We’re up to Part VI, which means we’re over halfway through the breakdown of financial crisis literature. Today John S looks at what might be the best book about the crisis, and what might be the most fun.
All the Devils Are Here: The Hidden History of the Financial Crisis
by Bethany McLean and Joe Nocera, 2010
If I had to recommend just one book about the financial crisis, it would probably be All the Devils Are Here. It’s not necessarily the best-written or most thrilling book on the subject, but it’s the most comprehensive, and perhaps the only book that captures just how nuanced the causes of the crisis were. Instead of focusing on one bank or one cause or one period of time, McLean and Nocera trace the origins of the crisis back decades, and examine precisely how things evolved.
One thing they illustrate well is how Wall Street tends to create something useful, and then, in the course of trying to find new ways to make money off it, turns it into a weapon of wealth destruction. In the 1980s, for example, mortgage-backed securities seemed like a great idea. Grouping mortgages together into one security allowed investors to introduce capital to the industry without being subjected to the inefficiencies or risks inherent in one mortgage or even one region. They also helped the GSEs’ bottom lines, of course.
But as time went on, these securities changed the mortgage market itself. Wall Street’s demand for mortgages to securitize lowered lending standards and increased shady lending practices, like ARMs and NINJAs.
This pattern repeats itself throughout All The Devils: Wall Street does something innovative which, initially, solves a problem, but eventually creates far more problems. One chapter tells the story of VaR (Value at Risk), a tool created by JPMorgan in the 1990s to measure volatility. VaR used the bell curve to determine how much risk a firm was exposed to in 95% of circumstances. It “didn’t say a thing about what might happen the other 5 percent of the time,” but as a tool for measuring day-to-day risk, it was nevertheless helpful. Of course, as time went on and VaR became more commonplace, traders began using it as a synonym for risk itself, which obscured much of the risk banks were exposed to.
In yet another example, credit default swaps were created as a useful tool for spreading risk. JPMorgan’s first CDS actually came out of the Exxon Valdez disaster, when Exxon took a $4.8 billion loan in anticipation of the government fine. Rather than be exposed to so much risk from just one loan, though, JPMorgan agreed to pay a fee to a European bank in exchange for that bank assuming the risk of default. This made sense for both parties: The European bank pocketed money for assuming the risk of an almost riskless loan (Exxon was one of the biggest corporations in the world, disaster or not), and JPMorgan was able free up more capital for other loans.
These transitions from “useful tool” to “dangerous weapon” would also not have been possible without the aid of government. In 1996, just a few years after the first major CDS, the Federal Reserve “put out a statement saying that if a bank used credit default swaps… it would be allowed to hold less capital.” This led to a growth of tradable swaps and other derivatives, since they allowed banks to free up capital for other investments.
Meanwhile, the government was simultaneously saying that these derivatives were not futures,* and therefore were not subject to regulation by the Commodities and Futures Trading Commission (CFTC). This meant that a ballooning sector of the financial industry was getting virtually no government oversight.
*TIMEOUT: What is a “future”? A future is just an agreement to buy or sell a product at a certain price on a certain date. Historically, these contracts were developed for commodities like grain or oil, where prices are subject to a large number of variables outside of a buyer or seller’s control. With futures, a buyer and seller can both lock in a price for a sale without having to worry about, say, how big next year’s crop will be. Of course, there are now futures for nearly everything, but they are, by law, traded on exchanges so that prices are not opaque.
Since derivatives, like futures, were deals that were subject to some unknown future risk (in this case the risk of default) and are essentially agreements to buy something (in this case, a loan) at a fixed price at some specific date, it seems logical that they too would be considered futures. But banks resisted this classification for many reasons, not least of which was that trading on exchanges eliminates much of the information asymmetry that banks have about pricing.
Of course, even the story of government regulation is more nuanced than it seems, and McLean and Nocera go into great detail on that as well. Although the common perception is that the Federal Reserve “missed” the bubble in subprime mortgages, All the Devils identifies at least three people who tried to bring the issue to the attention of the Fed. At each instance, they were beaten back by those who insisted the market would regulate itself.
A similarly depressing story surrounds Brooksley Born, the head of the CFTC in the late 1990s, and her attempts to investigate the issue of derivatives. While the government initially insisted that derivatives were not futures and not subject to regulation, part of the rationale was that they were traded among “sophisticated” investors.* After investigating, though, Born concluded that many of these deals were using standardized language and being traded essentially off-the-rack. If so, then shouldn’t they be traded on exchanges, like futures?
*The credence and leeway given to “sophisticated” investors is another recurring motif in the story of the financial crisis.
As soon as Born broached the subject, however, she was met with resistance and downright hostility. What’s more surprising, though, is that this resistance and hostility didn’t just come from Wall Street, but from other figures in the government. Robert Rubin, then the Treasury Secretary, told her to back off, and Larry Summers screamed at her. In the last law President Clinton signed before leaving office, the Commodity Futures Modernization Act of 2000, derivatives were officially left out of futures regulation.
The picture McLean and Nocera provide of government oversight isn’t one of complete negligence or even outright corruption.* Instead, it’s of countless bureaucrats butting heads, and ex-CEOs trying to regulate their former colleagues. In many ways, this is even more disconcerting.
*Though certain things, like Rubin overseeing the repeal of Glass-Steagall as Treasury Secretary and then jumping to Citigroup, the company for whom the law was repealed, for a lucrative deal less than a year later certainly comes close.
But government failure was just one small part of the overall system failure. All the Devils gives perhaps the best explanation of the failures of the ratings agencies, and of the downfall of AIG.* Perhaps the most impressive thing about the book, though, is that it manages to tie all these stories together. Although the book is structured such that each chapter tells one story of the crisis, the authors never lose sight of the overall picture. They are adept at tying the Federal Reserve’s lax policies to the growth of the CDS market, the rising subprime market to the falling credibility at the ratings agencies, the success of Goldman Sachs to the failure of Merrill Lynch, etc. It is more than just impressive that McLean and Nocera can keep all these balls in the air—it is crucial to actually understanding the crisis as a whole.
*TIMEOUT: What exactly was the deal with AIG? AIG was one of the biggest failures of the crisis, but its failure was somewhat unusual. AIG is an insurance company, not an investment bank, yet it was still financial instruments that doomed it.
Although I never read a book that dealt solely with AIG, its story was told many times, and its role was pretty integral, so here’s a brief recap: One division of AIG, known as AIG-Financial Products, or AIG-FP, ended up being on the other end of the credit default swaps the banks were selling. In other words, when people like Burry and Paulson were buying their swaps, their hefty annual fees were going to AIG-FP.
On some level, this made sense: CDS were a kind of financial insurance, and AIG-FP was the financial division of an insurance company. But AIG-FP clearly didn’t understand the risk of these deals. As Joseph Cassano, the former head of AIG-FP, famously said, “It’s hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these transactions.”
In other words, he assumed, probably based on their AAA ratings, that the bonds would never default. And since CDS were not regulated like insurance, AIG-FP didn’t have to keep capital on hand in the event of a default. Instead, it used the AAA rating of AIG itself to borrow money cheaply. In its deals with investment banks, however, collateral calls were built in the event of a downgrade. As the bonds and AIG were downgraded, the banks started demanding this collateral from AIG-FP, which they could not provide. At this point, the government stepped in—first in the form of a loan from the Fed, then cash directly from TARP—to pay off AIG’s debts in full.
Reading All the Devils not only gives one a sense of the problems, but of their collective size. Although many people did indeed recognize pieces of the puzzle ahead of time, nobody could really see how they all fit together. Some people saw the housing bubble, others recognized that banks were overleveraged, others saw the dangers of derivatives, or the weaknesses of the ratings agencies models, but it was only when all these things were put together that the immensity of the problem emerged.
Nevertheless, the book is not hopeless about the inevitability of such disasters. Indeed, there are so many patterns and stories that repeat themselves in different sectors of the financial industry that it doesn’t seem impossible to identify and fix the overall problems. On whether or not that will actually happen, though, the authors conclude, “One can only hope…”
by Matt Taibbi 2010
Matt Taibbi is not known for his restraint. He was, after all, the writer who referred to Goldman Sachs as “a great vampire squid wrapped around the face of humanity.” And his book is no different—an unapologetic polemic aimed squarely at Wall Street and its excesses.
Unfortunately, sometimes Taibbi’s passion overshadows his perceptiveness and his great reporting. There are parts of Griftopia that vividly depict aspects of the crisis that normally go unmentioned, and then there are parts that are simply beautifully crafted invective.
At times, he manages to blend these two aspects, like when he breaks down the Tea Party, referring to Rick Santelli, who helped spawn the movement, as “a half-baked PR stooge shoveling propaganda coal for bloodsucking transnational behemoths.”
Behind that scorn, though, is an incisive breakdown of how the Tea Party and other populist political movements that followed the crisis managed to propagate the myth that the bubble was all poor people’s fault.
Of course, sometimes unrestrained vitriol* gets in the way of a good point, and some of Taibbi’s arguments—his book consists of self-contained essays on different subjects related to the concept of Wall Street greed—suffer for it. His disdain for Goldman Sachs, for example, seems more symbolic than substantive.
*Taibbi’s chapter on Alan Greenspan is called “The Biggest Asshole in the Universe.”
It’s true that Goldman seemed to be at the center of so many shady dealings during the crisis, but the firm’s real crime seems to have been being good at its job. It did a better job of guarding against risk, of limiting exposure, and of anticipating the bubble’s burst. This led to some unsavory profits, but Taibbi takes it a step to far.
He hypothesizes, for example, that Goldman’s collateral calls against AIG were in some ways designed to drive AIG out of business. While it’s true that the bailout of AIG was in many ways a backdoor bailout of Goldman (since AIG owed so much to the investment bank, and used a sizable portion of government funds to pay that debt), it hardly seems likely that Goldman wanted to drive AIG out of business. What possible motive could Goldman have for that?
Taibbi sometimes seems so caught up in his strong rhetoric that he fails to make a substantive argument. This is frustrating, because when he does make substantive arguments, they are very good. His chapter on the commodities bubble of 2008—back when gas prices shot up over $4-per-gallon for the first time, and then plummeted to under $2 just months later when the bubble burst—is a truly excellent work of reporting, getting past the political rhetoric and examining the workings of the commodities market.
Of course, even there, he sometimes gets too worked up. When inspecting the insufficiency of common explanations for the oil bubble, he points out that the chief economist of the CFTC cited “fundamentals” like the weather for the record high gas prices: “The government’s chief economist on the matter blamed the oil spike on the weather!” Taibbi writes incredulously. But the weather is a totally reasonable variable to cite when considering gas prices, since weather affects demand for oil. Taibbi persuasively argues that the weather isn’t enough to explain the wild divergence in prices, but that hardly calls for being so dismissive of the CFTC’s report.
I shouldn’t complain too much about Taibbi’s passion, though. In some ways, the best thing about reading him is his refusal to hold back. Like Ritholz’s book, there is something viscerally pleasing about reading someone so obviously angry, and Taibbi is even better than Ritholz at writing angry. What’s more is that Taibbi is obviously not worried about inciting “class warfare”—he relishes it. Taibbi writes as if everything the banks do is stupid or evil or, most likely, both. And while this may not seem like the most sophisticated moral judgment, it at least tempers the overwhelming deference so many tend to show towards Wall Street.
As Taibbi puts it, “Even after the rich almost destroyed the entire global economy through their sheer unrestrained greed and stupidity, we can’t shake the peasant mentality that says we should go easy on them, because the best hope for our collective prosperity is them creating wealth for us all.” Indeed, it’s nice to have someone like Taibbi, ready and willing to call bullshit on that idea.