Don't blame greed for the financial crisis
What caused the subprime meltdown and the global recession? If you listen to Michael Lewis, author of The Big Short, the culprits were Wall Street's swinish greed and its obsession with making a quick buck.
Lewis knows how to make his case. His new work of non-fiction is chock-a-block with characters that any novelist would envy: a one-eyed investment genius, the world's rudest money manager, and a swaggering bond trader who thought he was the smartest guy in the room until he lost US$9-billion. They make for a wonderful tale. In fact, there is only one problem with Lewis's technicolor account of the subprime crisis. When you strip away the color and the characters, it doesn't really explain much of anything.
Think about it. If porcine greed, by itself, is enough to crash the financial sector, why doesn't Wall Street crash every year? For that matter, why should the crash of the subprime market result in a recession so much worse than the one that followed, say, the dotcom bubble?
To answer these questions, you should read a very different book. Slapped by the Invisible Hand is a dry account of the financial crisis by Yale professor Gary Gorton. It's nowhere near as fun as Lewis's tale, but what it lacks in entertainment value, it makes up for in explanatory power.
Both authors go back in time to pinpoint where the problems started. Lewis, for his part, believes the rot began in the 1980s, when Wall Street investment banks transformed themselves from partnerships into publicly traded corporations.
The transformation meant that investment bankers no longer had a lifelong stake in their business. Rather than working under the watchful eyes of fellow partners, they had only anonymous shareholders to satisfy.
As Lewis tells it, the pros realized that anything goes under the new rules. They dropped their old school obsession with serving the client. They began to explore ways to screw the customer.
Financial engineers found ingenious ways to push hidden risk onto customers. For instance, the engineers took piles of dreck -- subprime mortgages given out to people who "were one broken refrigerator away from default" -- and restructured the trash into spiffy-looking securities called CDOs (for collateralized debt obligations).
Credit raters such as Standard & Poor's and Moody's were happy to accept a fee and slap investment-grade ratings on large portions of these CDOs. Investment bankers then proceeded to stuff the highly rated garbage down the gullets of gullible institutions that believed they were buying a riskless investment. Hence, in Lewis's view, the subprime bubble. And, hence, the inevitable collapse when mortgages started going bad.
So far as it goes, all of this is fair enough. But Lewis's lurid take on investment bankers' villainy seems incomplete. Granted, Wall Street is nasty, but that, by itself, doesn't explain the financial crisis.
One problem with blaming everything on the investment banks is that the banks themselves seemed baffled by what was going on. Many held CDOs and were surprised when their holdings turned bad. In retrospect, Lehman Brothers, Bear Stearns and Merrill Lynch don't look like evil geniuses. Schleps, more like.
Then there's the mystery of how the souring of the subprime market could taint the wider economy. Subprime losses were less than half a billon dollars. How could that bring down a US$60-trillion global economy?
Gorton's book provides an explanation. He says that traditional banking in the United States is not that profitable any more. The big loot has migrated to the "shadow banking" system -- investment banks, hedge funds and off-balance-sheet "conduits."
Shadow banks don't take deposits so they rely upon short-term loans to fund their needs. They raise these loans in the so-called repo or repurchase market. Under a typical repo deal, a shadow bank borrows $100-million overnight. In exchange it gives the lender a security worth $100-million and promises to buy back that collateral the next day at a slightly higher price.
So far, so good. But the hidden weakness in the system is the choice of collateral. By 2007, it had become highly rated slices of CDOs. When the mortgage market started to sour, the value of those CDOs came into question. Lenders were suddenly willing to lend far less money against the shadow banking system's collateral. The result was a massive exit of capital from the system -- which, in turn, forced fire sales of assets and a vicious spiral of falling prices and even more sales.
Gorton sees this as being like an old fashioned run on the bank. Bank runs ended when deposit insurance was introduced, so he thinks government should step in to rate securitizations and guarantee the best parts of them. If such a system had been in place in 2007, the shadow banking system would never have spiraled into disaster.
The contrast is stark: Lewis sees Wall Street as a den of sin that needs radical reform; Gorton views the problem as a broken fuse and argues that a bit of rewiring could put everything right. There's no doubt that Lewis is the more entertaining writer. But Gorton is the more interesting thinker.
Ian McGugan is a freelance business journalist who writes for the Financial Post.
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