Among those in the media who raised alarms about the new debt market and rising levels of borrowing were columnists Floyd Norris, chief financial correspondent for The New York Times; Steven Pearlstein of The Washington Post; and Allan Sloan, now of Fortune. All three raised questions early and often about risks in the economy. Here’s Norris in August 2005, for instance:
If housing prices fall, will mortgages cushion the downfall, or make it worse? Put another way, will more overstretched homeowners be forced to sell? At issue is whether financial innovations that have made it easier for Americans to buy homes have also made the system less stable and more vulnerable to shocks that could drive many of them from their homes, having lost all they invested in them.
Still, Norris says he wishes he had done more. “I did not take the time to understand the intricacies of collateralized debt obligations,” he says. “What I should have known, and didn’t, was that this amounted to financial alchemy to turn risky assets into risk-free assets, or at least to mostly fund risky assets with risk-free assets.” Norris says that he assumed that the rating agencies were correctly assessing risk, and also that he didn’t understand the extent of fraud going on in mortgage lending, with appraisers being paid to come in with higher assessments. “I would have studied CDOs and CMOs and all those things much earlier than I did, and I would have understood them.” One other point he makes: “I think we were all a little too willing to assume Alan Greenspan knew what he was talking about. It seems pretty clear to me now that Greenspan worshipped free markets but didn’t understand them.”
Now that we can learn from looking backward, here are some suggestions for going forward:
Pay more attention to the credit and derivatives markets. Financial journalists focus too much on the equities markets—after all, they are easy to understand, and stock prices often tell you about the relative health of companies or industries. It may be that the equities markets are the financial equivalent of political journalists covering the horse race.
But here’s one fact to keep in mind: compared to the credit markets, the equities markets are puny. At the end of 2007, the global stock-market capitalization was $64.6 trillion, compared to the global bond-market outstanding of $79.8 trillion—or more than 350 times its size in 1990, according to the Securities Industry and Financial Markets Association.
Convincing reporters to become experts on debt markets, or even convincing them just to read trade publications such as Inside Mortgage Finance and the Asset Securitization Report can be a hard sell. It’s just not sexy. “Credit markets tower over the equity markets in dollar value,” says James Grant, of Grant’s Interest Rate Observer and the author of Mr. Market Miscalculates. But he adds, “Credit markets, except for propeller heads, have very little entertainment value.”
Yet unregulated derivatives, including most recently credit derivatives, have been associated with financial disasters, including the bankruptcy of Orange County, California in 1984; the failure of Long-Term Capital in 1998; the problems at Enron culminating in 2001; and now the Big One. So it might be a good idea to cover them more consistently and less episodically.
Question what will happen when there are fundamental shifts in the rules of doing business, whether it’s Wall Street suddenly taking public tech companies with no track record or lenders giving up the concept of underwriting—i.e., looking at whether a borrower can make the payments—in favor of a belief that housing prices can go no place but up.
Don’t rely on self-interested experts. In the case of the unregulated collateralized debt obligations, derivatives, and swaps markets and the growing hedge-fund industry, most of the experts were also players. Though there are academics knowledgeable about these markets, too many reporters didn’t push for answers from anyone beyond the International Swaps and Derivatives Association, the rating agencies, or other self-interested participants.
Put me on this list, since my quest to know more started and stopped with the Bond Market Association.
When a huge new industry springs up, make sure you understand everything you can about it. It’s true that, with respect to the collateralized securities and derivatives markets and the hedge-fund industry, they were growing in the shadows, so it was harder to know what you didn’t know.
Grant describes his Interest Rate Observer as “focused pretty much single-mindedly on these mortgage contraptions.” But he says there “was not so much the general press could have known about. So much of the mortgage crisis was cooked up behind doors that were either closed by interested parties or doors that were closed except to the adepts and cognoscenti by virtue of the complexity of the structures.”