When Adam Smith wrote The Wealth of Nations in 1776, he sealed the foundations of what probably became the world’s most dominant economic model. The ideas of free markets, laissez faire and private sector hegemony appealed to most nations. The subsequent Great Depression came as a shock to the system but most experts, including a seminal study by Milton Friedman and Anna Schwartz, attribute the blame mostly to the policies of the US Federal Reserve (the Fed) and not really to the market participants. The convenient and successful marriage between private-sector reforms and communist ideology in China and the collapse of the Soviet Union in 1991 put a lid on the debate on free markets.
The subprime crisis of 2007 then came as a rude jolt. The meltdown of the financial sector struck at the heart of capitalist ideology -- market allocation of capital and risk. There is little surprise that there has been a lively economic debate since then on how the government should build a visible risk-management framework around the realm of the invisible hand.
It is in this spirit that Robert Shiller approaches The Subprime Solution: How Today's Global Financial Crisis Happened, and What to Do About It, which was one of the first books on the credit crisis when it was released in August 2008. The first part of the book deals with how the real estate bubble built up over the years. Shiller offers some interesting unconventional explanations: how social contagion builds information cascades where rational individuals suspend their independent judgments to believe in the speculative fervour all around. Thus, feedback loops form, which proves self fulfilling for some time.
This is an interesting grey area between behavioural norms and finance to explain the herd-behaviour that accompanies bubbles. It is reminiscent of the “reflexivity theory” that George Soros introduced in The Alchemy of Finance. However, it is disappointing that an economist of Robert Shiller’s stature lets Alan Greenspan (chairman of the Fed between 1997 and 2006) and his band off so lightly, saying the failure to anticipate or act on the bubble was a result of the regulators themselves being a part of the information cascade. The low interest rates and loose monetary policy are brushed away as not being the primary exogenous reason of the bubble.
Shiller is in the same boat as Paul Krugman in saying short-term bailouts and monetary expansions are necessary evils, though he does not suggest how the resulting devil of inflation can be slayed. He offers some interesting long-term solutions parallel to the regulatory response to the Great Depression. The regulatory response standardised the 30-year mortgage from the earlier short version and we probably need some similar innovations in the mortgage contracts to better suit the current social dynamics. Increased financial transparency, more education for the masses, more liquid real-estate futures and derivatives to hedge are all sound suggestions, but one waits for the missing avalanche on the rating agencies or the inept due diligence of banks issuing subprime loans to millions who did not understand and could not afford them.
Interestingly, Shiller mentions financial democracy and Peruvian policy innovator Hernando De Soto in the same breath. Soto was well known for using ownership of property for the poor as a lynchpin for credit availability for them. Niall Ferguson in The Ascent of Money aptly replies that while the principle is fine, you cannot force houses on those who cannot afford them, and that is probably the fundamental building block of the crisis.
The Ascent of Money is a delightful read. Ferguson is a master researcher and shares nuggets of information on the Medici and Rothschild families, the development of bond and insurance markets, war-time financing and much more. We see the default of the Spanish Crown despite a pile of silver from the New World which is in stark contrast to the rise of the British and the French. It is fascinating to learn about the cotton bonds issued by the South during the American Civil War, German and Argentine hyperinflation and the success of the “Chicago reforms” in Chile.
The attempt to write a financial history of the world is a very brave one. There are some notable omissions -- Marx’s financial dialectics and the Amaranth blow-up are the most conspicuous. In other places the book feels thinly spread. For example, the industrial revolution hardly gets a mention. In focusing too much on the past, and in addressing too broad an audience, Ferguson loses some of the dazzle.
The treatment of China is also a little half-hearted. It is a puzzle why the Opium Wars are so well described, while there is not a word on Deng Xiaoping and the market reforms. Chimerica, on the other hand, is analysed well: “For a time it seemed like a marriage made in heaven. The East Chimericans did the saving. The West Chimericans did the spending”. What happened next is of course history in the making.
The book ends on a philosophical note. There are parallels drawn between Darwin’s theory of natural evolution and the Schumpeterian principle of creative destruction. While that is a good way to chart the past, it sometimes feels as if there isn’t enough justice done to the present credit crisis.
And this is precisely where Michael Lewis takes over in The Big Short. The book focuses exclusively on every twist and turn in the crisis, through the eyes of a handful of investors who shorted subprime markets and made money. We meet Greg Lippmann, an obscure trader at Deutsche Bank, who tried hard to sell his short subprime trade idea to anyone who would listen. He would make spreads on executing the trade while his clients would make money on the trade -- it is surprising how little response he got. You can take the horse to the water but can’t force…..well you get it.
We also hear how Steve Eisman from Front Point Partners, Michael Burry from Scion Capital and Jamie and Charlie at Cornwall Capital Management discovered the trade, each in their own way. All the other characters on Wall Street are present, including the inept rating agencies which maintained assumptions of rising home prices and 5% loan losses right up till the heart of the crisis and American Insurance Group (AIG), which sold credit default swaps on collateralised debt obligations (CDOs) at as low as 28bp and sleazy CDO desks that peddled out the lethal risk in small bundles.
These trades take time to yield results and it is revealing to see Michael Burry at Scion dealing with impatient investors who threaten legal action at all times. These are realities for all hedge fund managers.
Michael Lewis has a tight grip on the pulse of Wall Street. Morgan-Stanley’s star trader Howie Hubler happily bet the house on subprime and was in fact Greg Lippman’s counterpart for two deals of triple-A rated CDOs worth $2 billion each. Steve Eisman shorted Merrill Lynch because “whenever there’s a calamity, Merrill’s there”. On the other hand, Goldman Sachs “did not leave the house before it began to burn; it was merely the first to dash through the exit -- and then it closed the door behind it”.
There is a slight surprise at the end. At a lunch with John Gutfreund, both Gutfreund and Lewis agree that most of the perverse incentives and faulty risk management at Wall Street could be traced back to the decision by investment banks to go public. No one can deny that we need more regulation and a better framework for the banks, but it is tough to imagine a world with no listed financial institutions. Lewis is a master story teller and should perhaps stick to that rather than try to work his magic to draw out solutions to the crisis.
Anuja Agarwal is a freelance writer based in Hong Kong.
