Bill Totten's Weblog

Sunday, July 04, 2010

The Pure Products Go Crazy

John Lanchester set out to pen a novel about the financial world, but found the topsy-turvy logic of modern finance stranger than any fiction.

Whoops!: Why Everyone Owes Everyone and No One Can Pay by John Lanchester (Allen Lane, 2010)

by Christian Lorentzen (February 18 2010)

Much about the present financial crisis has baffled members of the public not intimately familiar with the workings of Wall Street. How did a bursting housing bubble bring down the economy of Iceland, paralyse international credit markets, put Lehman Brothers out of business, and necessitate government bailouts of private institutions to the tune of trillions? Volumes chronicling, lamenting, and apologising for the crisis have poured forth from journalists, economists, Wall Street insiders, and public officials. Most of the crisis literature - if it deserves that name - has thus been written in the language of the business pages or the policy elite. What has been lacking is the perspective of an enlightened outsider: someone who might see through the many veils of jargon, dogma and excuse-making in order to connect the dots for the rest of us.

The novelist John Lanchester is ideally suited to that role. Lanchester, whose father was an international banker, set out in the summer of 2007 to research a novel set in the world of London finance. But he soon "realised that I had stumbled across the most interesting story I've ever found". The novel was laid aside and Lanchester began to write about the crisis itself. Those efforts, published in the London Review of Books and the New Yorker, became the foundation for a book called Whoops! Why Everybody Owes Everybody and No One Can Pay, a highly readable and elegant guide to the last two years of financial calamity. Though Lanchester's literary flair is evident on every page, Whoops! does not resemble a novel. The author makes no attempt to tie the events of the past two years into a coherent linear narrative or to draw any characters at great length. Instead he has written a broad and lucid dissection of an arcane system and its recent implosion.

Laymen may find the financial crisis as impenetrable as Finnegans Wake. For good reason, argues Lanchester: finance "underwent a change in the 20th century, a shift equivalent to the emergence of modernism in the arts - a break with common sense, a turn toward self-referentiality and abstraction, and notions that couldn't be explained in workaday English". (Lanchester's facility in explaining derivatives, securitisation, collateralised debt obligations, and credit default swaps is one of the work's great virtues.)

Lanchester dates this seismic change to the 1973 publication of an article in the Journal of Political Economy under the title "The Pricing of Options and Corporate Liabilities" by Fischer Black and Myron Scholes. The authors put forth an equation that made possible the calculation of the price of financial derivatives according to the value of the underlying assets. (Black died in 1995, but Scholes was awarded a Nobel Prize in 1997 for their joint work.) It was as if a casino had been opened.

"It still seems wholly contrary to common sense", writes Lanchester, "that the market for products that derive from real things should be unimaginably vaster than the market for things themselves". These new financial instruments presented an apparent paradox: complex derivatives allowed traders to hedge against shifts in the value of underlying assets, minimising risk; they were equally useful as tools for speculation, capable of producing immense profits if the right bets were placed on future asset values. But the potential downside to any miscalculation could be immense: it was now possible, as happened in January 2008, for a reckless trader like Jerome Kerviel of Societe General to lose $7.2 billion in a matter of days making allegedly unauthorised bets on European stock markets. Such catastrophic losses are rare. But, Lanchester argues, once they become possible - as a result of lax corporate oversight, "over-the-counter" trading, and scant regulation - their periodic occurrence becomes practically inevitable.

Bankers, Lanchester explains, view risk differently than the rest of us: the greater the risk, the greater the opportunity for profit. The trend that perhaps rendered the financial crisis inexorable was the new practice of swapping the risk that a borrower would default. Thus lenders could lend without worry that the borrower might not be able to pay because they could sell off the risk, which could then be bundled off and sold again. Banking, Lanchester writes, "is a guaranteed way of making steady money forever ... as long as one all important rule is followed: the bank has to be careful about to whom it lends money".

Subprime lending emerged as a formalised method of being uncareful about to whom money might be lent. Lanchester, a fan of the television programme The Wire, visits Baltimore, where more than 30,000 households have fallen to mortgage foreclosures. Lawsuits have been filed by the city and various non-profit against lenders such as Wells Fargo. Home ownership for the low-income and largely black victims of predatory lenders has now led to homelessness, after foreclosure ruins their credit and they are no longer able even to rent. A non-profit lawyer explains to Lanchester that the best hope for stopping such practices lies in establishing precedents convicting lenders of criminal activity when they pursue predatory lending practices: "This is the idea: how do you drive change in America? Real, noncosmetic change? Answer: by finding ways for lawyers to make money."

There are few particular villains in Lanchester's telling. He has a certain respect for bankers and observes - as they are also quick to point out - that the majority of the profession was not involved in the sort of lending, securitising, and hedging that brought down the economy. He does blame them, however, for "a failure to admit that this was a cultural issue, not just the result of a specific set of actions". It is unquestionably a culture marked by arrogance - for evidence one need look no further than the profession's unofficial embrace of Tom Wolfe's ironic moniker "masters of the universe" - and the arrogance goes hand in hand with the universal assumption that when it comes to questions of government policy the answer is always further market liberalisation.

One figure who earns Lanchester's scorn is former Federal Reserve Chairman Alan Greenspan. "I made a mistake", Greenspan said, "in presuming that the self-interests of organisations, specifically banks and others, were such as that they were best capable of protecting their own shareholders and their equity in the firms". Lanchester blames Greenspan for keeping interest rates low and perpetuating the housing bubble, despite various "funny smells" that should have warned him that such growth was unsustainable.

The crisis, for the Maestro, represented "the collapse of an entire ideological edifice". Yet this notion directly conflicts with an idea that governs the mentality of those who invest in sectors that are clearly experiencing bubbles: "the greater fool theory", that is, "that even though everyone knows that what's happening is crazy, there's still money to be made by buying stocks and selling them a little while later to the eponymous 'greater fool' ".

The greater fool theory is perhaps the best argument to be made for more stringent regulation of the financial industry. For until the masters of the universe are reined in, deglamourised, and made to serve society by allocating capital and credit in the manner of a public utility - like a power company - the victims of their follies will always be the greatest fools of all: taxpayers. From the bubble, when huge profits were channelled into to private hands; through the crisis, when AIG had the public "over a barrel"; and now a year past the bailouts, as banks post record profit while the rest of the economy continues to sag - the banks have evaded the damage their industry has wreaked on the world. Lanchester sees this for what it is: "100 per cent pure socialism for the rich".


Christian Lorentzen is a contributing editor of Harper's Magazine.

Bill Totten


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