The Bactra Review: Occasional and eclectic book reviews by Cosma Shalizi   142

Fool's Gold

How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe

by Gillian Tett

New York: Free Press, 2009

The Tragedy of Getting What You Want

This is an extremely smart and well-written look at the growth and explosion of credit derivatives, as told through the story of Tett's sources at J. P. Morgan. It's a really good book, which painlessly explains a lot of the details of how we got into the present mess, and I strongly recommend it. That said, Tett clearly sympathizes with her informants, and while she doesn't exactly re-touch and air-brush their portraits for maximum flattery, they're ones reasonable people would be happy with. A less becoming picture of the same facts begins like so: In the early to mid 1990s, the Morgan bank had a group of arrogant, inexperienced young financiers who looked at the damage then being done by unregulated financial derivatives, and decided the key institutions of the capitalist economy need some of that.

Historically, a major role of banks has been to help provide corporate governance, which (as Uncle Norbert would remind you) relies on information. When firms go to banks for credit, they have to disclose lots of information about their finances, workings and plans which would normally stay locked inside the firm. (The firm does not want its rivals to know these things.) Banks have allocated capital, or not, on the basis of this information. The bank, for its part, realized that it still risked loosing its money on the deal, so it charged a higher-than-risk-free interest rate (even if it took collateral for the loan), and, if it knew what it was doing, set aside capital in proportion to its exposure. Since many banks have found it more profitable, temporarily, to not know what they were doing, regulators now require those capital reserves. Like it or not, this pattern — banks as generators of information and mechanisms of control — has been in place since the days of J. Pierpoint Morgan and before.

(Banks have other functions as well, of course, like providing secure storage for money [historically the oldest], operating the payment system [the second-oldest], creating money, and finessing the trade-off between pooling enough capital to fund major enterprises and the transaction costs of negotiating with all those resource-owners. But generating information about firms, and monitoring firm performance, is a big one.)

What the Morgan crew did was figure out a way of using derivatives to let a bank take a portfolio of loans and sell the risk of the loans in chunks to institutions outside the banks. If the bank had just sold the loans, it would have lost all the payments on the loans, and the buyers would have had to administer them, which for the most part they had no interest in doing. Instead, the bank and the buyer entered into a type of bet called a "credit default swap". Every month, the bank would pass on to the buyer part of the payments it received from the borrowers; in return, the buyer promised to make the bank whole if the borrowers defaulted. To make sure that money was actually around, the buyers provide some fraction of it up front, to be held in trust. (As a legal dodge, the bank usually sets up a dummy corporation, or "special purpose vehicle", which nominally sells the securities to the buyers on the one side, and enters the CDS bet with the bank on the other.) In theory, then, the buyers had assumed the risks of the loans not being repaid, in exchange for a continuing flow of money. The bank, for its part, pays on an on-going basis to no longer bear any risk of default from those loans. Thus, supposedly, the loans required no capital reserves, so the bank could do more business with the same amount of capital. (Actually, the banks usually ended up holding on to a portion of the loan portfolio, which was supposed to be small and very, very safe. It grew large, and proved dangerous.) Of course, those who bought chunks of the loan portfolio had basically no ability to evaluate them, since they had no or almost no information about the borrowers, and the bank no longer had any incentive to generate that information; but somehow, The Market Would Take Care Of That.

On the buyers' side, the securities ("synthetic collateralized debt obligations", in the jargon) were supposed to be safe because they were diversified across many borrowers; also they were structured so that all the buyers with low-grade securities would have to be wiped out before the payments to high-grade securities were cut. Of course, if someone wanted to share in a bank's diversified loan portfolio, they could already buy the bank's stocks and bonds. By picking among common stock, preferred stock, bonds, commercial paper, etc., they could control their risk level, and if they wanted really safe exposure to the loan portfolio of a commercial bank, they could open a savings account. This would not, however, have served the bank's desires to evade regulation and reduce the effort it expended generating information. Nonetheless, the ratings agencies, through some truly ridiculous statistical modeling, obligingly decreed that these securities were as safe as high-grade corporate bonds while yielding much higher returns. (The implication that banks could make massive money by arbitrage against themselves appears to have troubled no one.) The buyers, for their part, do not seem to have thought too hard about anything at all.

In short, the group at Morgan decided to change the way a basic capitalist institution worked, on the basis of abstract ideological principles, without any concern for its real-world effects, or the hard-won experience embodied in the social order they had inherited. (No doubt it helped that they all considered each other super-smart.) In conjunction with their peers at other major banks and financial institutions, they created these instruments, and then engaged in a series of highly successful lobbying efforts to ensure that they remained unregulated, and indeed to make sure that they didn't even trade on organized exchanges, so as to keep the banks' customers from seeing the deals being offered on comparable securities. (Naturally, the bankers who lobbied against transparency claimed to act in the name of free-market competition.) This may not have involved any illegal, brown-paper-bags-stuffed-with-cash corruption, but it's still a striking example of how a compact, organized, and above all rich special interest group can bend the political process to its will.

It is at this point, after the victory of an elitist cadre of self-serving ideologues, that what Tett calls the "corruption" set in. The original Morgan group were rationalistic social engineers filled with hubris, but even they realized there were limits on the trick they devised. To pull it off, the bank had to estimate the risk not just of any one loan in the portfolio defaulting, but of groups of them doing so at once, which meant estimating the correlations among loan defaults. In the nature of things, this is much harder than just estimating the risk of a single loan, and in many cases, like defaults on sub-prime mortgages, the data just wasn't there to support any sensible kind of estimation. (Cf..) The Morgan team realized this, and so did only a few mortgage deals. The rest of the industry was not so scrupulous: some of them thought they had a way of letting the market figure out the correlations, without anyone in the market having any information about the underlying economic entities, while the ratings agencies, for their part, used correlations set not so much ex ante as ex ano. The result, naturally, was an orgy of leveraged risk-taking such as had not been seen since the banks and financial markets were regulated in the first place. I say "naturally" because banks compete for investors' money, and they do so by offering returns. Leverage and gambling increase your returns, at least when your bets pay off, so the leveraged, aggressive banks gain at the expense of their more prudent competitors, who can't easily prove that they're being prudent, rather than timid and incompetent. (Tett makes it clear that Morgan suffered from its comparative restraint, and, had the bubble lasted just a bit longer, would probably have been forced to join in by its shareholders.) So leverage and risk-taking tend to ratchet up, until things go bust. If the aggressive banks have had the brains to diversify, then they have by that token correlated their portfolios (even were there no correlations within each portfolio), and so they will all go bust together. Which brings us to the end of 2008, more or less.

After turning Tett's flattering portrayals into mug-shots, the truth is I find myself sympathizing with her protagonists. They are obviously nostalgic for being talented young people working on an innovative common project which they really believed in, and why not? That is a wonderful thing. (I can only imagine that being paid very well for being geniuses together enhances the experience.) Hearing about how their handiwork brought the global economy to its knees can't feel good. But they should relax. In the first place, if they hadn't put together the particular kinds of securities they did, others would have produced exceedingly similar ones very soon, to much the same effect. In the second place, the novel financial instruments really weren't the problem; the problem was that banks were leveraged thirty-to-one or more, that an entire "shadow banking" system had been created purely to escape regulation, etc. Financial trickery may have made this marginally easier than it would otherwise have been, but lots of such episodes have happened without the benefit of Girsanov's lemma and the Gaussian copula. The problem was that the capitalist social engineers got what they wanted.

293 pp., end-notes, index


Currently in print as a hardback, ISBN 978-1-4165-9857-2 [buy from Powell's], US$26

15 June 2009