Sunday, January 16, 2011

Book Review : Fool's Gold : How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe by Gillian Tett (Abacus 2010) / Whoops! Why everyone owes and no one can pay by John Lanchester (Penguin 2010) / Too Big to Fail : Inside the battle to save Wall Street by Andrew Ross Sorkin (Penguin 2010)

Syndicalist philospher Georges Sorel writes about Social Myths which may or may not be true, but act on a class or a group as a spur to action. For early Christians it was the prospect of the imminent return of Christ and for Syndicalists it was the General Strike which would herald a Socialist revolution. He writes in his Letter to Halevy that "People who are living in this world of "myths," are secure from all refutation; this has led many to assert that Socialism is a kind of religion" (

To this, Sorel could have added the Capitalists have their own myth, their own irrefutable doctrine that acts as a spur to action - that of a belief in the self-regulating nature of the markets in an environment free from regulatory interference. Now this may be true in the austere pages of economic textbooks, but generally such doctrines are underpinned by assumptions such as rational individuals making decisions based on perfect knowledge in a perfect market place. However, in reality, the rational individuals are characterised by greed and stupidity, knowledge is partial and monopolostic / monopsonistic powers hold sway over the marketplaces. The result is that markets in capitalist economies boom and crash as the tides ebb and flo and the Earth circles the sun.

However, in certain quarters there is a collective denial of the need for effective regulatory control of the excesses of the market - a quasi-religious belief in the face of all rational evidence that the markets were not only efficient but self-correcting - a denial, that is, until the Credit Crunch of 2007-9.

Now that the dust is settling on the Crunch, another mini-boom is underway - benign admittedly when compared with the excesses of expansion of Credit which characterised the early years of this century. This boom is in books from economics commentators, journalists and insiders all seeking to explain where it all went so horribly wrong, and point out what must be done to avoid repetition.

John Lanchester is an author who sought to understand for himself what was happening as the background to a novel, and discovered a more interesting story than the one he was writing. He takes a broad view and explains the concepts involved from first principles with wit, clarity and anger. If you don't know your CDSs from your CDOs then this is the place to start.

Lanchester's point is that effective legislation could have prevented the catastrophe, but that this was antithetical to the idealogues in Western governments, and to the major financial institutions themselves who were raking it in. He points out that Canada never had to bail out any banks, but had the tightest regulatory framework, the highest capital requirements, an insistance that those mortgaging over 80% of the value of their homes had insurance - and growth of 11% pa since 2004 compared with 5% in the US of A.

Gillian Tett of the Financial Times has consistently been the most readable and astute of the commentators on the crisis. In Fool's Gold, she looks at the origins of the crisis from the persective of the JPMorgan Investment Bank where Credit derivitives were first devised, but which missed out on the excesses of the boom as it stuck to its principles in risk management. This in turn has enabled it to become the world's leading investment bank as it emerges from the crash much stronger than its competitors.

Tett locates a fundamental problem as being how financial companies dealt with Super-Senior risk left over from the production of synthetic CDOs. Whilst JPMorgan continued to offset the Super-Senior risk, other companies as the Credit frezy set in retained this on their books or passed it on to undercapitalised monoline insurers or AIG. As a result, bankers at JPMorgan couldn't understand how other companies continued to make such strong returns, so they restricted their CDO pipeline thus limiting their exposure to the market.

The basic sound idea behind CDOs was that they allowed the dispersion of risk throughout the banking system. However, all the financial models which measured this dispersion were predicated on limited mortgage defaults in few localities. No-one had predicted systematic mortgage default across the country. But lax regulation - despite the unhappy memories of the Savings and Loans crisis in the 1980s - had allowed greed and stupidity to predominate. Mortgages were being sold to people who hadn't the abilty to repay them, but the sellers didn't care as their risk was being immediately sold on and rebundled by the banks within their mortgage-backed CDOs. However, when default rates started to hit 15%, then the concentration ratios started to change and Super-Senior dept was no longer impregnable. Tett tells the story with verve and clarity

The fall of Lehmans and its aftermath is the subject of Andrew Ross Sorkin's Too Big To Fail. Ross Sorkin charts the financial world trip to the edge of the abyss with a dizzying array of insider details. It reads like a thriller as it charts minute by minute the efforts firstly of Dick Fuld in trying to shore up Lehmans, and then the Fed and the US Treasury as they try to shore up Western capitalism. It is an astonishing piece of work, setting out in detail why Lehmans was allowed to fail, but AIG had to be saved, and how close to the precipice we had really come.

But whilst starting from different positions and looking from different perspectives, all three authors are agreed on one thing - the banking system has still not taken fully on board the lessons of the crash, and regulators are lagging in ensuring that the next economic cycle does not repeat the whole sorry story over again. We can list the crashes - secondary banking, Russian defaults, Internet bubble, Credit crunch. Yet markets are climbing once again bouyed by rock-bottom interest rates, quantitative easing and a commodities boom led by China. Yet as the Chinese economy starts to overheat and the Chinese government contemplate interest rate rises, and Euro sovereign debt concerns remain, and inflation grows and government cutbacks threaten a double-dip recession, we ask the question - is the self-regulating market mechanism the most efficient way we have to manage the scarce resources at our disposal, or is it a pure leap of blind faith?

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