Book Reviews


When it comes to the financial crisis, everyone carries some blame. Realizing that is the first step toward recovery.

By Paula Dwyer

Tagged EconomicsFinanceGreat Recession

The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means By George Soros • Public Affairs • 2008 • 162
pages • $22.95
The Return of Depression Economics and the Crisis of 2008 By Paul Krugman • W.W. Norton & Co. • 2008 • 191
pages • $24.95
The Ascent of Money: A Financial History of the World By Niall Ferguson
• Penguin Press • 2008 • 442
pages • $29.95
Panic: The Story of Modern Financial Insanity Edited By Michael Lewis • W.W. Norton & Co. • 2008 • 391
pages • $27.95

The symmetry is not obvious at first, but last year’s economic cataclysm and Bernie Madoff’s Ponzi scheme are near-perfect bookends for 2008. One began with a housing boom built on easy credit and flimsy mortgages, which infected the financial system through Wall Street’s securitization machine and then spread globally to investors eager for the higher returns that pools of American mortgages and their exotic progeny offered. The other began with an obscure Wall Street market-maker deciding to moonlight by managing other people’s money, at first for his country-club and civic-minded friends, and later for wealthy people around the world. He promised results he could not deliver, so he made up numbers out of whole cloth.

Both were fueled by low interest rates that led eager investors–be they European aristocrats or investment banks or American pension funds–to seek out fatter returns. They also both drew heavily on Charles Ponzi’s special skill as an asset manager–taking fresh funds from new victims to pay off existing ones. We know this is true in the case of Madoff because prosecutors say he has admitted as much. But the housing market, too, was the functional equivalent of a Ponzi scheme: Easy credit sucked in a steady stream of new buyers, many of whom got absurd “ninja” loans–no income, no job, no assets. Wall Street firms packaged these mortgages into bonds, credit ratings agencies slapped on a triple-A stamp, and investors bought them. It was all built on air, but as long as home prices kept rising–or as long as more suckers were drawn in–the housing Ponzi scheme kept rolling along.

In a thoroughly ironic twist, one Ponzi scheme undid the other. The housing bust exposed Madoff’s fraud when wealthy clients demanded their money back so they could pay off other debts that had gone sour or to meet margin calls. Flooded with $7 billion in redemption demands, he couldn’t keep up the ruse any longer and confessed to his brother and sons.

But more than anything else, the 2008 twin towers of financial disaster were made possible because, over the last decade, the United States government–Democrats and Republicans alike–tolerated, even encouraged, unregulated markets (securitization, credit default swaps), unregistered asset managers (hedge funds, private equity firms, or anyone with fewer than 15 investors, in Madoff’s case), and overly credulous gatekeepers (credit rating agencies, corporate boards, the Securities and Exchange Commission).

As the Obama Administration rolls up its sleeves to do the hard work of repairing the broken financial system, it is important to understand this as the über-lesson of 2008. Much as we can each name our favorite financial executive or deregulation-minded lawmaker as the evil mastermind, much as we can each finger our favorite runaway institution for providing the timber, and much as we can invoke our favorite dastardly financial instrument for lending the spark, a smart watchdog or two could have stopped them all.

It’s easy to look back on it all and ask: What were we thinking? But it made perfect sense. As George Soros, the hedge fund founder and philosopher, points out in The New Paradigm for Financial Markets, people acted rationally in the housing bubble’s buildup stages. Interest rates were so low that capital, for all intents, was free. “When money is free,” he writes, “the rational lender will keep on lending until there is no one else to lend to…And when the value of property is expected to rise more than the cost of borrowing, it makes sense to own more property than one expects to occupy.” But if the housing bubble wasn’t irrational, it sure was destructive. It was the job of regulators and other gatekeepers to spot this behavior.

In his latest book, The Return of Depression Economics and the Crisis of 2008, Paul Krugman, the 2008 economics Nobel prize winner, comes close to understanding this, though his book is more an updated 1999 tome on the Asian and Latin American crises than a full exploration–more like dashed-off thoughts in an epilogue–of 2008’s meltdown. The Madoff scandal had not even struck by the time he completed it.

Nevertheless, it’s an insightful read. The Asian and Latin financial crises were rehearsals for the global economic bust we are living through now, writes Krugman, a Princeton professor and New York Times columnist. While in the 1990s, growing international capital flows set the stage for devastating currency crises, the same globalized financial system allowed the spread of mortgage-backed securities to infect banks and investors around the globe, he writes. The credit crunch that grew out of the housing calamity then froze the rest of the world’s lenders, using the same viral pathway.

Krugman stops short of blaming the globalized financial system itself as the villain, though he drops several hints that it’s where he would like to pin blame. He is more on target, however, in awarding special opprobrium for the shadow banking system–the commercial banks, investment banks, insurance giants, and hedge funds that created, traded, and held trillions of dollars’ worth of unfathomable securities.

This is the financial alchemy that Wall Street began to create in the 1980s to make it easier to spread risk, but that became a fee-generating mania by 2000. It all goes under the name of structured finance, and it started with the invention of asset-backed securities, the packages of loans for everything from cars to college tuition to houses, which are sold to investors seeking predictable yields. In the 1990s, the shadow system moved into collateralized debt obligations (CDOs) in which bundles of loans, most often mortgages, were sliced into tiers, from low- to high-risk, to suit investor tastes. Not content with the lush fees being generated, Wall Street next came up with synthetic securities like CDOs-squared, in which bankers sliced up CDOs according to the risk of default and created altogether new ones whose face value sometimes exceeded the underlying mortgages.

The next absurdity was the structured investment vehicle, the off-balance-sheet companies that banks created to invest in high-yielding CDOs, supposedly to protect them in the case of losses but that ultimately became the equivalent of poisoning one’s own nest. Credit-default swaps, a form of insurance on all these derivatives, exploded onto the scene in 2005, and over three years mushroomed into a product with a worldwide face value of $45 trillion. And on and on it went–with nary a regulator seeing (or wanting to see) the enormous house of cards building up, or thinking for one minute about the broader systemic consequences if one of the cards fell.

In fact, all these securities lived outside the regulatory system. For the most part, the banks that created them and the funds that traded them were not required to hold reserves, maintain capital ratios, or pay into the deposit insurance system. At their peak, Krugman notes, asset-backed paper grew to $2.2 trillion. Hedge funds held a combined $1.8 trillion in total assets. Five major investment banks alone had highly leveraged balance sheets worth a total of $4 trillion. The entire regulated banking system, by contrast, held only $10 trillion.

Niall Ferguson, the prolific author who divides his life teaching half the year at Harvard and the other half at Oxford and is also associated with the conservative Hoover Institution, has a somewhat different take on the madness of 2008. In The Ascent of Money: A Financial History of the World, he too seems frightened by the size of the shadow banking system. But the demon he singles out is the trade relationship between the United States and China that resulted in the latter becoming the banker to the former. China made it possible for spendthrift Americans to consume way too much by selling them cheap goods made with cheap labor. And to finance that spending, China’s population of savers created what Federal Reserve Chairman Ben Bernanke has dubbed a “global savings glut,” which resulted in easy money arriving on American soil, fueling the consumption binge and the mortgage bubble. As China sold the United States far more than the United States sold to China, it built up a huge surplus of dollars. China also made sure its own currency did not rise against the dollar–and that its exports remained irresistibly cheap–by buying massive amounts of dollars and lending them back to the United States. Ferguson calls this symbiosis “Chimerica,” the “underlying cause of the surge in bank lending, bond issuance and new derivative contracts that Planet Finance witnessed after 2000.”

Now that the housing market has melted down and the trillions in financial flora and fauna that had grown up around it has became worthless, Ferguson suggests letting banks collapse, a tough-love solution. He approvingly quotes Joseph Schumpeter, the economist who suggested that ill-managed corporations should be allowed to fail and investors to lose their money in the process he called “creative destruction.” But Ferguson finished his book in mid-2008, before the Federal Reserve and the Treasury allowed Lehman to collapse, a Schumpeter-like solution now widely seen as a blunderbuss move for having triggered a global panic and a credit crunch of historic proportions.

And what if the mortgages the Chinese financed had been properly underwritten? What if the credit-default swaps derived from them had not gone poof? Wouldn’t we still be singing the praises of the mutually agreeable relationship between the United States and China if the securitized debts and off-balance-sheet vehicles that they spawned had been properly controlled by American regulators, had they been paying attention?

What if–and admittedly this is a big what if–the SEC, which had largely gone to a system of letting investment banks self-regulate, bravely put a stop to the debt buildup? The five biggest investment banks, after all, went from 10:1 leverage to more than 25:1 during the housing boom–towering ratios that left banks with a long fall once the boom ended. More than anything, that explains why Bear Stearns and Lehman Brothers have failed, Merrill Lynch has been sold to Bank of America, and Goldman Sachs and Morgan Stanley have converted to commercial banks.

And almost no one bothered to regulate the mortgage lending business, choosing under President Bill Clinton to let the states take the lead and, under George W. Bush, actively preventing the states from doing anything to suppress the inventiveness of the charlatans selling ninja mortgages. If all the regulators had been doing their jobs, it seems Ferguson’s well-argued thesis would still be just a thesis.

Like Krugman and Ferguson, Michael Lewis also conjures the ghosts of financial crises past. The well-known author of Liar’s Poker, Lewis has compiled an anthology of works by journalists, including himself, who wrote before and after modern financial upheavals, starting with the stock market crash of 1987 and ending with the current crisis. In some cases, the inclusion of an article in Panic is meant to ridicule–how could we have been so dumb as to believe that hype? The book opens with “Riding the Wild Bull,” a July 1987 Time paean to the individual investors who were day-trading large amounts of money for their own retirement accounts and those of their grandkids “in the seemingly relentless bullishness of the market.” The article quotes an 80-year-old Houston woman–”I am not all that smart, I’ve just got some common sense”–oblivious to the Black Monday stock market crash three months hence that would take her on a wild bear ride.

In other examples, Lewis is clearly asking, why didn’t we pay more attention to this clear-as-a-bell warning? While he doesn’t provide a roadmap to help us steer clear of the lunacies that seem to be occurring with more frequency, his choices suggest that he, too, thinks regulators and policymakers had their heads in the sand for much of the last decade.

The string of panics that began with the 1987 crash and continued on through the subprime mortgage debacle, he writes in an introduction, all grew from the confidence that huge risks could be quantified and controlled. In 1987, for example, the Black-Scholes options-pricing model said that a trader could hedge away risk by taking a short position and increasing that position as the market falls, thus protecting against losses, no matter how steep. True enough, on paper. The mistake, however, was the failure of the model to capture what human beings do in a market that is crashing–they refuse to buy. And if no one is buying, then it’s impossible to sell short. “The sweet logic of Black-Scholes was shown to be irrelevant in the real world of crashes and panics,” Lewis writes about the 1987 crash.

But we did it again and again. In 2008, credit-default swaps were sold by the trillions to insure investors against losses in mortgage bonds. Millions of homeowners got into the risk business by taking out loans they knew they could not afford, but they did so anyway by suspending their own disbelief that housing prices would rise forever–or that they could always refinance when their adjustable loans reset to a higher interest rate. Once again, the sweet logic of risk protection was irrelevant in the real world of crashes and panics. And once again, no savvy regulator looked into the fancy computer models, the derivatives and synthetic securities that Wall Street relied on to justify enormous risks, and asked: Can a computer-generated risk model really predict human behavior in the face of a panic?

Regulators, be they the SEC, the Federal Reserve, the Treasury, or any other Washington overseer, do not see around corners. They are, for the most part, drowning in enforcement cases and mundane day-to-day tasks like answering to Congress, justifying their spending, and hiring and training personnel. They aren’t sitting around trying to devise ways to let crooks go free. In fact, they like to catch the bad guys and enjoy carving another notch on their belt when they do. They do, occasionally, suffer from a lack of imagination about how crooks work. And they lack distance from the big players and establishment figures who too often get the benefit of the doubt.

Banking regulators also have a particular problem in that their oversight activities are funded by the very institutions they are supposed to be monitoring. Last year, the Web site of the Office of Thrift Supervision, which oversees savings banks, seemed to be competing against other agencies for banks’ business by trumpeting one-stop shopping convenience and a light regulator’s touch. The SEC’s singular failure was its inability to see the danger in what was perfectly legal–that highly leveraged investment banks were pumping out toxic securities to the rest of the world, and holding gobs of it on their own balance sheets.

But perhaps the most important lesson of the 2008 economic fiasco is that Washington’s regulatory hodge-podge has a little known but fatal flaw: Agencies do not look holistically at an entire institution’s activities, risk-taking, and record books. Each agency, usually by law, sees only a slice of the big picture. Within agencies, the slicing continues, with one SEC division watching stockbrokers and another watching investment advisers. The two SEC units, let alone two entirely separate regulatory bodies, often do not compare notes.

If you are Bernie Madoff, this “functional regulation,” as it is called, is an invitation to operate in the seams. The Financial Industry Regulatory Authority (FINRA)–the self-regulator that the SEC relies on to oversee the securities industry day to day–investigated Madoff in 2006 and found that he violated a few technical stock-trading rules. But FINRA never looked into Madoff’s money-management business because its powers extended only to brokerage accounts, and Madoff’s Ponzi scheme took place outside those accounts.

Functional regulation also means that no single agency looks broadly at the amount of risk any single institution is taking on. The holding company atop Citigroup, for example, was subject to regulation by the Federal Reserve, but its Smith Barney brokerage unit was overseen by the SEC. Until Citi divested its insurance business, state regulators monitored those insurance products. When Citi traded commodities like crude oil or Treasury futures, the Commodity Futures Trading Commission (CFTC) kept watch.

As Congress and the Obama economic team wrestle with the financial industry cleanup, their top priority must be to find a way for regulators to monitor the whole organism under one roof. That might require combining the SEC and the CFTC, or assigning the Federal Reserve the role of overall risk regulator. Either way, the reckless behavior that consumed Wall Street in the last decade will resume once again unless regulators can see how much is being borrowed and lent and with what collateral–up and down an entire organization.

It is also clear that regulators, lawmakers, and ordinary Americans have convenient memory lapses. Many of the problems that caused the 2000 stock bust also hurt us this time around. Take the ruse of putting assets off the balance sheet, the accounting method Enron used to hide ventures it wanted to keep from shareholders and regulators but that eventually brought the company down. In much the same way, financial institutions around the world bought the mortgage securities that Lehman Brothers, Bear Stearns, Merrill Lynch, and the rest had sliced into tranches and packaged into high-yielding bonds, hiding them in new-fangled investment vehicles. And when the investments went sour, the banks had to take the bonds onto their balance sheets, which caused huge losses and led them to hoard capital, triggering the credit crunch.

Credit-rating agencies, one of the villains in the Enron fiasco, played an even bigger role in the housing implosion. In 2001, as Enron’s credit was fast deteriorating, the rating agencies never downgraded the debt. Only four days before Enron declared bankruptcy in December, 2001 did Standard & Poor’s reduce its ratings on Enron’s bonds to sub-investment grade. By then it was too late for most investors.

During the housing bubble, the agencies slapped their highest, triple-A seal of approval on pools of mortgages that turned out to be highly questionable. All the while, the ratings agencies maintain enormous conflicts of interest, including the fact that bond issuers pay the agencies for ratings. And why should they bite the hand that feeds them? The SEC sponsors these agencies by conferring its own seal of approval on their activities, but it has never forced them to rid themselves of such conflicts.

And once again, bonuses provided all the wrong incentives, for example, by allowing structured-finance employees to think only about their personal short-term reward and not about the long-term consequences if the underlying mortgages failed. As Franklin Roosevelt said in his second inaugural speech, “We have always known that heedless self-interest was bad morals; we know now that it is bad economics.”

As a country, we are eager to apportion accountability; we all want to blame someone for the painful losses we have suffered in our retirement accounts, our kids’ college savings, and in the value of our homes. But the housing-bust-turned-credit-crisis and the Madoff crime depended on all of us to suspend disbelief. In the case of Madoff, it was that his steady 1 to 2 percent returns every month were real, no matter how strong or weak the overall market was, because a piece of paper said so. In the broader economic crisis, it was that housing prices would rise inexorably.

But the hard truth is that we all share some of the blame. We have been living way beyond our means, personally and as a nation. We failed to weed out financial sharks by performing simple due diligence, or by demanding that our brokers and advisers do so (which, after all, is their job). It may seem heartless to say so, with more than two million people having lost their jobs and nearly that number turned out of their homes, but the Great Economic Bust of 2008 could turn out to be a good thing–if, this time, we learn the right lessons.


Read more about EconomicsFinanceGreat Recession

Paula Dwyer is an editor in the Washington bureau of The New York Times. She previously spent twenty years as a writer for BusinessWeek in Washington and London.

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