Alchemists of Loss E-Book

Kevin Dowd

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 749

Veröffentlichungsjahr: 2010

Beschreibung

An engaging look at how modern finance almost destroyed our global economy Over the last thirty years, capital markets have been restructured through the tenets of modern finance. This has been enormously profitable for the financial services sector. However, these innovations, coupled with unsound risk and regulatory practices have proved disastrous for the global economy. In a clear and accessible style, ex-investment banker and financial journalist Martin Hutchinson, and highly respected academic, Kevin Dowd show how modern finance combined with easy money threatened to bring down the world financial system. At the heart of the book is modern finance as a U.S. invention, the theories and practices associated with them, and the changes they made in business models and risk management on Wall Street and other major financial centers. * Breaks down the events involved in the 2007-08 financial collapse * Reveals how botched policy response made a bad situation worse * Focuses on lessons that the practice of finance must learn from recent events The Alchemists of Loss will help you to understand how our financial system crashed and show you what it will take to make sure this won't happen again as we move forward.

Leseprobe

Table of Contents

Title Page

Copyright Page

Acknowledgements

Foreword

Part One - Past Successes and Disasters

Chapter 1 - Introduction

Chapter 2 - Pre-Modern Finance

Chapter 3 - Lessons from Past Financial Crises

Part Two - The Modern Financial Theory Engine

Chapter 4 - Theoretical Foundations of Modern Finance

Appendix 1: Some Leading Financial Alchemists …

Appendix 2: … And Some Non-alchemists

Chapter 5 - Modern Financial Theory’s Hideous Flaws

Hideous Flaw I: Assumption of Gaussianity

Hideous Flaw II: Assumption of Stable Underlying Laws

Hideous Flaw III: Parameter Problems

Hideous Flaw IV: Behavioral and Institutional Obstacles

Chapter 6 - Risk Management: Daft Theory, Dodgy Practice

Part Three - Interactions with the Real World

Chapter 7 - The Real World Becomes Modern Finance-friendly

(i) The Increasing Dominance of Managerial Capitalism

(ii) Change in Investment Focus from Long-term to Short-term

(iii) Growth and Metamorphosis of the Financial Services Industry

Chapter 8 - Modern Finance Captures Wall Street

(i) Investment Management

(ii) Trading/insider Trading

(iii) Derivatives

(iv) Securitization

(v) Housing Finance

(vi) Credit default swaps

Chapter 9 - And Wall Street Metamorphoses

Chapter 10 - Derivatives and Other Disasters

Procter & Gamble

Daiwa

Orange County

Barings

Part Four - Policy Accommodates Modern Finance

Chapter 11 - Loose Money

Chapter 12 - Government Meddling in the Financial System

Part Five - Götterdämmerung

Chapter 13 - Bubble, Bust, and Panic

Chapter 14 - The Slope Down Which We’re Heading

Part Six - Charting a New Way Forward

Chapter 15 - The Math of Proper Risk Management

Chapter 16 - Back to the Future - A New Vision of Finance

Chapter 17 - A Blueprint for Reform

Chapter 18 - Lessons to Take Away

Bibliography

Index

This edition first published in 2010

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Acknowledgements & Dedication

It is a great pleasure to thank the many people who have contributed to this book. We thank the former editor of Financial Engineering News, Jim Finnegan, who first brought the two of us together. We thank Martin Walker for his splendid Foreword, and Philip Booth, Jim Dorn, Steve Hanke, Alberto Mingardi and Andrew Stuttaford for their generous endorsements. We thank the Wiley and Sparks teams, especially Pete Baker, Aimee Dibbens and Viv Wickham, for their work and support in this project. We also thank the following for all manner of diverse contributions: Mark Billings, David Blake, Carlos Blanco, Chris O’ Brien, Andrew Cairns, Dave Campbell, John Cotter, Roger Field, Chris Humphrey, Anwar Khan, Duncan Kitchin, Bill Lee, Anneliese Osterspey, Dave Owen, Stan Szynkaruk, Margaret Woods, Basil Zafiriou and Martin’s colleagues at Reuters BreakingViews and Agora Publishing, both fertile sources of good ideas and inspiration. Finally, thanks to Heather Maizels, whose inspiration led to the cover design. Most of all, we thank our long suffering families - most especially Mahjabeen Raadhiyah and Safiah on Kevin’s part, and Anna and Rumen on Martin’s.

Dedication

Kevin: to Mahjabeen, Raadhiyah and Safiah.

Martin: To Brian, Jean, Virginia, Anna and Rumen, the Hutchinson family.

Foreword

This book will startle readers. So it should. The scale and breadth of the latest financial crisis justify a fundamental re-assessment of the way that economic affairs are managed. And there could hardly be anything more fundamental than the authors’ recommendations. They advocate a return to the classic form of banking developed in 18th century Scotland; the abolition of state guarantees of bank deposits and of home mortgage tax relief; the eradication of the World Bank and International Monetary Fund and a return to the gold standard, or some commodity-based equivalent. They also propose a tax on US banks whose assets are greater than $360 billion (2.5% of US GDP), in order to shrink them to manageable size. The six largest US banks are their target.

They do not suggest that Wall Street and the City of London will disappear. They do, however, maintain that their fate will resemble that of the American rustbelt; Wall Street will be like the Cleveland, Ohio, of the 1970s and they see its skyscrapers becoming ghost buildings. London is condemned to become the Youngstown, Ohio, of the 1980s, “an excellent market for rottweilers, wire mesh and tattooed thugs.” The author’s pungent opinions, uncompromising analyses and muscular prose style make this an entertaining and provocative as well as an instructive read.

Perhaps the most striking feature of this book’s full-blooded defense of genuine free market economics is that so many of its proposals have already been espoused by more conventional economists. Its call for a tax on financial transactions to discourage trading was originally framed by the Nobel prize-winner James Tobin. Its insistence that no bank should be permitted to become too big to fail has been echoed by the former chief economist of the IMF, Simon Johnson, who also maintains that the profound political influence of the big banks in the American political system can be seen as a kind of coup d’etat. Like another Nobel laureate, Paul Krugman, this book argues that the financial sector had become a classic example of rent-seeking. And the gold standard has many defenders, including former Federal Reserve chairman Alan Greenspan. He is hailed in this book for calling the bubble fifteen years ago with his warning of “irrational exuberance, and excoriated for doing nothing about it. In that, too, these authors are in good company.

It should come as no great surprise that serious economists, whatever their political leanings, can agree on crucial issues. There are absolute truths in economics, and it is the great merit of this book to restate them, and to recall to mind that Ur-text of economic wisdom, Rudyard Kipling’s poem ‘The Gods of the Copybook Headings.’ It reminds us of the wisdom of our grandmothers, who warned us that all that glitters is not gold, that we should save for a rainy day, and that if something sounds too good to be true then it probably is. A mortgage for 125 percent of a house’s value, with no deposit and amounting to six times the applicant’s annual income, is certainly too good to be true. And yet these were the terms being advertised by the British bank Northern Rock shortly before its collapse and rescue by the British taxpayer. There could have been few clearer signs of an unsustainable bubble.

There were many such signs. The fall of the US personal savings rate below zero in 2006 was one. The rise in personal debt to over 100 percent of national income was another. The way chronic imbalances between Chinese surpluses and US deficits became routine should have been yet another. The dangers of a European monetary union without the assurance of a responsible sovereignty to support it was yet another. The emergence of “the Greenspan put,” in which financiers were encouraged to assume by the Fed that any financial crisis would be met by a rescuing surge of liquidity, should also have sounded an alarm. It changed the essential balance between risk and reward. To put it another way, it encouraged greed while reducing fear. It encouraged bankers to throw caution to the winds, since in the immortal words of Citibank chief Chuck Prince in 2007, “As long as the music is playing, you’ve got to get up and dance.”

Bankers should not speak and far less act like this. Bankers should be sober men in a reliable and even boring business, cautious custodians of other peoples’ money. We have heard this before, most memorably from Walter Bagehot, a polymath who wrote on physics and philosophy and literature, edited The Economist and produced in Lombard Street (1873) the first classic book on banking. His advice on the role of central banks in financial panics and crises has never been bettered: “to avert panic, central banks should lend early and freely, to solvent firms, against good collateral, and at high rates.” These three essential conditions have been signally and perilously flouted in our current crisis. Central banks have lent to the insolvent, against toxic collateral and at the lowest of rates. We will pay dearly for the temporary and unconvincing relief the Fed’s actions have delivered.

Bagehot argued, in a remark that neatly encapsulates the core argument of this book, that “The business of banking ought to be simple; if it is hard, it is wrong.” The Alchemists who are the targets of this book made the business of banking and credit and debt management into something not only hard, but well-nigh impenetrable. Their algorithms and quants and Gaussian models and Efficient Market hypotheses turned finance into an arm of higher mathematics and bamboozled investors and bankers in the process. Their mumbo-jumbo perfectly embodied George Bernard Shaw’s remark that “any profession is a conspiracy against the laity.” It also failed its first real market test, with the Long Term Capital Management fiasco of 1998, a warning that was ignored, thanks to a brisk exercise of the Greenspan put.

The authors predicate a (somewhat) mythical golden age of finance, characterized by “the importance of trust, integrity and saving, the need to invest for the long term,” and proceed to contrast it with Modern Finance. This is defined as “a focus on marketing and sales, form over substance, and never mind the client; an obsession on the short-term and the next bonus; a preference for speculation and trading over long-term investment; stratospheric remuneration for practitioners, paid for through exploitation of clients and taxpayers.”

Modern finance and its mathematician-alchemists are the targets of this book, but the authors identify a single arch-villain it is the eminent British economist John Maynard Keynes, characterized here as “the sublime Paracelsus of economic alchemy.” And yet Keynes is cited with approval for his famous remark on the founder of the Soviet Union in Economic Consequences of the Peace: “Lenin was certainly right. There is no subtler, no surer means of over-turning the existing basis of society than to debauch the currency… By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”

Because of the actions taken over the past two years by governments and central banks, a new inflation is almost certainly coming. Between them government with over $3 trillion in deficit spending and central banks with another $4 trillion in liquidity creation have pumped over 10 percent of global GDP into a heroic effort to fend off a new Great Depression. As a result, the level of government debt in most developed countries is now approaching or exceeding 100 percent of GDP. There are three ways to deal with such debt. The first is to grow out of it. The second is to default. The third, and easiest for governments to deliver, is to inflate it away. For all their criticisms of Keynes, the authors of this book whole-heartedly endorse his warning.

The real trouble with Keynes, of course, is the Keynesians in government who donned his mantle and claimed to be enacting his precepts when they went into deficit to invigorate a temporarily sluggish economy. Keynes advocated extraordinary spending by government in times of emergency. Politicians of all parties quickly misapplied his theories to justify borrowing money in ordinary times to give gentle boosts to an economy, usually in time to produce an artificial boom before an election. Such Keynesians gave Keynes a bad name. “We are all Keynesians now,” a phrase originally attributed to Milton Friedman in a Time magazine interview in1965, has come to be associated with President Richard Nixon in 1971. It is sometimes forgotten that it was Nixon, a Republican president, who took state intervention in the economy to its greatest extreme in US peacetime history. In the weekend of August 14, 1971, Nixon imposed a wage and price freeze, an import surcharge, and finally severed the dollar’s link to gold and abandoned the Bretton Woods system (which Keynes had devised). The Great Inflation of the 1970s followed.

Our financial crisis has been brought about by an unholy combination of model-crazed mathematicians, dancing bankers, profligate central banks and politicians who believed their own rhetoric about their ability to manage and to deliver economic growth. Nixon was but an extreme example of this hubris, one particularly ugly sub-peak in a very long and rising trend. In 1901, the revenues of the federal government of the United States were just under 3 percent of GDP, and being in modest surplus it spent rather less. In 2010, the federal government will spend 28 percent of GDP. Add in the 8 percent spent by the individual states, and government as a whole in the US approaches that 40-50 percent of GDP routinely arrogated by the welfare state governments of Europe.

These swollen governments have meddled increasingly in national and international economics. They impose taxes in order to enact social goals and political targets, from generous pensions to subsidized health care and education and housing. The intentions were usually admirable; the unintended consequences less so. The current financial crisis first became apparent in 2007 in the sub-prime mortgage sector. A major reason for this was that the US Congress had required that the two government-sponsored enterprises in housing, Fannie Mae and Freddie Mac, should make 55 percent of their loans to borrowers at or below the median income level.

Unless restrained, the role of government is almost certain to grow in the aftermath of the current crisis. For the first time, the developed economies are starting to feel the pinch of baby-boom retirement. The four eurozone countries in the most trouble, Portugal, Italy, Greece and Spain, have the most difficult demographics of any of Europe’s OECD countries; that is, the lowest birth rates combined with a swelling population of retirees. There are not enough workers coming into the system to pay for the pensioners leaving it. This is starting to hit countries world-wide, including the United States, Japan and China. It makes the crisis of public finances, after the massive deficit spending and money creation of the last two years, look even more intractable. We shall all pay for this, through the nose. And the best reason to read this book is that the authors were among that select and disregarded band who saw it coming.

Martin Walker, Washington DC, March 2010 Senior Director, Global Business Policy Council, AT Kearney

Part One

Past Successes and Disasters

1

Introduction

Towards the end of his General Theory of Employment, Interest and Money, published in 1936, John Maynard Keynes wrote that:

“… the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.”1

In this book we suggest that the key to understanding the recent financial crisis is to appreciate the impact of two belief systems, at first sight unconnected. Both of these belief systems originated from economic theories propounded by “defunct economists.”

The first of these is Modern Finance. At its broadest level, Modern Finance consists of a set of attitudes and practices, perhaps best understood by comparing it to what went before. In the past, finance emphasized old-fashioned values: the importance of trust, integrity and saving; the need to build long-term relationships and invest for the long term; modest remuneration for practitioners and a focus on the interests of their clients; and tight governance and a sense of harmonized interests and mutual benefit. All of these dovetailed together into a coherent whole.

Modern Finance emphasizes the opposite: a focus on marketing and sales, form over substance, and never mind the client; an obsession with the short-term and the next bonus; a preference for speculation and trading over long-term investment; stratospheric remuneration levels for practitioners, paid for through exploitation of clients and taxpayers, or “rent seeking”2; the erosion of the old governance mechanisms and out-of-control conflicts of interest.

Underpinning much of Modern Finance is a vast intellectual corpus, the formidable mathematical “Modern Financial Theory.” This includes Modern Portfolio Theory developed in the 1950s; the Efficient Market Hypothesis and the Capital Asset Pricing Model developed in the 1960s; the weird and wonderful universe of financial derivatives pricing models, including notably the Black-Scholes-Merton equation for valuing options, developed in the early 1970s, and its many derivatives; and financial risk management or, more accurately, the modern quantitative theory of financial risk management, which emerged in the 1990s.

Modern Financial Theory soon became widely accepted; those who questioned it were, for the most part, drummed out of the finance profession. It became even more respectable with the award, to date, of no fewer than seven Economics Nobels, ample proof of its scientific respectability.

Modern Finance was big on promises. We were assured that it would provide us with the ever-expanding benefits of “financial innovation” and sophisticated new financial “services,” and not just at the level of the corporation, but trickling down to the retail level, benefiting individual savers and investors in their everyday lives. The evidence for this was, allegedly, the much greater range of choice of financial services available and the expanding size of the financial services sector as a percentage of GDP. At the same time, improvements in financial risk management meant that we could sleep easily in our beds, knowing our hard-earned money was safe in the hands of financial institutions working on our behalf. Or so we were led to believe.

Yet, intellectually impressive as it is, most of this theoretical edifice was based on a deeply flawed understanding of the way the world actually works. Like medieval alchemy, it was an elegant and internally consistent intellectual structure based on flawed assumptions.

One of these was that stock price movements obey a Gaussian distribution. While the Gaussian distribution is the best-known distribution, it is only one of many, and has the special property that its “tails” are very thin - i.e. that events from outside the norm are truly rare, never-in-the-history-of-the-universe rare. History tells us that’s not right; markets surprise us quite often.

Among some of the other common but manifestly indefensible claims of Modern Finance are that:

• modern “free markets” ensure that financial innovation is a good thing, which benefits consumers and makes the financial system more stable;

• risks are foreseeable and, incredibly, that you can assess risks using a risk measure, the Value-at-Risk or VaR, that gives you no idea of what might happen if a bad event actually occurs;

• highly complex models based on unrealistic assumptions give us reliable means of valuing complicated positions and of assessing the risks they entail;

• high leverage (or borrowing) doesn’t matter and is in any case tax-efficient; and

• the regulatory system or the government will protect you if some “bad apple” in the financial services industry rips you off, as happens all too often.

The invention and dissemination of Modern Financial Theory is a startling example of the ability to achieve fame and fortune through the propagation of error that becomes generally accepted. In this, it is eerily reminiscent of the work of the Soviet biologist Trofim Denisovich Lysenko, a man of modest education whose career began when he claimed to be able to fertilize fields without using fertilizer.

Instead of being dismissed as so much fertilizer themselves, Lysenko’s claims were highly convenient to the authorities in the Soviet Union, and he was elevated to a position of great power and influence. He went on to espouse a theory, “Lysenkoism,” that flatly contradicted the emerging science of genetics and was raised to the level of a virtual scientific state religion. Those who opposed his theories were persecuted, often harshly. Lysenko’s theories of agricultural alchemy in the end proved highly damaging and indeed embarrassing to Soviet science, and Lysenko himself died in disgrace.

Of course, the analogy is not perfect: proponents of Modern Financial Theory did not rely on Stalin to promote their ideas and silence their opponents, nor did they rely on the prison camps. Instead, their critics were sidelined and had great difficulty getting their work published in top journals, so ending up teaching in the academic “gulag” of less influential, lower-tier schools. But what the two systems share in common is a demonstrably false ideology raised to a dominant position where it inflicted massive damage, and an illusion of “scientific” respectability combined with a very unscientific unwillingness to listen to criticism.

For its part, the financial services industry eagerly adopted Modern Financial Theory, not because it was “true” in any meaningful sense (as if anyone in the industry really cared!) but because the theory served the interests of key industry groups. After the investment debacles of 1966-74, investment managers wanted a scientific-seeming basis to persuade clients to entrust their money to them. The options and derivatives markets, growing up after 1973, wanted a mechanism to value complicated positions so that traders could make money on them. Securities designers wanted mechanisms by which their extremely profitable derivatives-based wrinkles could be managed internally and sold to the public. Housing securitizers wanted a theory that reassured investors and rating agencies about the risks of large packages of home mortgages, allowing those packages to get favorable credit ratings. Back-office types and proprietary traders wanted models that would provide plausibly high values for the illiquid securities they had bought, allowing them to be marked upwards in financial statements and provide new profits and bonus potential. Most of all, Wall Street wanted a paradigm that would disguise naked rent seeking as the normal and benign workings of a free market.

With this level of potential support, it’s not surprising that Modern Financial Theory was readily adopted by Wall Street and became dominant there, even though crises as early as 1987 demonstrated that it was hugely flawed. It didn’t hurt that, in parts of the business, the universal adoption of Modern Finance techniques tended to validate them, as options prices arbitraged themselves towards their Black-Scholes-Merton value, for example. After 1995, the loosening of monetary conditions for a time created an apparently eternal “Great Moderation” bull market environment in which Modern Finance techniques appeared to work well, but then broke down completely when they were really needed.

Nevertheless, for those with open eyes, it has been apparent for some time that Modern Financial Theory wasn’t delivering what was promised on its behalf. The industry was benefiting, to be sure: its remuneration skyrocketed, and perhaps that had something to do with its expanding share of GDP. But what about everyone else? What exactly were these new financial services that were benefiting us all? More credit than we could afford to repay? Subprime mortgages? Unwelcome cold calls at dinner time from our bank pestering us to buy expensive “products” we didn’t want? Or, at the corporate level, credit derivatives perhaps? And if risk management was working so well, why were there so many risk management disasters over the last two decades? Something was going wrong.

For a long time the problems were explained away or swept under the rug, and critics were dismissed as coming from the fringe: if you held your nose and didn’t look too hard at what was going wrong, you could perhaps still just about persuade yourself that it really was working. Occasional problems were, after all, only to be expected.

But there eventually came a point where denial was no longer an option: as institution after institution suffered unimaginably unlikely losses in 2007 and 2008 and much of the banking system simply collapsed, the edifice of Modern Financial Theory (and especially Modern Financial Risk Management) collapsed with it.

And, to any flat-earther who denies what is self-evident to everyone else, we would ask: if the events of 2007-08 do not constitute a failure of Modern Financial Theory, then what exactly would?

Yet, even after this debacle, Modern Financial Theory remains in daily use throughout Wall Street. Its models are still used to manage investments, value derivatives, price risk, and generate additional profits, just as if the crash had never happened. Needless to say, this refusal to recognize reality is deeply unhealthy, although the costs will probably be borne yet again by taxpayers and the global economy in general rather than by Wall Street’s denizens themselves. A new paradigm is urgently needed.

The second belief system that led to financial disaster is one which celebrates the benefits of state intervention into the economy. Of course, there are many such belief systems, but the one most directly relevant when seeking to understand the current financial crisis is Keynesian economics. The “defunct economist,” in this case, is Keynes himself.

Keynesian economics came to dominate economic thinking in the 1930s, as people tried to come to terms with the calamity of the Great Depression. It maintained that the free market economy was inherently unstable, and that the solution to this instability was for the government to manage the macro economy: to apply stimulus when the economy was going down, and put on the brakes when it was booming excessively.

In his General Theory, Keynes explicitly put himself in the dubious tradition of the monetary cranks, the “funny money” merchants of old, who had been dismissed before then. He sneered at the Gladstonian notion that the government should manage its finances like a household and instead offered a macroeconomics founded on paradox - in particular, the “paradox of thrift,” a notorious idea infamously espoused by Bernard Mandeville in his Fable of the Bees: or, Private Vices, Publick Benefits (1714) that caused great offence when it was first suggested and was aptly described later as a cynical system of morality made attractive by ingenious paradoxes. The gist of it was that we can somehow spend ourselves rich. Keynes not only resurrected the idea and made it “respectable,” but enthroned it as the centerpiece of his new theory of macroeconomics.

Keynes liberated us from old-fashioned notions about the need for the government to manage its finances responsibly, inadvertently perhaps also paving the way for the more recent belief, widespread before the current crisis, that we as individuals didn’t need to be responsible for our own finances either.

Keynesianism ruled the roost for a generation or more. In practice, Keynesian policies almost always boiled down to more stimulus, typically greater government spending and/or expansionary monetary policy.

The result was inflation, low at first, but by the late 1960s a major problem. Keynesianism never really came to terms with this problem, and its most significant attempt to do so - the treacherous Phillips curve, interpreted by Keynesians as a trade-off between inflation and unemployment - was refuted by Milton Friedman in his famous presidential address to the American Economics Association in 1967. In the long term, no such trade-off existed.

Yet policymakers were reluctant to embrace Friedman’s position that bringing inflation down required tight monetary policy - lower monetary growth and higher short-term interest rates - which was likely to produce short-term recession as a side effect. Policymakers were hooked on “stimulus.” In any case, if inflation ever did get out of hand, they could always apply brute force or wage and price controls to contain it, and they ignored the warnings of Friedman and his monetarist followers that controls wouldn’t work either.

Keynesian economics reached the apogee of its influence after World War II in both the United States and Britain, then ran into serious trouble in both countries after 1970. After the 1970s’ Keynesian-driven stagflation, a move towards much tighter money eventually worked. Inflation was brought down and seemed to be conquered for good.

Yet slowly, quietly, Keynesianism made its comeback. Most economists and policymakers had never entirely given up on the idea that policy should have some element of “lean against the wind,” even if they acknowledged that “old” Keynesianism had gone too far. Moreover, as the memories of past inflation horrors began to dim, the Federal Reserve in particular slowly began to squander the inflation credibility it had earned with such difficulty and cost in the Paul Volcker 3 years of tight money in the late 1970s and early 1980s. In the meantime, Volcker had been replaced by Alan Greenspan,4 who began in the mid-1990s to pursue the easy-money policy demanded by politicians and the stock market. For over a decade the Fed pushed interest rates down, and its ‘accommodating’ - that is to say, expansionary - monetary policy fueled a series of ever more damaging boom-bust cycles in asset markets, the worst (so far) of which culminated in the outbreak of crisis in the late summer of 2007.

More ominously, the policy response to the most acute crisis since the Great Depression was massive stimulus - deficit spending on an unprecedented scale; even more accommodating monetary policy, with interest rates pushed down to zero; and massive taxpayer bailouts of financial institutions and of the bankers who had led them to ruin. Keynesianism was now back with a vengeance. Thus, in another one of those Keynesian paradoxes, the Keynesian medicine that had helped fuel the crisis was now, in huge doses, the only solution to it. The irony was lost on most policymakers.

One of the few exceptions who didn’t lose his mind in the panic was the social democrat German finance minister, Peer Steinbrück. In December 2008, he expressed the bewilderment of many when he observed how

“The same people who would never touch deficit spending are now tossing around billions [and, indeed, much more]. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn’t this the same mistake everyone is suddenly making again …?” 5

Indeed it is.

Both these ideologies, Modern Financial Theory and Keynesian economics, have proven themselves vulnerable to the revenge of the gods of the Copybook Headings, in the words of Rudyard Kipling’s poem. Kipling wrote it in 1919, at a time of sadness and disillusionment after losing a son in World War I. Its central theme is that whatever temporary beliefs we may acquire through market fluctuations or fashionable collectivist nostrums, eventually the old eternal truths of the children’s copybook return to punish us for having departed from them:

“Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew

And the hearts of the meanest were humbled and began to believe it was true

That All is not Gold that Glitters and Two and Two make Four

And the Gods of the Copybook Headings limped up to explain it once more.” 6

Kipling was an instinctive economist; this verse of the poem describes exactly how the wizards of the tech boom and the housing boom withdrew at the peak of the market, when the gods of the Copybook Headings reawakened and took their revenge. Traditional truths about the market that had been thought outdated and irrelevant were then revealed to have been in control all along.

Copybook Headings whose gods have already come back to haunt us include the following, out of many others:

“Speculation always ends in tears.” This is the oldest Copybook Heading of all, and we have all known about this since the foolish Tulip Mania in Holland in 1636-37, when at one point 12 acres of prime farmland was allegedly offered for a single tulip bulb - needless to say, a painful crash followed. A recurring feature of speculative manias is how, as the market peaks, those involved reassure themselves that some new paradigm is now in control that guarantees that, this time, the laws of economics no longer hold and the market can only go up and up. We saw this at the peak of the tech bubble when “new economy” proponents assured us that internet stocks obeyed a different set of rules, free of the constraints of old economics. The central premise of Pets.com, that money could be made by express shipping catfood around the US, was so risible that a moment’s reality therapy should have exposed it, but there was no reality in that market. We saw it again in 2006-07, when believers in the Great Moderation fallacy assured us that the vagaries of the business cycle had finally been conquered, shortly before a very immoderate crisis broke loose. The god of this Copybook Heading is particularly powerful and vengeful, with a long memory.

“Whoever makes a loan has responsibility if it goes wrong afterwards.” One of the most important gods of traditional banking, this one was widely flouted in the securitization markets, in which loan originators were able to escape responsibility for poor credit decisions. The result was an orgy of poor housing lending, involving not simply poor credit decisions but outright fraud, connived in by loan originators who collected their fees and passed the fraudulent paper on to Wall Street and international investors. In this disaster, Wall Street was self-deluded, drunk with excessive money supply, aided and abetted by mortgage brokers whose ethics would have made used-car salesmen blush.

“Don’t take risks that you don’t understand.” Flouted openly in most bubbles, this god was drugged during this one by perverted science, most egregiously, by “Value-at-Risk” risk management methods, which controlled risk just fine provided that the markets involved were not in fact particularly risky.

“The maximum safe leverage is 10 to 1 for banks and 15 to 1 for brokers dealing in liquid instruments.” This Copybook Heading was widely ignored, most openly by investment banks operating at leverage ratios of over 30 to 1 by the end of 2007, the sin made worse by banks hiding their risks by pushing assets off their balance sheet by use of “structured investment vehicles” funded by commercial paper that was apt to become illiquid when most needed. This god’s revenge is traditionally very painful and is proving so again.

“Investments should be recorded in the books at the lower of cost or market value until they are sold.” This time around the accounting profession adopted “mark-to-market” accounting, which allowed investments to be “marked up” on rises in value, with mark-up earnings reported and bonuses paid even when the investments had not been sold. Wall Street is now bleating about “mark-to-market” because it requires mark-downs of investments that have fallen in value; the real reason why it should be dropped is its enabling of spurious mark-ups, of which the Street took full advantage. Mark-to-market is highly pro-cyclical and provides counterproductive incentives to fallible and greedy bankers. But as this Copybook Heading god is rather young and junior, it is not yet clear how severe his revenge will be.

“Don’t inflate broad money much faster then real GDP.” This very mild version of the Sound Money Copybook Heading seeks to ensure stable prices and suppress asset bubbles. It was followed by Paul Volcker and by Alan Greenspan in his first seven years in office, then abandoned in early 1995, since when money supply has soared ahead of real GDP. Its abandonment resulted in series of asset bubbles, the more dangerous of which was that in housing because of the debt involved. Its god is something of a Rip Van Winkle, having allowed 12 years of misbehavior whilst he slept soundly from 1995 to 2007, but is exceptionally powerful and malignant when roused, as we discovered in 2008, but may need to learn again.

“Save for a rainy day.” One of the oldest and most venerable Copybook Headings, this articulates the notion that long-term prosperity requires that we restrain our impulse to spend everything today, and be especially careful about living on credit. Keynes and his followers took particular delight in teasing its god with their arguments that prosperity required spending rather than saving. This god is famously slow to anger, but his revenge is devastating when it comes: his specialty is a disappearing act, when all that credit-fuelled prosperity suddenly vanishes and those who defy him discover to their dismay that they are thrown out on their ears, stark naked, like Adam and Eve expelled from the Garden of Eden.

As well as the above gods, whose revenge has already become partly or fully apparent, recent events have flouted further Copybook Headings that will in due course no doubt produce further retribution:

“Allow capital to flow to its most productive uses.” This Heading is always flouted during bubbles, when capital is allocated to innumerable unproductive dotcoms or ugly undesirable McMansions. It is sometimes also flouted during downturns, when the government rescues failing industries, devoting capital to the dying and unproductive. Examples abound, notably in Britain in the 1960s and 1970s and in France in the 1980s and 1990s. In the present crisis, there is not just the $700 billion debt bailout, but the $400 billion rescue of Fannie Mae and Freddie Mac, the $50 billion rescue of the automobile industry, and the clearly impending bailouts of overseas governments and various states and municipalities in the US to be considered. In downturns, capital is especially scarce; hence flouting this Copybook Heading during a downturn produces a much nastier revenge by its god, killing off far more new and productive investments than it would in a boom and slowing long-term economic growth to a crawl.

“Keep the fiscal deficit to a level that prevents the public debt/GDP ratio from rising.” This, originally propounded by Gordon Brown, when UK Chancellor of the Exchequer and before his recent apostasy, for which he will certainly be called to account, is the wimpiest possible version of the Copybook Heading warning against budget deficits. The stricter and more substantial versions of Gladstone’s time mandated low levels of government debt and prohibited deficits altogether. The Brownian version is the bare minimum, and even that is defied now more than ever before, both in the short term through $1 trillion plus deficits from recession and bailouts and in the long term through the actuarial problems in Social Security and Medicare. The revenge of this god is exquisitely cruel; he turns the country into Argentina.

We can speculate why the last decade has seen such a record level of Copybook Heading flouting. Maybe the Baby Boom generation, who have been in charge, were affected so badly by the permissive theories of Dr. Spock and the “flower-power” 1960s that rejecting conventional wisdom in the form of the Copybook Headings became second nature to them. But be that as it may, the gods are clearly not happy and, as the Chinese might say, there are interesting times ahead.

In the remainder of this book, we will begin with history, move on to financial analysis, show how the theory intersected the reality, add the element of monetary policy, and demonstrate how the result was market chaos and meltdown. Having anatomized the disaster, we will suggest some solutions, theoretical, institutional, and practical, as well as examining the financial services business’s likely future.

The next two chapters are historical. Chapter 2 looks at the traditional financial system, in London and New York, and discusses why it worked, in particular what mechanisms it had to ensure its long-term continuance and the financial system’s overall stability. Chapter 3 anatomizes previous market meltdowns, drawing lessons as appropriate that throw light on recent events and on our current situation. Current difficulties have their reflections in past crises, and anatomizing a broad range of such crises is the best way to analyze the present. Useful past history is not limited to the Great Depression.

Part Two is the analytical core of the book. It begins (Chapter 4) by setting out the principles of Modern Financial Theory, along with a light-hearted gallery of the financial alchemists involved, seven Nobel prizes and all. It then (Chapter 5) examines the assumption flaws underlying the theories, why they were unrealistic, and why their lack of realism caused the theories themselves to be hopelessly fallible when applied in practice. Finally (Chapter 6), this section examines the theory of risk management, that new science, whose principles were derived from Modern Financial Theory, which gave practitioners and regulators alike a spurious sense that all was rationally controlled. Since the theories underlying risk management techniques were themselves flawed, risk management likewise broke down. Indeed, commonly practiced modern risk management turned out to be a perfect paradigm of error, focusing risk managers’ attention away from the periods during which major risks arose, and failing utterly when it was most needed.

Part Three examines the interaction of theory and practice, how modern financial theory migrated to Wall Street, and why it was given vastly more attention and resources than is granted to most professorial maunderings.

The first chapter (7) details changes in the business environment from the 1960s that both accompanied the introduction of Modern Finance and made the financial services business especially receptive to it. Chapter 8 details the process by which sector after sector of Wall Street found elements of modern theory exceedingly useful, whether as sales techniques, as spuriously precise valuation methodologies, or as generators of new opportunities to make remarkable profits producing “products” that had little or no social value or were just downright dangerous. Chapter 9 looks at the other side of the coin - how the adoption of Modern Financial Theory modified Wall Street itself. It looks at how the incentives of Wall Street interacted with the techniques of Modern Finance and captive regulators to produce a system that enlarged risk rather than controlling it, and led to unprecedented levels of rent seeking and crony capitalism. Chapter 10 then takes a closer look at the litany of financial disasters that have occurred in Wall Street’s wake.

Part Four looks at how policy, captured by Wall Street during these years, interacted with the financial markets to make matters worse. Chapter 11 looks at monetary policy, and how it metamorphosed in the last three decades, and how the long period of excessive monetary expansion since the mid-1990s fuelled a series of boom-bust cycles, so creating the perfect environment for Wall Street’s excesses. Chapter 12 looks at how the regulatory system not only failed, but actively contributed to these excesses.

Part Five, Chapters 13 and 14 looks at the events of 2007-09, the bursting of the bubbles and the market, and the public reactions to that bursting. Chapter 13 also suggests alternative steps that could have been taken at various points during the crisis, which might well have mitigated the losses for taxpayers and would certainly have reduced the crisis’ overall costs to the global economy. In the official responses to crisis, remnants of belief in the Modern Finance chimera mingled with anti-Wall Street populism, but there were very few practicable suggestions of how we might move towards a financial system that would actually work. In Chapter 14 we outline the nightmare scenario that will unfold if no substantial reform steps are taken.

Finally, in Part Six we turn to possible solutions. Chapters 15 and 16 return to first principles and discuss how financial alchemy might be turned into reality-based chemistry, the first chapter dealing with quantitative risk management methods, and the other with the needed institutional changes for the finance industry. Chapter 17 suggests some policy reforms to provide a legal and monetary framework within which the finance industry especially and the economy generally can be returned to health; underpinning this is the need to rein in rampant cronyism and restore the moral authority of the capitalist system. The last chapter offers some final thoughts on what we might learn from the dreadful experiences of recent years.

This book details how a misguided alchemy-like corpus of Modern Financial Theory combined with a wishful-thinking Keynesian mindset, ever present greed, and inept monetary and regulatory policy to produce a “perfect storm” of financial meltdown. Global prosperity, endangered in any case by the inexorable rise in population and the not unreasonable demands of the new billions for Western living standards, mandates that we learn deeply and permanently how to avoid a similar comedy of errors in the future.

2

Pre-Modern Finance

Finance is not naturally particularly risky, nor is it exceptionally profitable. Before the emergence of Modern Finance it was a stable, even slightly dull, activity whose institutional participants tended to last a couple of centuries and whose leaders were not exceptionally rich. As John D. Rockefeller reputedly said in 1913 when learning of the $100 million legacy of J. Pierpont Morgan, by far the greatest financier of his time: “Well, and to think that Mr Morgan was not even a wealthy man!” 7

Before we examine today’s finance, it is worth examining what finance used to be like. In doing so, we quickly notice that there are two distinct eras of “pre-Modern Finance.” There was the period before 1914, when finance and trade became globalized, and there was by later standards very little government control, financial regulation or taxation. Then after a “broken” period including the two World Wars, finance revived in the late 1950s, but on a much more controlled basis, in a more protectionist and restricted world. It was also organized around the reality of very high personal tax levels in both Britain and the US. This second era lasted until roughly 1980, after which the Modern Finance revolution took hold and turned the practice of finance on its head.

The financial world before 1914 evolved as a system of specialists, their specialties reflecting their origins. London merchants evolved into merchant bankers, their initial role of financing international trade later encompassing the financing of overseas governments as well. British merchant banks did not, however, generally arrange finance for domestic industry - that was done primarily by brokers.

Brokers had evolved as promoters of new companies at the time of the South Sea Bubble in 1720. They, in turn, dealt with company promoters, typically small operations headed by a flamboyant personality, which later evolved into specialists.

The London Stock Market also emerged at around the same time, and the actual trading (or “market making”) was done by jobbers. This split between brokers and jobbers was felt to protect market integrity, and to limit insider trading practices such as the “front running” of large investor orders.

In England, banking (the taking of deposits and making loans) was typically done by private banks. These were much the same size as merchant banks but evolved out of the wealthier domestic merchants in a community rather than out of any foreign trade connection. After their legal restriction to a maximum of six partners was removed in 1826, these banks grew in size, many of them taking advantage of the joint-stock (or limited liability) corporate form, especially after the Companies Act of 1862. The retail banks were involved in the low-complexity end of the business, since their principal functions were to act as risk-free homes for deposits and to finance local businesses.

In the United States, the large agglomerations of capital necessary for private banking did not exist outside the international trading community. Thus joint-stock banks on the British model, primarily oriented to retail business, never became very important. Instead, the merchant banks did both banking and broking (or issue business), and the distinction between banks that took retail deposits and banks that did primarily issue business never became so firm. So, for example, both J.P. Morgan (with a few retail clients) and First National Bank (the nucleus of Citigroup, which had a large international branch network quite early) combined some level of retail banking services with a full range of wholesale banking services. Making markets in shares, however, was in New York as in London separate from the sales function, being carried out by specialists in the New York Stock Exchange.

Other countries had somewhat different models. Paris, the third leading financial centre of the period, had “banques d’affaires” that were involved in venture capital to an extent unimaginable among the London merchant banks or even in New York. The result was a less well developed public equity market, than in the other two centers, but a financial system that if anything was rather better at developing new industrial and infrastructure ventures.

Nevertheless there was a considerable commonality about the division of labor in all three centers. All three had leaders - the merchant banks in London, the leading “universal” banks in New York, and the banques d’affaires in Paris - who arranged deals and essentially ran the system. In all three centers the brokerage function - matching buyers and sellers in securities - was regarded as secondary. And in all three centers retail banking - the taking of deposits and the making of domestic loans - was regarded as a backwater, considerably less well remunerated and less well regarded than the more dashing deal arrangement function.

At this distant perspective, it is clear that the nineteenth century had two pre-eminent financiers, at opposite ends of the century: Nathan Meyer Rothschild (1777-1836) and John Pierpont Morgan (1837-1913). Finance evolved considerably between their eras, but both were revolutionary in their impact on its practice. It is therefore instructive to examine their careers in a little more detail.

Rothschild, the son of the Frankfurt banker Mayer Amschel Rothschild (1744-1812), began in the textile business in Manchester, then in 1804 moved to London and began dealing in foreign bills, government bonds, and gold. He and four brothers coordinated a system of money transfers across the continent of Europe during the latter stages of the Napoleonic wars. After the war, he used his brothers’ international network to push Barings from its previous position of pre-eminence and establish Rothschilds as the leading house in continental bond finance, as well as in the trade finance in which his house specialized.

Morgan was also the son of a successful banker, Junius Spencer Morgan (1814-1891) a New England merchant who took over the London merchant bank that became Morgan Grenfell. He began in 1860 as New York agent for his father’s firm, then in 1871 formed a partnership with the Drexels of Philadelphia, which after 1893 he controlled outright, renaming it J.P. Morgan & Co. He made his initial fortune through bullion dealing during the US Civil War, then moved into railroad finance, where he was active in a number of reorganizations.

After 1880, Morgan moved from railroads into industrial finance, carrying out the merger that formed General Electric in 1892 and the merger that became US Steel in 1901. During the financial crisis of 1895, he bailed out the US Treasury by arranging a syndicate that provided it with a gold loan of $65 million. Most famously - and this was before the advent of the Federal Reserve System, when the US had no central bank - he played the leading role in ending the Panic of 1907 when he orchestrated the rescue of the New York trust banks and arranged the emergency sale of the Tennessee Coal, Iron and Railroad Company to US Steel.

Both Rothschild and Morgan bore certain resemblances to modern investment bankers or hedge fund managers. Both employed leverage to great effect. Both were expert insider traders, who did not hesitate to engage in “principal trading” for their own account as they arranged deals. They also leveraged their knowledge of corporate operations, political and military developments and funds flows to make profits that were unavailable to less-informed outsiders.

Today, by contrast, insider trading on corporate information is illegal, but insider trading based on inside knowledge of political developments remains common in the shadowy “crony capitalism” nexus between finance and government. As for insider trading based on knowledge of funds flows, now mechanized through computerized “automated trading programs,” it has become one of the most important profit sources for the market leaders.

In one way, Rothschild but not Morgan resembled his distant successors. Rothschild’s business was oriented much more towards markets than most merchant bankers of his day or the succeeding century, and he did not finance industrial companies except in their short-term trading activities. Hence client relationships played only a modest role in his activities. There was however one notable exception: his activities for the British government in ensuring the bullion flow to pay the Duke of Wellington’s armies in the Peninsula required close relationships with the War Office and the Treasury, and were sufficiently well known as to make his name in Britain and also make a considerable portion of his fortune.

For Morgan, by contrast, client relationships were paramount. He would have been unable to put together General Electric and U.S. Steel without a network second to none, and client service was his principal raison d’être. Morgan was a consummate market operator, but his market operations almost always had a client-driven rationale and a clear industrial logic. Above all, Morgan emphasized the quality of the advice he gave: this was key to getting deal mandates, which were the principal drivers of his firm’s profits. His advice was also much sought after, and those who sought it included a succession of Presidents, British prime ministers and other international statesmen, and the titans of American industry.

One key difference between Rothschild and Morgan and their modern equivalents was the time horizon on which they operated. For Rothschild, this was partly a matter of technology; as a major trader and trade financier, he was constrained by the limited communications of the day. Nevertheless his strategic sense in building up his business and in developing client relationships indicated that his priority was not next quarter’s profit, but to build a business that his descendants could take over. For Morgan, the long time horizon was even more explicit. By his time, communications had improved, so that instantaneous transmission of information across the Atlantic was possible. Nevertheless he worked closely with his father in his earlier years and his son in later years to build the power of the Morgan house, and create a bank with a market position that would outlast him for a very long time.

Another difference was that Morgan and Rothschild both relied on remuneration structures that were economically rational, in the sense that their incentives were much better aligned with those of the outside capital they deployed. Even if they got free shares in deals, there was no question of “incentive compensation” payouts until deals were finally sold. Nor was there any question of them taking a share of the profits in the good times whilst avoiding the losses in the bad, in the way of a modern private equity fund or hedge fund.

But probably the most important distinction between Rothschild and Morgan and their modern counterparts was the partnership structure of their operations, and consequent unlimited liability. In Rothschild’s time, limited liability was very restricted indeed; an Act of Parliament was necessary to obtain it. For Morgan, limited liability was an option, but one of which he did not avail himself either in New York or London. When Morgan Grenfell was reorganized in 1909 it remained a partnership, with the New York house being a 50% partner. Even in New York, where the major commercial banks with which Morgan competed had limited liability, Morgan still chose to keep the partnership form.

Both Rothschild and Morgan had full liability for their risks, and this liability extended to their own personal fortunes. Nineteenth century bankruptcies such as Pole Thornton in 1825 demonstrated the harsh reality of this liability: there was no safety net for either the bank or its partners if things went badly wrong. They were therefore highly unlikely to take on businesses that produced short-term profits with the danger of major long-term risks to the institution. And, of course, their willingness to bear the risks of unlimited liability was a key factor in reassuring their counterparties that their money would be well looked after.

Finally, Morgan and Rothschild employed the ethos of “gentlemanly capitalism” in which their word was trusted, and they expected business partners to be trustworthy as well. They took the motto “My word is my bond” with deadly seriousness. For his part, Rothschild realized that a reputation for probity was essential and he fought the anti-Semitism common at the time to establish a business that was highly ethical by contemporary standards and grudgingly acknowledged as such. Morgan’s ethos of gentlemanly capitalism was most famously expounded in his exchange with Samuel Untermyer, counsel to the 1912 Pujo Committee, at the end of his life:

Untermyer: Is not commercial credit based primarily on money or property?

Morgan: No sir, the first thing is character.

Untermyer: Before money or property?

Morgan: Before money or anything else. Money cannot buy it. … Because a man I do not trust could not get money from me on all the bonds in Christendom.8

It was a maxim that today’s bankers could usefully follow.

The (fairly) free market financial system came to an abrupt end on the outbreak of war in 1914. The governments of belligerent countries promptly suspended the gold standard and took control over their countries’ financial systems for war purposes. After 1918, Britain no longer had the financial strength to act as entrepôt of the world, and the Bank of England restricted British houses in their international lending.

Their internationally inexperienced cousins in New York were happy to fill the gap and seized former British clients in Latin America and Europe with enthusiasm untempered by much prudence. Inevitably, they overreached themselves and, when the next downturn happened after 1929, the result was mass defaults, and a subsequent refusal by US investors to place money overseas. With the US running massive protectionist trade surpluses in the 1930s and Britain unwilling to lend outside its Empire, the system of international finance seized up altogether. The new crisis also brought down the partially restored gold standard of the 1920s, and the resulting exchange rate instability added further to the miseries of the 1930s.