Surveying the Wreckage: What can we learn from the top books on the financial crisis?

City Journal:

In January 2007, four small-time fund managers with few Wall Street connections invited themselves to a Las Vegas conference of players in the mortgage-bond business. The interlopers’ mission: to see if they were wrong in betting against subprime mortgage securities. They found a money manager who couldn’t care less if his clients lost everything on mortgage-related collateralized debt obligations (CDOs): he made money on quantity, not quality. They found a Bear Stearns CDO salesman more interested in playing cowboy at a shooting range than in discussing the housing market. They found ratings analysts utterly indifferent to their crucial jobs—assessing the risk of trillions of dollars’ worth of mortgage-related securities. And they learned about some of the average people who had taken out so many mortgages, including a stripper who was juggling five home-equity loans, all dependent on ever-rising home prices.

The four men went home surer than ever that “this is a fictitious Ponzi scheme,” as one of them told journalist Michael Lewis, who recounts the story in his gripping new book The Big Short: Inside the Doomsday Machine. “Convinced that the entire financial system had lost its mind,” they ramped up their bets. One of the men told his mother that America risked “the end of democratic capitalism”; she suggested that he take an antidepressant. But the four were right, of course, and once enough investors agreed with them, the housing and financial bubbles burst and drove the economy into a deep contraction.

It would be easy to read the Vegas story as one more piece of evidence that free markets in the financial world failed us over the past two years. How could the markets have been so wrong, so careless, and so wasteful? Even Steve Eisman—one of the four Vegas interlopers, who made a mint from their contrarian stand—sees the financial crisis as evidence of market failure. Eisman was shocked, he told Lewis, that “inside the free market” there hadn’t been any “authority capable of checking its excess.” This has become the casual mainstream narrative arc of the crisis: deregulation took the economy down, and the government had to step in to save us from free markets.

Over the past year, hundreds of authors have published books on the crisis. What becomes clear—often despite the authors’ own intentions—after reading ten of the most significant of these works is that the mainstream narrative is wrong. Over the two decades leading up to 2008, financial markets were anything but free. The nuts-and-bolts government infrastructure that free markets require to thrive—healthy fear of failure, respect for the rule of law, and fair rules for everyone—was crumbling. The crisis books make clear, too, that Washington’s extraordinary rescues of Wall Street have eroded much of what’s left of free-market infrastructure in finance. Worse, Congress’s efforts to reform the industry will do yet more damage. The next time the financial world implodes, it will hurt the economy even more severely.

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The answer lies in the United States government’s quarter-century-old policy toward the financial sector: to subsidize its growth at all costs. The delirious 1980s party on Wall Street lasted until 2008—and has even started up again—because a bailout-happy Washington hasn’t allowed finance to benefit from the market discipline of self-correction. This policy has been particularly damaging because the financial industry underpins the rest of the economy. Financiers determine which industries, which companies, and which individuals get investment capital, and on what terms. A distorting government hand in finance reaches past Wall Street into every industry and community in America and beyond.

A decade before Lewis landed at Salomon, Wall Street was already becoming proficient in bailouts. In 1975, the City of New York looked close to defaulting on its municipal bonds, as Charles Gasparino, now a Fox Business reporter, recalls in The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System. But a young bond salesman named Jimmy Cayne—the pot-smoking, bridge-playing future CEO of Bear Stearns—didn’t think his city would walk away from its debt. Cayne bought tens of millions of dollars’ worth of New York’s bonds from panicked investors, who were selling them for pennies on the dollar. When the state and the feds came through with a rescue, Cayne had made a “small fortune” for his firm. It was a great trade. But Gasparino fails to mention the most fateful part of the tale: Cayne undoubtedly absorbed the lesson that the federal government, fearful of the disruptive consequences, would not let big borrowers default. He was among the first to bet on bailouts.

Over the next decade or so, the lesson would be repeated, with financial firms becoming the borrowers considered “too big to fail.” In the early eighties, Washington bailed out lenders to the Continental Illinois bank. Later that decade and into the next, it rescued the bondholders of big savings-and-loan banks. As lenders to the financial industry grew comfortable, realizing that their money wasn’t at risk, and as interest rates and inflation plummeted, the banks and investment houses could borrow more, earning ever-fatter profits. Wall Street could help old-fashioned banks lend more to consumers, too, by transforming debt into tradable securities and getting it off small banks’ books quickly. Financiers became more and more creative, eventually threading untenable debt levels through the economy by using “exotic” debt derivatives—financial instruments whose value derived from the value of certain debt securities. These instruments were exotic only in that they escaped Depression-era rules limiting borrowing (so as to protect the greater economy from mass financial bankruptcy) and enforcing public trading of securities (so that everyone could see what was going on).

The problem wasn’t “Wall Street greed,” the first culprit implicated in Gasparino’s subtitle, but “government mismanagement,” the second. Finance was responding rationally to the government’s signal. That signal got stronger in 1998, when the Federal Reserve forced the nation’s big banks to rescue lenders to the Long-Term Capital Management hedge fund, which had relied on unregulated derivatives to make more than $1 trillion in promises to the rest of the financial system. The Fed stepped in because the hedge fund’s failure could have bankrupted two of its creditors, Lehman Brothers and Merrill Lynch, with their bankruptcy, in turn, bankrupting others. If the Fed had failed to avert the panic, “middle America” would have learned “the definition of systemic risk,” Gasparino writes. “The acute pain of systemic risk was certainly avoided, but so was a valuable lesson: that risk taking should have consequences.”

Read it all.