And now on to my post-World Cup summer obsession: reading interesting books about the global financial crisis. (Yes, such things exist!) I just finished two more books that help explain the mess the world economy got into by 2007 or 2008. The first, although prophetic, is now slightly dated and probably too technical for the average reader; the second is a current and compelling story that most people would grasp.
Dated and a bit technical, but prophetic
Charles Morris' 2008 book The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash was one of the first books published on the mess, coming out even before the full scope of the disaster was apparent. Morris was a former banker, with some high-level Wall Street connections (he thanks Nouriel Roubini, an early prophet of doom; George Soros, a world-famous currency speculator and intellectual; and Satyajit Das, an expert on the crazy financial products called derivatives, for helping him). Interestingly, Morris blames the free market ideology of the so-called Chicago School and of former Fed Board of Governors Chairman Alan Greenspan for a hands-off approach to regulating finance. In Morris' view, the roots of the crisis go back to the rise of "monetarism"--the belief that money supply drives inflation--in the 1980s. Deregulation was in, so financiers were left alone to police themselves.
But he goes beyond ideological polemics to explain the history that preceded the current mess. Three precedents are the 1987 "Black Monday" stock market crash, the 1998 Long Term Capital Management collapse, and the 2000 popping of the dot-com stock market bubble--all of which illustrated the flaws of applying mathematical models to manage the risk of market downturns. History doesn't obey the law of averages but has a way of coming up with never-before-anticipated events--events that don't fit on a "normal" bell-shaped curve. Globalized finance is not like physics and its mathematical expression:
The mathematics of big portfolios analogizes price movements to models of heat diffusion and the motions of gas molecules, in which uncountable randomized micro-interactions lead to highly predictable macro-results. Although it's theoretically possible that all the air molecules in my room will shift to one corner . . . the laws of large numbers ensure that the actual frequency of such events is way beyond never. Large securities portfolios usually do behave more or less as the mathematics suggest. But the analogies break down in a time of stress. For shares to truly mirror gas molecules, trading would have to be costless, instantaneous, and continuous. In fact, it is lumpy, expensive, and intermittent. Trading is also driven by human choices that often make no sense in terms that models understand. Humans hate losing money more than they like making it. Humans are subject to fads. . . . [I]n real financial markets, air molecules [real human beings] have a disturbing knack for clumping on one side of the room (pp. 56-57).Even though the crisis was just beginning to unfold, Morris identifies several new financial products that contributed to making the crisis so massive: collateralized mortgage obligations, collateralized debt obligations, and credit default swaps. If all these terms confuse the heck out of you, then try watching the "Crisis of Credit Visualized" video, which is very helpful. Credit default swaps are what led to the Fall 2008 near-collapse and $85 billion bailout of AIG, a giant global insurance firm, which had not yet happened when Morris was writing, but he could claim to have seen it coming (at least in general). Which just goes to show you that this thing was entirely possible to anticipate. While it took a while for President George W. Bush to realize that "this sucker could go down," people like Morris saw it coming well ahead of time.
A compelling story for most readers
David Faber, a reporter for CNBC, has the courage to say that he honestly missed this story as it was unfolding. But thanks to a hedge fund manager in Texas named Kyle Bass, who called him to clue him in, he eventually started piecing together what was really happening at multiple levels. In other words, Faber figured out the story that only a few experts on the edges of Wall Street like Bass (the same people that are heroes in Michael Lewis' The Big Short) had told up to that point. Once he "got it," he needed to tell the story.
As a result, Faber's book And Then the Roof Caved In (2009) does a nice job framing the crisis as a compelling narrative, with real characters taking actions that drove the story from its beginning to its end. It looks like Faber basically converted his reporting for the CNBC documentary House of Cards into book form. Unlike Morris, he limits to the story to the critical period between 2001 and 2008, focusing on the links between 1) ordinary homebuyers who were trying to use increasing house prices to get ahead financially, 2) unregulated subprime mortgage lenders who were eager to lend at high rates of interest, 3) Wall Street banks desperate to buy up "physical" mortgages to pool into mortgage-backed bonds, 4) global investors desperate for high returns above the low interest rates set by the Federal Reserve (Fed), 5) credit rating agencies (Moody's, Standard & Poor's, and Fitch) that were complicit with the Wall Street firms that paid them to rate bonds issued by the same firms, 6) a Fed that failed to regulate the subprime mortgage market or take action to ease the housing bubble (the steady increase in housing prices and the flow of overseas capital into the mortgage bond market), and 7) Wall Street bankers (like Stan O'Neal, the head of Merrill Lynch) who were more interested in playing golf and paying themselves huge bonuses than in what was going on.
These seven are the main characters in any accurate rendering of the drama (is it a tragedy or comedy?). I want to comment briefly on ordinary people, Wall Street banks, and global investors.
I was especially glad to see the attention paid to the impact of all this financial maneuvering on ordinary people (#1 above). Faber focuses on the story of Arturo Trevilla, an upwardly mobile Mexican immigrant to California, and his family. They bought a house for $584,000, signing papers that said he took home $16,000 a month when he really earned $3,600 a month. (Arturo's English wasn't great, and even if it was, loan papers are hard to understand.) He also borrowed money for the down payment (a so-called "piggyback" loan). He was hoping to get out of his subprime loan in the future by borrowing against the expected future value of his home, which he, like everyone, assumed would keep increasing. Then he could borrow $70,000 of his home equity and start the embroidery business he was dreaming of. Unfortunately, by the time his adjustable rate mortgage payments zoomed up to $5,000 a month, he was in trouble. Then he lost his job, and he, his wife, his three kids) moved into an apartment with another family. Predatory lending or irresponsibility? A little of the latter, but mostly the first, I think.
The issue of ordinary people "flipping" homes for profit was also a major contributor to the crisis. Kyle Bass, the hedge fund guy, knew there was a problem when he chatted with a bartender in Las Vegas in 2007 who told him that he wasn't doing so well because his "three houses are killing me" (151). He'd been borrowing to buy and flip houses but couldn't sell them. Yes, a regular old bartender was doing that. And, yes, the inability to sell suggested that the real estate price bubble had popped--especially in places like Las Vegas (or California, Arizona, or Florida).
Why was Wall Street so stupid? In passing, Faber mentions a study of 24 housing busts that had happened since the 1970s (p. 175). In the last post, I reviewed John Lanchester's I.O.U., who had lived through a real estate bubble in England And yet really smart people all over the world were convinced that housing prices in the US would keep rising? Everyone knew that things were getting risky, so why did they keep investing in mortgage-backed bonds? According to the former CEO of Citigroup, they were afraid of losing market share (p. 168).
The global dimensions of this crisis are significant. Without the "giant pool of money" held by investors outside the U.S.--something like $70 trillion in 2008--this crisis wouldn't have started or become so widespread. According to Faber, "In 2005, 80 percent of subprime mortgages were being securitized and sold to voracious investors around the world. The subprime mortgage had become the chief export of our country" (p. 78). Message to the world from the USA: "Sorry about that."
On two controversial, politically charged points in the narrative, Faber weighs in with his own reading of the evidence.
First, he doesn't blame Fannie Mae and Freddie Mac, the two federally supported mortgage guarantors, for driving the crisis. After delving into the story, he attacks the "myth" that "the lax lending standards of Fannie and Freddie promulgated the current crisis. It is not true. Wall Street rushed into the vacuum created by the absence of Fannie and Freddie in 2003-2005 [because they were under pressure to be more cautious and accurate in their financial statements]" (p. 66). 70 percent of U.S. mortgages originated in 2003 were sold to Fannie and Freddie. By 2006, only 30 percent of mortgages were (p. 65). However, he does note that Congressman Barney Frank, the Chair of the House Financial Services Committee, later encouraged Fannie and Freddie to increase lending, on the theory that extending credit to less creditworthy borrowers would help expand the American Dream of homeownership. Still, in Faber's view, Wall Street is the one that drove the game.
Second, probably because he scored an interview with Alan Greenspan in 2008, Faber gives a wide berth to accusations that Greenspan and the Fed failed to take appropriate regulatory actions (in contrast to Morris, as noted above). However, he does point out (on pp. 50-54) that Edward Gramlich, one of the Fed's Governors, and Sheila Bair, the head of the Federal Deposit Insurance Corporation (the main regulator of banks), tried to persuade Greenspan to tighten lending requirements for mortgages. No dice.
Because of this reverence for Greenspan, Faber ends the book on a rather futile note, with no lessons for possible future corrective actions. As he puts it, in the final paragraph of the book,
Greed is the fuel that makes our capitalist system run. It is a powerful emotion. When I asked Alan Greenspan about it, he agreed, and then he gave me a sideways look from that famous 82-year-old face and said: "And you're going to outlaw that? Go ahead and try it."Well, there's nothing we can do. There is No Alternative to letting the market run. You might as well try to pass a law against gravity.
Do you buy that?