Friday, July 2, 2010

Summer Reading on the Financial Meltdown

On my summer reading list were a couple of books on Wall Street's subprime mortgage meltdown: Michael Lewis' The Big Short, which is a readable, personality-driven narrative; and Roger Lowenstein's The End of Wall Street, which is a more detailed, less entertaining, journalistic analysis of the major Wall Street firms' mistakes. Neither would make great beach reading, but if you are interested in understanding recent history both would be worthwhile reads.

Given that chapter 3 of The Fullness of Time touches on the roots of this crisis (at least in my view), I was curious to see how these authors interpreted the mess, and to see how well I understood it. 

Lewis really doesn't offer much of an analysis, preferring instead to let his sources spin a story of greed, excess, and blindness. And these sources are the heroes who didn't succumb to the blindness -- analysts and traders who saw the crisis coming and bet against collateralized debt obligations (CDOs) backed by subprime mortgages. By selling these bonds "short" -- borrowing to sell them first and buying them back later at a low price, while pocketing the difference -- these characters made astronomical profits. It's an interesting story but it doesn't help most of us understand the crisis a whole lot better. Greed still wins out, just on the other side of the trade.

By contrast, Lowenstein tries to analyze deeper roots of the crisis and offer more general lessons along the way. While his narrative is confusing at times, he makes telling comments about what was happening. Two passages in particular struck me.

The first was a passage where he talked about the use of quantitative methods within Wall Street firms, based on inadequate historical data. They thought they had quantified and mastered the risks of mortgages defaulting:
Historical data, such as stock prices and mortgage default statistics, were seen as evidence of immutable truths: the stock market is relatively stable; the housing market doesn't crash; home mortgages default at a rate of 1 percent per annum. Wall Street adopted quantitative strategies because they afforded more precision than old-fashioned judgment--they seemed to convert financial gambles into hard science . . . . The problem was that homeowners weren't molecules, and finance wasn't physics (p. 45).
I argue in chapter 3 (and also in a 2008 Christian Scholar's Review article that I adapted into part of that chapter) that arrogance and abstraction (cutting oneself off from concrete reality) were two key roots of the crisis. Both of these are evident in this passage. Lowenstein goes on to describe the precision with which Merrill Lynch estimated its potential lossses from subprime CDOs at "$71.3 million." As he puts it, "This was absurd--not because the number was high or low, but because of the arrogance and self-delusion embedded in such fine, decimal-point precision" (p. 46).

Abstraction was evident throughout the process, as traders forgot that the entire system was based on loaning ever-increasing amounts of money to borrowers who were likely to default. They forgot what their money was actually doing on the ground. Michael Lewis notes that a Mexican grape picker who made less than $20,000 a year was approved for a loan to buy a house worth more than $500,000. Loans were given to NINA (no income, no assets) borrowers and then packaged into these CDOs. Thus, the very foundation of these CDOs was shaky from the start, and anyone who could have thought concretely about where their money was actually going could have seen this (as Lewis' heroes did).

The other interesting passage in The End of Wall Street strikes again at the problem of thinking that one can control risk:
The new finance was flawed because its conception of risk was flawed.  The banks modeled future default rates (and everything else) as though history could provide the odds with scientific certainty--as precisely the odds in dice or cards. But markets .  .  . are different from games of chance. The cards in history's deck keep changing. Prior to 2007 and'08, the odds of a nationwide mortgage collapse would have been seen as very low, because during the previous seventy years it had never happened. What the bust proved, or reaffirmed, was that Wall Street is (at unpredictable moments) irregular; it is subject to uncertainty (p. 288)
As I argue, the practice of humility would have recognized this uncertainty and moderated the excessive risk taking that destroyed financial markets in 2007 and 2008. I also argue in chapter 3 that a healthy appreciation of concreteness--thinking in detail about what money is actually doing--would have prompted traders to stop what they were doing. And the practice of relationality--understanding what investment money was doing to human relationships and embedding money within those relationships--would have helped us all to recognize what was happening.

Are these utopian hopes? Or everyday virtues modeled by Christians? I think we are already practicing all three of these all the time. We just need to let them inform what we do with our money.

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