In times of high stress, many in the financial world seek solace in watery metaphors. We hear of vast irresistible forces converging in "perfect storms" and unforeseeable events contributing to "100-year floods."
How could we have expected, let alone prevented, this?
Count on Warren E. Buffett to cut to the truth. Years ago, referring to reckless corporate debt, Buffett noted (or so the story goes): "You never know who is swimming naked until the tide goes out."
The tide's moving, and we're starting to get the full, not-so-pretty view. Along with the bare swimmers emerging from the soggy murk, we're being reminded of some of the dumb ideas and reckless choices that helped deliver us to our current debacle. As stunning as the scene seems, we've actually had plenty of experience with this sort of thing. But like some stubborn residents of hurricane zones, we swiftly choose to forget the last tempest and reassure ourselves that things will be different from now on. Why don't we learn the obvious lesson to the contrary? Answers: the timeless power of hubris during periods when profits seem easy, and a set of foolish financial notions that have become prevalent over the past three decades.
One of those beliefs is the indiscriminate anti-regulatory ideology one hears preached on Wall Street with tent-revival fervor. What makes this thinking so perplexing is that many of the free-market true believers also assume the federal government will save them if they flop. Consider the extraordinary taxpayer-backed rescues of insurance titan American International Group, housing financiers Fannie Mae and Freddie Mac, and, before those, the Treasury-guided merger of Bear Stearns into JPMorgan Chase. It brings to mind the homeowner who rants about getting Washington off his back but wants federally guaranteed flood insurance no matter how close to the Gulf Coast he builds his house.
Other by-now-familiar attitudes have helped put us in the drink: In good times, there's no such thing as too much leverage. (Remember Michael Milken?) Derivatives don't require oversight, even though almost no one understands them. (How now, Long-Term Capital Management?) And, don't worry, the quantitative geniuses have devised models to eliminate extreme risk. (Enron, anyone?)
"Now, again, the banks and the Bush administration and [Treasury Secretary Henry] Paulson and [Federal Reserve Chairman Ben] Bernanke would like you to think these crises are like floods or hurricanes," says Michael Greenberger, a senior official at the Commodity Futures Trading Commission during the Clinton administration. An advocate of more aggressive regulation of investment banks, he was shot down in the late 1990s by Democratic colleagues, not just GOP foes.
Most financial calamities aren't like natural forces beyond control, Greenberger says. "These are predictable events." Predictable events, of course, are more likely to be prevented with sound rules and stiff enforcement.
Lenders, for one, demanded lots more freedom. But they "were a different kind of animal" from airlines and trucking firms, which the Carterites also deregulated, Kahn says. "They were animals that had a direct effect on the macroeconomy. That is very different from the regulation of industries that provided goods and services. ... I never supported any type of deregulation of banking."
During the Reagan years, Kahn's cautious industry-by-industry analysis was replaced by the all-encompassing anti-regulatory ideology of the University of Chicago. One result: the liberation of an armada of savings and loan pirates, abetted by congressional Democrats as well as Republicans, many of them drunk on S&L campaign largesse. (Wall Street lobbyists with open wallets have since perfected the practice of neutralizing Congress on a bipartisan basis.) Hundreds of thrifts ultimately collapsed in the late 1980s and 1990s amid greedy and, in some cases, fraudulent real estate deals.
As early as 2000, William J. Brennan, a prominent consumer attorney who has represented mortgage borrowers since the S&L catastrophe, warned in testimony before the House Financial Services Committee that real estate finance would return in new guises to haunt us. Few listened. Behind every burst of ill-advised lending lurk financial innovators creating new mechanisms to entice ever-more-sketchy borrowers, says Brennan, the director of Atlanta Legal Aid Society's Home Defense Program.
In the 1980s, Michael Milken and his comrades at the now-defunct Drexel Burnham Lambert investment bank exacerbated the S&L fiasco by hawking their thrift clients' high-risk junk bonds. More recently the likes of soon-to-be-defunct Lehman Brothers and Bear Stearns engineered the securitization of mortgages, encouraging home lenders to spew wildly unwise loans. "Lending without regard [for] the ability to pay back started with the S&L scandal," says Brennan. In the 1980s the borrowers were reckless shopping-mall developers; in the recent boom, unsophisticated and sometimes cavalier homeowners.
Wall Street transformed dicey subprime mortgages into the toxic securities that have required hundreds of billions in writedowns and that drove once-mighty Merrill Lynch to sell itself to Bank of America. One of the most striking aspects of the current turbulence is the degree to which banks invested in the noxious fare themselves, notes Emanuel Derman, who heads risk management at Prisma Capital Partners, a hedge fund in Jersey City, N.J. "These guys ate their own cooking; they didn't just pass it on to clients."
The outsize appetite on Wall Street for hazardous mortgage-backed securities and even more obscure derivatives has had a lot to do with the people in the kitchen failing to understand fully what was in their recipes. All of this is painfully familiar to anyone who paid attention to past adventures with wizards who claimed their esoteric models had magically eliminated risk and uncertainty. Hedge fund Long-Term Capital Management couldn't imagine Russia defaulting on its debt, much as Lehman apparently couldn't conceive of housing prices across the country deteriorating simultaneously, followed by a paralyzing credit crunch.
For four years in the mid-1990s, LTCM boasted extraordinary profits based on supposedly flawless computer formulas devised by a team that included two Nobel laureates. But in the summer of 1998, Russian credit disintegrated, one of several concurrent global shocks that the LTCM crew had failed to factor into their algorithms. After losing more than $4 billion in a few months — in retrospect, the amount seems almost quaint — the hedge fund received a federally organized rescue, although it later shut down altogether.
Financial "rocket scientists," says Henry T. Hu, a corporate law professor at the University of Texas in Austin, have a knack for neglecting low-probability, catastrophic events. The smartest guys in the room at Enron similarly assumed away risks they didn't want to confront. "These models … work in normal circumstances but not during times of market stress, when it really matters," Hu says. "It is almost like a safety belt that only fails in a serious car crash."
One of the things that dismayed outsiders about LTCM after it came apart was the size and complexity of its derivatives portfolio. Some in the Clinton administration pushed for more oversight of the unregulated, privately traded instruments whose value derives from price shifts in currencies, securities, or other assets. Then-Fed Chairman Alan Greenspan, allied with Robert E. Rubin, Clinton's Treasury secretary (and now a director and senior counselor at Citigroup), opposed tougher policing of derivatives. Banks could watch over each other more effectively than regulators could, Greenspan argued. This turned out to be shortsighted.
In an interview, Greenspan doesn't back down, even after all we've seen lately. "The majority of lawyers, in my experience, seek to regulate — that is, to contain certain activities with little weight given to the lost benefits of such activities," he says. "The question is: What do you lose? In this case, a very valuable instrument [credit default swaps, the derivatives at the core of the current mess] for the diminution of systemic risk. You can stop the system dead and eliminate speculative losses. But you will also get significantly reduced economic activity and ultimately lower standards of living."
Greenspan adds: "I've been extraordinarily distressed by how badly the most sophisticated people in the business handled risk management. But the question is: If, protecting their own resources, they can't do it, who's going to do it better?" (Well, maybe regulators who don't have big bonuses at stake would be less likely to get carried away by the euphoria.)
‘Too big to fail’
Rubin says separately that he didn't oppose the general idea of scrutinizing derivatives, but instead argued against particular proposals in the late '90s to expand CFTC authority. "I have always been concerned about derivatives," he says.
Michael Greenberger served as the CFTC's director of trading and markets at the time. A proponent of tougher oversight, he recalls the Greenspan-Rubin resistance as being fierce and across-the-board. "If we had prevailed, the [subprime-securitization] party would never have gotten started; the wildness wouldn't have happened," he says. "There would have been auditing requirements, capital requirements, transparency. No more operating in the shadows. Bear Stearns, Lehman, Enron, and AIG would be thriving, and spending every waking hour complaining about regulatory restraints imposed upon them."
Now a law professor at the University of Maryland, Greenberger adds: "In a booming economy, people couldn't be convinced that without corrections, LTCM would happen again — bigger and with more ramifications." Today, Bear, Lehman, and AIG have untold amounts of outlandish derivatives on their books. It could be years before anyone untangles what they're worth.
One other legacy of LTCM is "moral hazard": the prospect that other financial actors would take greater risks because at some level they'd assume that they, too, would be considered "too big to fail." Surely one can surmise that Fannie Mae and Freddie Mac overstepped in part because of an implied federal safety net that turned out to be a very real one.
Edward S. Lampert, the hedge fund tycoon who controls Sears Holdings, worries about yet another twist. He says the current wave of federal intervention sends the opposite signal from what's intended: that officials are panicking because of broader instability. "As an investor, that was my immediate reaction" to the Fannie and Freddie moves, he says. "They completely destroyed confidence in any financial institution."
Lampert frets that with investment banks failing and merging, the resulting consolidation will concentrate risk and invite more rescues. "You are going to have Citi, JPMorgan, and Bank of America with $2 trillion-plus in assets each," he notes. "That's three times the size of Fannie and Freddie. Now if they end up with problems, what do you think is going to happen? They are too big to fail."