sheet stress test is famously known as ‘the WOW', standing for ‘worst of the worst'. The WOW is designed to interrogate whether the bank could survive the worst conditions encountered in the preceding decade in each market simultaneously, worsened by a further 30 per cent – and it was here made to appear optimistic. As American consumption slackened month by month, cruelling worldwide demand, forecasts became unremittingly bleak, whether it was the International Labour Organisation estimating that fifty million jobs would be lost, or the World Bank's prophecy that between 200,000 and 400,000 more children will die annually between now and 2015 than had earlier been predicted. Of course, there is something deeply ironic about trusting the prophecies of many of the same economists whose predictions were so rosy so recently.
The coping mechanisms agreed on are risky, involving the continuance of institutions of dubious solvency. The crisis has already been marked by several intemperate acquisitions, such as Wachovia's of Golden West and Lloyds TSB's of HBOS: governments are placing themselves in similar positions. The burden of salvage on the state almost beggars belief. In renaissance Florence, keepers of the exchequer distinguished between the Monte Vecchio (Old Mountain), debt sustained in fighting Genoa, and the Monte Nuovo (New Mountain), debt sustained in fighting the Turks. The American economy now bears similar twin burdens: the toll of the initial damage and the cost of the repair. Barack Obama's budget digest, ironically entitled A New Era of Responsibility (Office of Management and Budget, 2009), forecasts his government taking on more than US$9 trillion in new debt in the decade to come, and deficits averaging almost 5 per cent in each of the five years after the recession's forecast end. An auction of British government debt failed in March; the Australian budget in May was a sobering reflection of the layers of cost lying ahead. With levels of risk aversity as pusillanimously high as they were casually low two and a half years ago, the state's capacity to spend will be severely constrained.
In other words, crisis is again worth the name, rather than being the stuff of passing headlines, short-term corrections and token recalibrations; indeed, it has embedded itself with a vengeance. For even after its economic impacts have faded, the collapse of credit and the end of stupid money will leave a social and cultural imprint, in the form of fears, taboos, superstitions, cautionary tales, diminished expectations – indeed, in some respects, perhaps this is to be hoped for, lest it be repeated sooner rather than later. Last time I was in Sydney, I happened to pass through the foyer of the same tower in which I'd worked a decade ago, although the bank itself is no longer there, swallowed by another, franchise destroyed, personnel scattered. The intents, the expressions, the atmosphere – all brought back old memories. But experientially, the people could not have been other than different.
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