The Financial Times is running a very good (so far) series it calls “The Future of Capitalism” this week. At times recently it’s felt like there may not be such a future, but the profit motive is resilient and won’t be stamped out by such things as “socialist” policies that return top income-tax rates to a bit more than half what they were less than thirty years ago.
It doesn’t feel like that in banker land, though. Here’s a quote:
“Our world is broken – and I honestly don’t know what is going to replace it. The compass by which we steered as Americans has gone,” says Bernie Sucher, head of Merrill Lynch’s Moscow operations. “The last time I ever saw anything like this, in terms of the sense of disorientation and loss, was among my friends [in Russia] when the Soviet Union broke up.”
That’s from today’s edition of the series, wherein the FT’s star reporter Gillian Tett posts a very interesting analysis on the role that complexity had in causing the financial crisis. It was not insignificant, as anyone who’s tried to get his head around this has found. But don’t feel bad. The folks who created it didn’t understand it either.
During the past two decades, a wave of innovation has reshaped the way markets work, in a manner that once seemed able to deliver huge benefits for all concerned. But this innovation became so intense that it outran the comprehension of most ordinary bankers – not to mention regulators.
As a result, not only is the financial system plagued with losses of a scale that nobody foresaw, but the pillars of faith on which this new financial capitalism were built have all but collapsed. That has left everyone from finance minister or central banker to small investor or pension holder bereft of an intellectual compass, dazed and confused.
Tett does well to dip back into history, something that too often eludes us—something I’ll explain after the following:
The current crisis stems from changes that have been quietly taking root in the west for many years. Half a century ago, banking appeared to be a relatively simple craft. When commercial banks extended loans, they typically kept those on their own books – and they used rudimentary calculations (combined with knowledge of their customers) when deciding whether to lend or not.
From the 1970s onwards, however, two revolutions occurred: banks started to sell their credit risk on to third-party investors in the blossoming capital markets; and they adopted complex computer-based systems for measuring credit risk that were often imported from the hard sciences – and designed by statistical “geeks” such as Mr den Braber at RBS.
Part of the problem with the media is its institutional knowledge only goes back so far. The crusty old reporter has almost never been around more than thirty years (Carol Loomis of Fortune is a prominent exception), and the institution forgets lessons it had previously learned. So, “stocks always go up over the long term” didn’t sound so bad to those of us who weren’t reporting on finance before the 1980’s (which is almost all of us).
The problem is particularly acute with young reporters fresh out of college. They’re often only as good as their sources are, and their sources’ memories rarely go back more than twenty or thirty years. A lot of financial reporters I’ve known just don’t know much about history, and particularly financial history. That makes it easier to get caught up in the moment, to buy the “New Paradigm” nonsense that is the biggest red flag you can have that a bubble is under way.
I don’t know how to fix this problem, I’m just pointing out that it’s there.
But I digress.
Tett points out how banks gamed the “free market”:
But as innovation grew more intense, it also became plagued with a terrible irony. In public, the financiers at the forefront of the revolution depicted the shifts as steps that would promote a superior form of free-market capitalism…
In reality, many of the new products were so specialised that they were never traded in “free” markets at all. An instrument known as “collateralised debt obligations of asset-backed securities” was a case in point. This gizmo turned up in the middle of this decade when bankers created bundles of mortgage-linked bonds, often intermingled with other credit derivatives. The alphabet soup of abbreviations this generated was often as baffling as the products that the acronyms represented. In 2006 and early 2007, no less than $450bn worth of these “CDO of ABS” securities were produced. Instead of being traded, most were sold to banks’ off-balance-sheet entities such as SIVs – “structured investment vehicles” – or simply left on the books.
There’s no market if there are no trades. That’s the donnybrook we find ourselves in now as the banks (with the aid of Geithner and Obama) refuse to sell their junk assets at prices the market has set—because it would show them to be insolvent. Instead, the banks and the administration cling to the hope that these assets will come back into favor, at much higher prices—something that’s just not gonna happen.
Interestingly, Tett reports that even the computers could hardly keep up with the complexity:
The result was that a set of innovations that were supposed to create freer markets actually produced an opaque world in which risk was being concentrated – and in ways almost nobody understood. By 2006, it could “take a whole weekend” for computers to perform the calculations needed to assess the risks of complex CDOs, admit officials at Standard & Poor’s rating agency.
She then writes about how the downward spiral began, as investors realized the computer models and ratings agencies they’d relied on had been horribly wrong. And here’s the lesson:
But the brutal truth is that until financial markets live up to their name – becoming places where assets are traded and priced in a credible manner – it will be difficult to rebuild investor trust. Not for nothing does the root of the word “credit” come from the Latin credere, meaning “to believe”.
This can’t be emphasized enough. If markets are not transparent and liquid then they’re not really markets at all—they’re casinos. If a product is too complex for mere mortals (see: bankers) to understand, why should it be allowed to be created at all?