A number of books seem to have come out recently about the financial meltdown. Today's New York Times has a review of two. The title of the article - Greed Layered on Greed, Frosted With Recklessness - sums up the story. I have used the analogy of a juggling act perched on the top of a house of cards build on a foundation of quicksand. The quicksand was the overextended mortgages with teaser rates and interest only payments. (For the record, I think it was the adjustable rates that really created the ticking time bomb). The house of cards was the slicing and dicing of the mortgage-backed securities. The juggling act was the interest rate and currency arbitrage going on backed by those securities and the insurance scam know as "credit default swaps."
The book review points out a very important fact. One of the books is Fool's Gold by Gillian Tett. The subtitle of that book is especially telling: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. As the review notes:
There is another part of the overall story of this financial innovation that often gets missed. The sad fact is that all of these derivative financial instruments were designed to use financial markets to manage (i.e. reduce) risk. They are all elaborate forms of insurance -- such as by making counterbets (futures) or spreading the risk (securitization). Using the market for risk management is a useful undertaking. But, in the end many of these tools not only increased risk, they made it much less understandable and therefore much more dangerous.
There are important lessons to be learned here as we take up financial reform. But the lesson learned should not be to stop innovation in financial markets. That would be folly. The point is to understand when an innovation goes beyond its useful sphere. We generally thing of a rose as a desirable plant. But a rose growing in the middle of a wheat field is probably better characterized as a weed.
Our trick in revamping the financial system is to build a mechanism that can tell the difference between a rose and a weed -- and know when a rose has become a weed.
The book review points out a very important fact. One of the books is Fool's Gold by Gillian Tett. The subtitle of that book is especially telling: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. As the review notes:
At the heart of "Fool's Gold" is Ms. Tett's portrait of the high-octane culture at J. P. Morgan in the 1990s. She shows the premium that young hotshots there placed on "innovation" and "creativity," and she also conveys the horror that some of them later felt when they saw that their Frankensteinian brainchild had become a "rapacious scourge," as other firms monkeyed with its genetic code, moving from the world of high-grade corporate lending into the far more hazardous realm of subprime mortgages.In other words, this all started out as a positive innovation that went wrong.
There is another part of the overall story of this financial innovation that often gets missed. The sad fact is that all of these derivative financial instruments were designed to use financial markets to manage (i.e. reduce) risk. They are all elaborate forms of insurance -- such as by making counterbets (futures) or spreading the risk (securitization). Using the market for risk management is a useful undertaking. But, in the end many of these tools not only increased risk, they made it much less understandable and therefore much more dangerous.
There are important lessons to be learned here as we take up financial reform. But the lesson learned should not be to stop innovation in financial markets. That would be folly. The point is to understand when an innovation goes beyond its useful sphere. We generally thing of a rose as a desirable plant. But a rose growing in the middle of a wheat field is probably better characterized as a weed.
Our trick in revamping the financial system is to build a mechanism that can tell the difference between a rose and a weed -- and know when a rose has become a weed.
Leave a comment