Fool's Gold Reviewed
“As long as the music is playing, you’ve got to get up and dance,” Charles Prince, CEO, Citigroup, 2007.
In a sense that one, pithy, statement neatly sums up the tragedy of the financial meltdown that we've witnessed over the past two years. Having lived, quite literally, through the penning of a new chapter of History, the first assessments of what went wrong during the Summer and Fall of 2008 are emerging. Fool's Gold by Gillian Tett, assistant editor at the Financial Times, is one such example. I managed to corral Pramod's (signed!) copy of the book, before he returned to the UK.
After having read so much about the crisis over the past couple of years (The Economist, FT, WSJ, NYT, the list is endless), I was under the impression that there wouldn't be much new to learn from this book. Having taken just two days to run through it, you can guess that I was totally off the mark! The book provides an interesting vantage point to understand the crisis - from the offices of J. P. Morgan, the commercial bank, where much of the technology that helped to create the Credit Crunch was itself invented. At a gross level, the book is not so much about the implications and the motivations of the bankers whose rapacious greed has radically reshaped the financial system, but focused more intently on those "Financial weapons of mass destruction," credit derivatives.
In order to understand a new technology, it is usually useful to understand the historical motivations of the designers of the technology - the problem they hoped to solve, their approach to solving it, the compromises they made in finding a solution. Fool's Gold provides this perspective in spades. The notion of credit derivatives emerged at J. P. Morgan in the mid-nineties. The idea was to create a derivative instrument that helped to push risk off of J. P. Morgan's balance sheet to someone else who was willing to take on the risk of holding the debt on their books. The team designed such a product for corporate debt instruments, which proved very successful. Essentially, they created a Credit Default Swap. However, the swaps were legally complicated and cumbersome, and since they needed to be concluded anew between two parties separately for each new swap contract, the J. P. Morgan team came up with a way of "industrializing" the swap creation process - the Collateralized Debt Obligation. Gillian Tett expertly takes the reader through the process by which these instruments were engineered. This is the book that you should read to understand the financial technology that lead to todays malaise.
What the J. P. Morgan team found when they tried to use the same technology to sell mortgage risk, was that it was impossible to justify the ratings of the CDS contracts, given the lack of data to accurately assess the behavior of the contract under distress. Given this, J. P. Morgan sold only one mortgage-backed CDS contract, and decided to stay away from the whole mortgage-backed security (MBS) market. However, this didn't prevent other people from taking this idea and running wild with it. In fact, J. P. Morgan could be said to be mildly culpable, since, while they were happy to disseminate their creation to the wider financial world, they did not accurately portray the risks involved in the creation and selling of MBS's, despite knowing them. And this is probably the greatest weakness in this excellent book - J. P. Morgan comes out too easily as a bit of a shining knight. A little more skepticism of their motivations might've been useful - but then again, that might just be me fluttering in the prevailing wind, given the current disgust with bankers.
Where this book falls short is the overt focus on J. P. Morgan. I hope that this is but a first installment in a series of books assessing the credit crunch. The questions that I would love to read Ms. Tett explain, in any subsequent books, include -
1. What was the role of the ratings agencies, in all of this? They come out unscathed in Fool's Gold - which I find implausible. How did they manage to rate tranches of instruments like CDO-squared and CDO's of Mezzanine ABS, as essentially risk-free, when they clearly weren't? What of their incentive structure - why is it that the people paying the ratings agencies are the companies issuing the debt instruments, and not the buyers of the debt?
2. Why was there no clearing house or exchange created for credit derivatives? Why were most of these instruments being created and transacted between two parties in the dark? Especially since, increasingly, these instruments are being sold to uninformed investors?
3. The incentive structure for bankers - what made them get down and dirty, just because others were too? Why did they have to dance the dance? What happened to their rationality, in the face of gross market distortions?
4. Why were more and more complex instruments created, without the implications of these instruments being fully understood? Why was there an almost stupidly evangelical faith in mathematical models?
Of course, not all of these questions can be answered in one book. But, I hope that this is just a beginning by Ms. Tett, for she has the ability to explain complex financial mumbo-jumbo in rather simple terms. At the end of the book, one is left craving more information on the policy drama of September and October of 2008 - for instance, why Lehman Brothers was allowed to fail, but AIG not (all within a few hours of each other) isn't touched upon at all. Having said that, this is still a very powerful, cogent, account of the beginnings of the most recent chapter in History, and one that must be read to get a foundation on which to understand the wider implications of the Credit Crunch. Highly Recommended.
Cross-posted at AMusings.