Even More Summer Reading on the Global Financial Crisis

First off, thanks to Google for making a new template available that works well for a blog about "the flat world." For those who've seen the blog before, this should be a less cluttered look and a better pairing of medium with content. (Let me know if you disagree!)

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?

More Summer Reading on the Global Financial Meltdown

After surviving the World Cup (too late to blog about) and a couple of weeks at Calvin College in a seminar on "Faith and Globalization," I've gone back to my summer reading on the causes of the global financial crisis.

This time, I turned to British novelist John Lanchester's I.O.U.: Why Everyone Owes Everyone and No One Can Pay. It's the clearest, funniest, and most helpful examination of the crisis yet. Not only does he do a good job bringing the whole crisis down to earth, explaining it well, but he also thinks clearly about the larger context in which the crisis took place. And he makes the reader laugh along the way.

He correctly observes that one of the biggest gaps of cultures today is between those who understand global finance (very few) and those who don't (most of us). By trying to bridge this gap, he serves both cultures: the culture of global finance experts and the culture of the rest of us.

As I did in my last post, I'm going to focus on the overlapping points in his analysis and my own in chapter three of the book. At several points, he makes observations paralleling those in The Fullness of Time.

• The collapse of the Communist bloc (pp. 12-24) as the opening for the triumph of global finance (i.e., "the end of history"means that there are no ideological competitors to challenge capitalism).
• ATMs and "frictionless" money: He starts out his first chapter (not unlike my third chapter), with a story of going to an ATM in Hong Kong with his father in the 1970s and being bothered. "The sheer frictionlessness with which money moves around the world is frightening; it can induce a kind of vertigo" (p. 8).
• Money as an abstraction: He points out that we have a hard time grasping what money is, until realities intrude on us (pp. 8-9). He even points out that the way that money began to operate was like postmodern theories about the "play of signifers," and so on.
• The role of arrogance and quantitative abstraction in underestimating risks: In chapter 4 of I.O.U., Lanchester observes how the quantitative "geniuses" were building a system that depended on subprime borrowers:

By 2006, "more than half of all applications for mortgages were either 'piggback' loans, meaning that they were double loans taken out to buy the same property, or 'liar loans,' in which applicants were invited to state their own income, or 'no doc' loans, in which the borrower produced no paperwork. Gee, what could possibly go wrong" (p. 132)?

• Mathematical abstractions replacing common sense and a concrete sense of what's going on: 

"Consider the case of Lawshawn Wilson in Baltimore, with no job and no income, supposedly making mortgage payments to the trustee who was the ultimate owner of her mortgage, Citigroup Mortgage Loan Trust Inc., 2007-WFHE2. How likely is a problem with that and similar mortgages? Not too unlikely, one would have thought. But by the time the market had finished with its packaging and securitization and CDOs [collateralized debt obligations] and CDSs [credit default swaps, or insurance against failures]  . . . the CFO of Goldman Sachs, David Viniar, described  [it] like this: 'We were seeing things [subprime defaults and collapsing real estate prices] that were 25-standard deviation moves, several days in a row.' It is almost impossible to put into words how big a number 25 sigma is, expressed as odds to one . . . . It's equivalent to winning the U.K. national lottery twenty-one times in a row. That's the probability of a single 25-sigma event. Goldman were claiming to experience them several days in a row" (p. 164) . . . . They weren't just wrong in practice, the way you are wrong if you call heads and a coin lands tails; they were philosophically wrong. They [global financial firms] were exposed as doing something which was contrary to the nature of reality" (p. 167).

• The failure of regulators to ask simple questions of global financial firms like "I don't understand, please explain"(p. 181)--something that humility and a sense of groundedness in concrete realities might have promoted. Instead regulators in the UK and US trusted firms to police themselves with "market discipline" and instead used "light touch regulation."

• The difference between the pursuit of money and the practice of industry (similar to the central theme in a recent article of mine):

"There is a profound anthropological and cultural difference between an industry and a business. An industry is an entity which as its primary purpose makes or does something and makes money as a by-product. The car industry makes cars, the television industry makes TV programs, the publishing industry makes books, and with a bit of luck they all make money too, but for the most part the people engaged in them don't regard money as the ultimate purpose and justification of what they do. Money is a by-product of the business, rather than its fundamental raison d'etre. Who goes to work in the morning thinking that the most important thing he's going to do that day is maximize shareholder value? Ideologists of capital sometimes seem to think that that's what we should be doing--which only goes to show how out of touch they are. Most human enterprises, especially the most worthwhile and meaningful ones, are in that sense industries, focused primarily on doing what they do; health care and education are both, from this anthropological perspective, both industries . . . . Money doesn't care what industry it is involved in, i just wants to make more money, and the specifics of how it does are, if not exactly a source of unconcern, very much a means to an end: the return on capital is the most important fact, and the human or cultural details involved are just that, no more than details" (pp. 197-98). 

• Summing up his thesis: 

"The credit crunch was based on a climate (the post-Cold War victory party of free-market capitalism), a problem (the subprime mortgages), a mistake (the mathematical models of risk), and a failure (that of the regulators) . . . . But that failure wasn't due so much to the absence of attention to details as it was to an entire culture of the primacy of business, of money, of deregulation, of putting the interests of the financial sector first. This brought us to a point in which a belief in the free market became a kind of secular religion" (p. 202).

When he gets to his final chapter, on where to go from here, he doesn't have a lot to say, but I think we can be hopeful that the god of Mammon failed to deliver on all of his promises, opening us up to hopeful alternatives. The Christmas story provides one such alternative, as it re-enacts (among other things) the paradoxical triumph of humility, concreteness, and embodied relationships.

There are Alternatives: Local Currency

I've been thinking a lot lately about the TINA argument applied to globalization. TINA is short for "There is No Alternative," and it's a phrase that Margaret Thatcher was fond of using when speaking of her free-market reforms. It's also a phrase that people apply to globalization, suggesting that we cannot escape it.

One of the insecapable aspects of our global economy is the use of currency, which then implicates us in all kinds of problems, including the love of Mammon and a host of other problems (see Chapter 3 of my book). Money is fundamental to our being globalized; when we use it, we participate in global flows of currency and capital. (Does that make sense?)

But Sunday's Washington Post reports on the use of a new local currency in the London borough of Brixton: Brixton pounds. The idea is to encourage people to shop and spend locally. You exchange one British pound for one Brixton pound, but you can only use the Brixton pound in the local area, and only at selected businesses that choose to accept it. Bill McKibben reports on a similar alternative currency idea in his nice little book Deep Economy. I'd love to see other people doing this.