Bill Totten's Weblog

Saturday, July 10, 2010


High Finance versus Human Nature

by John Lanchester

The New Yorker (June 01 2009)

Complex risk engineering ignored emotions like avarice and envy:

The world of banking, it's becoming clear, operates according to different norms from those of the rest of the business world. Take the offsite corporate weekend. Normal behavior on these occasions consists of punishing the minibar and nursing consequent hangovers, hitting on long-fancied colleagues, and putting embarrassing items, ideally pornographic videos, on one another's hotel bills. For form's sake, a few new ideas are cooked up, and then gradually allowed to die a natural death when everyone is back at work and liver-function levels have stabilized. In June, 1994, when a team from J P Morgan went on an off-site weekend to Boca Raton, they conformed to normative behavior in certain respects. Binge drinking occurred; a senior colleague's nose was broken; somebody charged a trashed Jet Ski and many cheeseburgers to somebody else's account. Where the J P Morgan team broke with tradition was in coming up with a real idea - an idea that changed the entire nature of modern banking, with consequences that are currently rocking the planet.

The new idea was based on an old one, that of the swap. Say you're in the grocery business, and feel gloomy about your prospects. Your immediate neighbor is in the stationery business, and he feels gloomy about his prospects, less so about yours. You get to talking, and one of you hits on a brilliant idea: why not just swap revenues? You take his earnings for the year, and he takes yours. The actual business doesn't change hands, making the swap, in banking terminology, "synthetic". The first currency swap took place in 1981, and allowed IBM to trade surplus Swiss francs and Deutsche marks for dollars held by the World Bank. The two institutions exchanged their obligations to bondholders and their bond earnings without actually exchanging the bonds. The deal, brokered by Salomon Brothers, was worth two hundred and ten million dollars over ten years and ushered in a whole new field of finance. As Gillian Tett tells it in her book Fool's Gold (Free Press, 2009), by the time of the Boca Raton off-site, swaps had become a roaringly successful feature of the banking world: the volume of such interest-rate and currency derivatives was worth twelve trillion dollars, more than the entire US economy.

But competition was making those swap deals less profitable. The quest was for a new, and therefore newly lucrative, product to sell. What got the J P Morgan team rolling was this thought: instead of swapping bonds or currency or interest rates, why not swap the risk of default? In effect, it could sell the risk that a borrower won't be able to pay back his debt. Since banking is based on making loans to customers, the risk of default by those customers is a crucial part of the business. A product that made it possible to reduce that risk - by selling it to somebody else - had the potential to create a gigantic new market.

The broad outline of the financial crash is becoming well known. The value of Gillian Tett's book is in the level of detail with which she tells the story, concentrating on the specific sequence of inventions and innovations that made it possible. Tett, a Financial Times reporter who covered the credit markets, was one of the few people to have seen the implosion coming. A critical factor was that she has a PhD in social anthropology - a "hippie" background, as one banker told her, intending no compliment. It helped her focus on what she calls "social silences" in the world of banking. It's not always what people say that contains the most important information; often, it's what they take for granted. To Tett, it was obvious that the banking sector was running irresponsibly large risks in the overexpansion of credit and the overingenuity of its financial engineering. So she was perfectly placed to follow the story as it happened, and to pull together the story of how we got here. There are a number of different ways of peeling this particular onion; Tett does so through the J P Morgan team that helped create the new credit derivatives. These lie at the heart of the current crisis, and Tett's account of their invention and dispersal makes Fool's Gold a gripping and indispensable book.

The Boca Raton meeting first bore fruit when Exxon needed to open a line of credit to cover potential damages of five billion dollars resulting from the 1989 Exxon Valdez oil spill. J P Morgan was reluctant to turn down Exxon, which was an old client, but the deal would tie up a lot of reserve cash to provide for the risk of the loans going bad. The so-called Basel rules, named for the town in Switzerland where they were formulated, required that the banks hold eight per cent of their capital in reserve against the risk of outstanding loans. That limited the amount of lending bankers could do, the amount of risk they could take on, and therefore the amount of profit they could make. But, if the risk of the loans could be sold, it logically followed that the loans were now risk-free; and, if that were the case, what would have been the reserve cash could now be freely loaned out. No need to suck up useful capital.

In late 1994, Blythe Masters, a member of the J P Morgan swaps team, pitched the idea of selling the credit risk to the European Bank of Reconstruction and Development. So, if Exxon defaulted, the EBRD would be on the hook for it - and, in return for taking on the risk, would receive a fee from J P Morgan. Exxon would get its credit line, and J P Morgan would get to honor its client relationship but also to keep its credit lines intact for sexier activities. The deal was so new that it didn't even have a name: eventually, the one settled on was "credit-default swap".

So far, so good for J P Morgan. But the deal had been laborious and time-consuming, and the bank wouldn't be able to make real money out of credit-default swaps until the process became streamlined and industrialized. The invention that allowed all this to happen was securitization. Traditionally, banking involves a case-by-case assessment of the risk of every loan, and it's hard to industrialize that process. What securitization did was bundle together a package of these loans, and then rely on safety in numbers and the law of averages: even if some loans did default, the others wouldn't, and would keep the stream of revenue going, thereby diffusing and minimizing the risk of default. So there would be two sources of revenue: one from the sale of the loans, and another from the steady flow of repayments. Then someone had the idea of dividing up the securities into different levels of risk - a technique called tranching - and selling them off accordingly, so that riskier tranches of debt would pay a higher rate of interest than safer ones. Bill Demchak, a "structured finance" star at J P Morgan, took the lead in creating bundles of credit-default swaps - insurance against default - and selling them to investors. The investors would get the streams of revenue, according to the risk-and-reward level they chose; the bank would get insurance against its loans, and fees for setting up the deal.

There was one final component to the J P Morgan team's invention. The team set up a kind of offshore shell company, called a Special Purpose Vehicle, to fulfill the role supplied by the European Bank for Reconstruction and Development in the first credit-default swap. The shell company would assume $9.7 billion of J P Morgan's risk (in this case, outstanding loans that the bank had made to some three hundred companies) and sell off that risk to investors, in the form of securities paying differing rates of interest. According to J P Morgan's calculations, the underlying loans were so safe that it needed to collect only seven hundred million dollars in order to cover the $9.7-billion debt. In 1997, the credit agency Moodys agreed, and a whole new era in banking dawned. J P Morgan had found a way to shift risk off its books while simultaneously generating income from that risk, and freeing up capital to lend elsewhere. It was magic. The only thing wrong with it was the name, BISTRO, for Broad Index Secured Trust Offering, which made the new rocket-science financial instrument sound like a place you went to for steak frites. The market came to prefer a different term: "synthetic collateralized debt obligations".

Inevitably, J P Morgan's innovation was taken up by more aggressive and less cautious banks. Mortgage-based versions of collateralized debt obligations were especially profitable. These CDOs involved the techniques that the J P Morgan team had developed, but their underlying assets were pools of mortgages - many of them based on the most lucrative mortgages, the now notorious subprime loans, which paid higher than usual rates of interest. (These new instruments could be pretty exotic: some consisted of CDOs of CDOs, pools of pools of debt.) J P Morgan was wary of them, as it happens, because it didn't see how the risks were being engineered down to a safe level. But institutions like Citigroup, UBS, and Merrill Lynch plunged in.

The new financial instruments, as clever as they were, had an unfortunate side effect: they broke banking. At its heart, banking is a simple business. Customers deposit money at a bank, in return for interest; the bank lends that money to other people, at a higher rate of interest. This isn't glamorous or interesting, but banking is not supposed to resemble skydiving or hip-hop; what recommends it is that it's a good way of making steady money (and of creating credit in the economy), as long as the bank is careful about whom it lends money to. The quality of the loans is critical, because those loans are the bank's earning assets.

This isn't some incidental issue; it's the very core of what banking is. But the model of packaging plus securitization spurned the principle that a bank had to individually assess and monitor every loan. The mathematics of valuation models - horrendously complex equations to assess probabilities and correlations, cooked up in mad-scientist style by the firms' "quants" - took on the burden of assessing statistical risk. The idea that a banker looks a borrower in the eye and takes a view on whether he can trust him came to seem laughably nineteenth-century. As for the risks? Well, as Lawrence Summers said when he was Deputy Secretary of the Treasury, "The parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies".

Alas, Richard A Posner, a judge on the US Court of Appeals for the Seventh Circuit, observes with pointed restraint, "That turned out not to be true". The result has been, in the title phrase of Posner's new book, A Failure of Capitalism (Harvard, 2009). He argues that we are now in a bona-fide depression, which he defines as "a steep reduction in output that causes or threatens to cause deflation and creates widespread public anxiety and, among the political and economic elites, a sense of crisis that evokes extremely costly efforts at remediation". His book is an attempt to write "a concise, constructive, jargon- and acronym-free, non-technical, unsensational, light-on-anecdote, analytical examination of the major facets of the biggest US economic disaster in my lifetime and that of most people living today".

Accounts of the banking-and-credit crisis tend to focus their explanations, which usually also means their blame, on one or more of the following four factors: greed, stupidity, government, and the banks. The process resembles a children's game in which you spin an arrow and it lands on a word. Tett spins twice, and lands on greed and the banks; Posner suggests that he doesn't know what the word "greed" means, and his spin lands firmly on government. "We are learning from it that we need a more active and intelligent government to keep our model of a capitalist economy from running off the rails", he writes. "The movement to deregulate the financial industry went too far by exaggerating the resilience - the self-healing powers - of laissez-faire capitalism".

This isn't an original conclusion, but the way Posner arrives at it is new and bracing. His first claim to fame was as one of the founders of a school of thought that takes economic ideas and techniques and applies them to the law, as well as to life more generally. He has published nearly twenty books in just the past decade, a superhuman rate of productivity, bearing in mind that Posner is also a practicing judge, a senior lecturer at the University of Chicago, and an energetic blogger (in association with the Nobel Prize-winning economist Gary Becker). He has the rare kind of mind that is a pure pleasure to watch in action, regardless of the subject and the argument being made.

A Failure of Capitalism argues that the risks taken by the banks were rational, for two main reasons. First, it's only with the benefit of hindsight that we can know that a bubble in prices was taking place. Bankers had to assign a probability to the prospect that there was a bubble, and, second, to the prospect that, if there was a bubble and it burst, house prices would fall by twenty per cent or more - this being the decline that precipitated the general crisis of bank insolvency. Now, suppose that the risk of both things happening was one per cent. Whether an event with that likelihood is worth worrying about depends on what its consequences will be. From the larger point of view, the consequences included systemic meltdown; but Posner invites us to focus our attention on what they looked like for individual bankers. They had strong incentives for taking the maximum amount of risks in their lending, since risks are correlated with rewards, and the bankers were so well paid that they didn't really have to worry about being laid off. "The greater the gains are from taking risks that enable very high short-term profits, and the better cushioned the executive is by his severance package against the cost of losing his job, the more risks he rationally will take", Posner notes. Besides, if a bank avoids these risks, and its competitors don't and therefore make more money during the boom, the cautious bank risks going out of business anyway, because its clients will walk away.

People taking out what now look like crazily risky mortgage loans were being rational, too, because they were acting on the widespread assumption that house prices would continue rising. If house prices fell, well, tough luck, they'd walk away from the loan and go bankrupt - but they probably had lousy credit ratings anyway. "Thus the downside of the home buyer's speculative investment is truncated, making his 'reckless' behavior not only rational but also consistent with his being well informed about the risks", Posner writes. The conclusion: "Risky behavior of the sort I have been describing was individually rational during the bubble. But it was collectively irrational." As for the idea that the bankers were dumb to get so carried away: "I am skeptical that readily avoidable mistakes, failures of rationality, or the intellectual deficiencies of financial managers whose IQs exceed my own were major factors in the economic collapse. Had the mistakes that brought down the banking industry been readily avoidable, they would have been avoided."

This is a familiar place for these arguments to end up: economists often find that apparently erratic behavior is, at heart, rational. It helps that the definition of rationality can be stretched to include emotion, which "is not necessarily or even typically irrational", Posner argues. Reckless greed, incompetent assessments of probability, blindness to the inevitability of downturns, failure to hedge risks so big that they threaten a firm's very existence: all are rational.

It seems a pity that a man as unflinching as Posner didn't put his ideas under more pressure from the specifics of what the bankers did. He is willing to criticize those who have criticized bankers - "the distinguished economist Paul Krugman", for instance, "who should know better" - but no banker is named and blamed. One can regret that Posner didn't get the chance to read Tett's book, which offers the opportunity to assess in detail the kind of risks that the bankers were taking.

Blythe Masters, who was in charge of the Exxon Valdez deal, and of selling the very first BISTRO notes, and thus one of the creators of the entire credit-default-swap industry, was among those baffled by the CDO boom. "How are the other banks doing it?" she asked. "How are they making so much money?" The answer, Tett says, is that "she was so steeped in the ways of J P Morgan that it never occurred to her that the other banks might simply ignore all the risk controls J P Morgan had adhered to. That they might do so was simply outside her cognitive map."

In particular, those banks had accumulated huge amounts of super-senior debt. In the first BISTRO, remember, only seven hundred million dollars was reserved to cover $9.7 billion of risk. The remainder of the debt was regarded as marvellously safe. Bankers call that kind of debt "super-senior", that is, better than AAA grade, safer than US Treasury bills, so secure that it didn't need to be insured. So what to do with it? Some banks simply let the super-senior debt accumulate on their balance sheets. The amount of this debt "was a closely guarded secret, even within the banks themselves", Tett writes, and the collapse in their value helped bring down the big banks. It would be interesting to read Posner's analysis of these specific actions, which to the layman seem, as they seemed to so many of the J P Morgan team, insanely reckless.

A common mistake of very smart people is to assume that other people's minds work in the same way that theirs do. This is a particular problem in economics. Its mathematically based models and assumptions of rational conduct can appear, to non-economists, like toys, entertaining but, by definition, of limited utility. Even Posner, who spent years extending the purview of economic thought, thinks that "the depression is a wake-up call to the economics profession". It's no surprise to find the Yale economist Robert J Shiller as one of the first respondents to that call. Shiller - not content with having predicted the bursting of the dot-com bubble in his book Irrational Exuberance (Broadway Business, 2006); co-creating the standard measure for tracking house prices, the Case-Shiller index; going on the record with worries about the housing bubble as early as 2003; and writing one of the first books on the crash, The Subprime Solution (Princeton, 2008) - has now, with George A Akerlof, the 2001 Nobel winner in economics, co-written a book on the influence of emotions on economics. Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism (Princeton, 2010) takes its title from John Maynard Keynes, who, in a famous passage of his treatise The General Theory of Employment, Interest and Money (1936), mused about how businessmen manage to make decisions, given the level of uncertainty about the future. "Our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing", he wrote. We can't know the future, and therefore our inclination to act, to do things, "can only be taken as a result of animal spirits - of a spontaneous urge to action rather than inaction". Akerlof and Shiller extrapolate from this an idea of animal spirits encompassing "noneconomic motives and irrational behaviors", a slightly broader idea than Keynes's usage, but one that allows them to study a range of negative impulses as well as the basic urge to optimism about which Keynes was talking.

Animal Spirits is addressed to a general reader, but it's hard not to feel that the book's real audience is among economists. The general reader needs no persuading about the influence of non-rational, non-economic forces on economic thinking. Within the economic profession, however, the subject of strict rationality is the occasion of a permanent pitched battle. (Posner: "The very existence of warring schools within a field is a clue that the field is weak, however brilliant its practitioners".) Animal Spirits, like A Failure of Capitalism, is a campaigning maneuver in this ongoing struggle.

Akerlof and Shiller have a set of specific proposals for how the animal spirits might be incorporated into their science. They set out a framework of factors - Confidence (and the lack thereof), Fairness, Corruption and Bad Faith, Money Illusion (the failure to understand the impact of inflation), and Stories - and then apply their ideas to a series of specific questions. Some of this is very timely, such as a chapter on "The Current Financial Crisis" and one asking "Why Are Financial Prices and Corporate Investments So Volatile?" But it's clear that the great white whale of modern economics, a thing that would appease the descendants of both Milton Friedman and John Maynard Keynes, is a quantifiable, evidence-based theory of how bubbles are formed, and, hence, how to forestall them. Bubbles are irrefutably clear in hindsight; but an economist who found a way of proving their presence with foresight would be doing humanity a profound favor.

We aren't there yet, though Akerlof and Shiller's book does give the profession some suggestions for the search. There is barely a page of Animal Spirits without a fascinating fact or insight, and by no means all from a reflexively liberal viewpoint. One of their culprits for the crisis is Andrew Cuomo, who, as Secretary of Housing and Urban Development, sharply increased the mandated lending to underserved communities by Fannie Mae and Freddie Mac, and in the process lowered credit standards, thus making it "easy for mortgage lenders to justify loosening their own lending standards". Despite the various ideological and methodological differences with Richard Posner, Akerlof and Shiller's fundamental view of how capitalism should work is similar: "What allows capitalism to function is the regulations", they write. This should be an enduring lesson of the crisis - an understanding that the rules governing the operating of markets were not handed down on stone tablets but are made by men, and are in constant need of revision, supervision, and active, imaginative enforcement. All these books coincide on this point: human beings make markets. A general recognition of that fact, led by the economic profession and taken to heart by politicians, would be a step so important as to be almost worth what it has cost to be reminded of it.

Bill Totten


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