There is widespread agreement that the Great Recession from which we are now struggling to extricate ourselves stemmed from overextended credit, a credit bubble. Once the booming expansion of easy credit started to contract, producing an avalanche of defaults, the economy went into a tailspin. Companies couldn’t borrow money to cover expenses, consumers cut back on purchases, jobs were cut, and governments curtailed essential services as tax revenues fell.
But what produced the bubble? This is usually viewed as a purely economic problem. In this paper, I look at it as a psychological problem as well: a systematic effort on the part of lenders to deny the risk they faced. Those who extended credit as well as those who received it lost touch with the real danger of default. This widespread denial of risk was the result of interlocking collusive social processes.
One set of processes occurred within the financial industry itself, an industry that expanded and changed dramatically since WW II. Complex interactions between banks, regulators, hedge funds, ratings agencies, and mortgage companies within the industry as well as with consumers account for this systematic denial. The second set of answers has to do with the larger social and historical setting within which the industry was situated, and the political issues we faced following the fall of communism. I will look at the larger picture after examining what happened to the financial industry.
Part One: The Financial Industry
Common sense suggests that the greatest risk to the security of banks is theft. Al Capone, asked why mobsters robbed banks, famously said, “That’s where the money is.” But bankers always knew that while it was important to guard against theft, that was never the main risk they faced.
To pay interest on deposits, banks lend money to businesses, would-be homeowners, entrepreneurs, and others, using their money to make money. They can do this, of course, modestly and safely, but they can make more money if the risk is greater. Borrowers pay a higher rate of return if the chance they can not repay is greater. In a nutshell, that is the business opportunity for banks: taking greater risks to gain greater returns.
Throughout history, banks did take risks and did occasionally fail. At the same time, by funding the factories, railroads, steamship companies, coal mines and so forth that made the industrial revolution and our westward expansion possible, they made a lot of money for their depositors and themselves. To guard against risk, J. P. Morgan always insisted that any firm receiving funds from his banks had to have several of his people on their boards. That kept those companies from taking excessive risk, and it kept Morgan informed of the risks he was running. But not every banker had that kind of clout.
This picture began to change radically after WW II. Three interlocking factors brought about today’s hyper-fueled financial world:
- Our economy entered a phase that has been called “investor capitalism.” Investing, along with risk-taking, has come to involve all of us. In 1948, 90 percent of Americans were opposed to buying stocks as an investment; they thought stocks were unfamiliar, “not safe,” a “gamble” (Berenson, 2003, p. 34). Now there is virtually no alternative to our being invested in CDs, pension funds, college funds, 401k’s, endowments, etc.
- Money to invest also streamed in from around the world. Since before World War II, the dollar has been the world’s strongest currency, US government treasury bills the most secure investment, while US stock markets provided unparalleled investment opportunities. And that, in turn, created great opportunities for banks and others in the investment business. More money to invest meant more money to make.
- Finally, as a result, banking became intensely competitive. Under the pressure of all the new money coming into financial markets and with the repeal of many of the restraints on US banking that had been put in place following the Great Depression, banks and other investment firms began to compete more aggressively to manage and to profit from of the increasing numbers of investment dollars. Moreover, a whole new set of organizations was developed to take advantage of these opportunities, what has now come to be called the “shadow banking system,” operating outside the purview of regulators – and sometimes even outside their awareness, mortgage companies, private equity firms, hedge funds, and so forth.
These were the essential conditions that fueled the growth of our financial industry.
Increasingly, it attracted brilliant college graduates who looked towards lucrative careers on Wall Street. Business schools, which had grown throughout the 20’s and 30’s as a training ground for managers of larger and more complex American business, became a choice destination, and their focus gradually shifted to finance. Their graduates, in turn, gradually displaced the established and wealthy families that had traditionally run the banks and investment firms. More and more Americans invested.
As Ron Sorokin put it in Too Big to Fail, his account of the recent crisis: from “something of an unseen backroom support for the broader economy, helping new businesses get off the ground and mature companies adapt and expand . . . the finance sector itself became the front room. The goal on Wall Street became to generate fees for themselves as opposed to for their clients.” (Loc. 10338-48)
To the newly trained financiers, in the 70’s and 80’s it became apparent that most established American businesses were undervalued, measured by their stock prices. They had become more efficient and profitable as management improved and markets for their goods and services expanded, but that was not reflected in the market value of their stocks. This led to an intense phase of mergers and acquisitions, a source of great profit for the banks and other investment firms who arranged the deals. Other new investments were sought, junk bonds, and so forth to capitalize on this undervaluation and provide investment vehicles for our savings accounts, pension plans, CD’s, college funds, etc. etc. In the 90’s, hedge funds look off.
Constantly looking for new and more profitable investments for their enlarging pool of customers, financial firms found more and more clever ways to calculate and cover risk, allowing them to leverage more and more of their resources into investments that paid off – that is, so long as they got returns for their investments.
This is the backdrop to the story I want to tell about the collusive, interlocking processes that produced the denial of risk we are now imperfectly struggling to repair. Bear with me. For a time, this may sound like a crash course in economics, but we have to understand some of the mechanics of the system to grasp how the contagion of denial spread so widely. As story unfolds we will see that will include economists, investors, ratings agencies, regulators, legislators, and home-owners. Indeed, virtually all of us have been players in this process.
For banks, there have been three ways to expand the value of their assets. In addition to leveraging their assets further by calculating risks more precisely, they could move liabilities off their books, and they could take out insurance against loss. Let’s look at these strategies more closely.
In the last ten years, banks leveraged their assets to unprecedented degrees. In 2001, Merrill Lynch’s leverage ratio had stood at just 16 times; that is, it kept 1 million on hand for every 16 million invested. By 2007, it was 32 times. The ratio at Goldman Sachs stood at 25, Morgan Stanley at 33, Bear Stearns at 33, and Lehman Brothers at 29. Here the newly recruited and well remunerated economists and mathematicians come into the picture, with their sophisticated models applied to analyzing past market data.
Academic economists cooperated with their increasingly firm ideological conviction that “markets are perfect,” that is, they reflected accurately all the risks faced by investors. With what in hindsight clearly seems unwarranted confidence, they believed they could determine risk precisely. Investors, reassured by the theories of Nobel prize-winning economists, were emboldened to assume even more risk.
Even so, there were limits to leveraging. The securitizing of mortgages allowed banks to take them off their books. Banks and other mortgage firms went into the business of bundling them together into various levels of risk, called “tranches,” and then issuing stock based on those bundled assets. Thus investors in such securities never held specific mortgages, but held “derivatives” based on the presumed value of those mortgages. (Home owners, in turn, often had the bewildering experience of finding that the bank or mortgage company with whom they had originally contracted for their mortgage was now completely out of the picture. They sent their payments to new companies that, often, they had never known existed.)
These new “structured investment vehicles,” or SIVs, were often pioneered by sophisticated new investment units in banks that impressed management with their ability to generate extraordinary profits. Moreover, the fact that these derivatives took loans off the books meant that the bank did not have to set aside capital against potential losses. That made it possible for banks to invest more of their capital, gaining greater profits, though it also meant that there was no capital cushion against losses. “In 2006, Citibank’s off-balance sheet assets amounted to $2.1 trillion; its on-balance sheet assets were $1.8 trillion.” David Wessel, economics editor of The Wall Street Journal, commented later: “Not only were these enormous loans hidden, but several top Fed staffers confessed later that they hadn’t even heard the term “SIV” until the end of July. Neither had some senior Fed officials.” (Wessel, p. 104)
The riskier securitized mortgages yielded the best returns, in accordance with the old principle that investors get rewarded for taking risks, and the greater the risk the greater the return. This conflicted, however, with the desire of those who packaged and sold the new investment vehicles to make them appear desirable and safe to some investors. Hedge fund managers might be comfortable taking the risk associated with bundled, securitized sub-prime mortgages, but managers of pension funds, endowments, and savings vehicles could not afford to take that kind of risk, even if they desired that kind of return.
Here is where the ratings agencies got involved in the process. The anthroplogist, Gillian Tett, wrote in Fool’s Gold: “As these new securities had little track record, the agencies charged fees to rate them, sometimes commanding a fee of $100,000 per shot, or even several times that level. And that business grew fast. By 2005 Moody’s was drawing almost half of its revenues from the structured finance sector.” The fees initially were justified on the grounds that these new financial products were difficult to assess as there was little if any historical data to go by or models for calculating risk. But perhaps because of their difficulty in understanding these new derivitives, perhaps because of conflicts of interest from the high fees they earned, they often ended up giving the derivatives the high ratings that enabled the managers of pension funds and other funds that were strictly overseen to make substantial investments in them.
The third way banks found to increase their assets was to purchase insurance against loss. AIG, the insurance giant, began actively promoting new kinds of credit derivatives that were sold as guarantees against losses. These “credit default swaps,” as they were called, were new ways of securitizing debt, making it seem that the risk of loss could be covered by third parties. As a result, not only was the debt moved off the books, they became a new source of investment.
AIG faced the problem of figuring out how default patterns could be modeled, a problem that paralleled the problem of the ratings agencies. There was so little good data to work with. Was it safe to assume that defaults would play out in the future as they had in the past? The trickiest issue of all was working out the level of “correlation”—figuring out how likely it was that one default would trigger others.
In retrospect, it’s clear they got this wrong, assuming in accordance with their theory of “perfect markets” individuals would make rational decisions. Economists did not make much allowance for minds influenced by the contagion of group process, or what happens when markets panic.
Nor did they take into account the increasing interconnectedness of the market. As Sorokin pointed out (Loc. 1909-160: “Although securitization supposedly reduced risk and increased liquidity, what it meant in reality was that many institutions and investors were now interconnected, for better and for worse.”
By and large, the bankers themselves poorly understood the new derivatives they increasingly relied upon for their sense of security and increasing prosperity, the SIVs and CDOs. Even regulators seemed only vaguely aware of what the banks were really doing.
Gillian Tett wrote: “like priests in the medieval church, ratings agency representatives spoke the equivalent of financial Latin, which few in their investor congregation actually understood. Nevertheless, the congregation was comforted by the fact that the priests appeared able to confer guidance and blessings.”
But perhaps more importantly, investors began to believe that the extent of their leveraging or insurance coverage actually did not matter. More important was the underlying data about revenues and profits. If trends were up – as they were – there was less risk. If they were to continue up, there was no risk at all. This is the kind of logic that characterizes all financial bubbles.
To summarize, heightened leverage, packaging debt to move it off the balance sheet, and insurance – these strategies allows banks and other investment firms to extend their assets, taking greater and greater risks in the process. Moreover, intense competition among banks provided a strong incentive to focus on ever-higher returns. They had to deliver better results in order to compete successfully against each other, they had to continue delivering higher revenue on investments or their own stock prices would decline, sometimes drastically. According to a report of The Boston Consulting Group: “Banks now face the challenging task of sustaining their success in creating value. . . . Continuing to increase profitability remains important but becomes more and more difficult as profitability has already reached a new level.” (Tett)
It is not as if many bankers and investors caught up in this cycle did not know that something was dangerously amiss. Incredulous at the extreme leveraging of their competitors’s assets, they were often forced to conclude that competitors knew something they themselves didn’t or couldn’t know. Tett cites a banker at JP Morgan: “it never occurred to her that the other banks might simply ignore all the risk controls J.P. Morgan had adhered to…. That … was simply outside her cognitive map.”
The executives who ran the big banks were similarly trapped in keeping up the competition. John Cassidy wrote: “In an interview with the Financial Times in July 2007, [Chuck Prince, CEO of Citigroup] acknowledged the constraints he was operating under. ‘When the music stops, in terms of liquidity, things will be complicated,’ Prince said. ‘But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.’ Four months later, Citi revealed billions of dollars in losses on bad corporate debts and distressed home mortgages. Prince resigned, his reputation in tatters.” (How Markets Fail (John Cassidy)- Highlight Loc. 276-84)
In other words, a new form of risk came to preoccupy the financial managers: not the risk of default, but the risk of failing to compete against other banks and losing, as a result, the competitive advantage and value that their own firms had built up through past successes. I think it would be fair to say, in fact, that in the minds of bankers this new risk of failing at competition gradually all but obliterated the old risk of default.
When the sub-prime mortgage market began to collapse, not only did the value of real estate dramatically decline, but this whole array of derivatives and insurance plans collapsed as well. Soon the decline became an avalanche. The very effort to spread and minimize risk had produced a level of interconnectedness among financial institutions that spared no one from overwhelming loses.
Alan Greenspan testified before Congress about his own miscalcuation: “I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms . . . The problem here is something which looked to be a very solid edifice, and, indeed, a critical pillar to market competition and free markets, did break down.” (How Markets Fail (John Cassidy)- Highlight Loc. 133-37)
Part Two: The Social and Political Environment: “Irrational Exuberance”
I want to look outside the financial industry now, at the context that encouraged and supported this credit bubble. There are two underlying historical factors that help to account for why this happened: the first was the sense that free market forces had triumphed over communism. With the fall of the Berlin Wall and the collapse of the Soviet Union, socialism along with virtually any system that advocated economic planning had been discredited. The second was the actual failure of our economic system to extend the benefits of its greater productivity to the bulk of its workers and citizens.
As the Yale economist, Robert Schiller, put it: “Since the end of the cold war most other countries have seemed to be imitating the Western capitalist economic system.” Communist China gradually embraced market forces, and now . . . “markets are everywhere. In most of the world, economic competition in free markets is becoming the guiding idea.”
This “triumphalism” of the ideology of free, unfettered markets encouraged the dismantling of many forms of government regulation and the repeal of laws that restricted competition. Paul Krugman wrote in The Return of Depression Economics: “who now can use the words of socialism with a straight face?” (p. 14)
By the 1990s, Bill Clinton, Tony Blair, and many other progressive politicians had adopted the language of the right: “With the collapse of communism and the ascendancy of conservative parties on both sides of the Atlantic, a positive attitude to markets became a badge of political respectability. Governments around the world dismantled welfare programs, privatized state-run firms, and deregulated industries that previously had been subjected to government.” (Cassidy)
The 1990’s were generally considered the “golden age” of investing: “More Americans owned investments than ever before, and stock prices were rising to astonishing heights.” [Lowenstein, When Genius Failed, p. 23.] In 1996, Alan Greenspan, the then revered Chairman of the Federal Reserve Bank, coined the term “irrational exuberance” to describe the ever rising speculative fever of financial markets, then being fueled by the “dot com bubble.” But throughout this period sectors of the market that declined were succeeded by new sectors, new investor enthusiasms.
Schiller adds other factors, some of which are clearly related to this “triumphalism” (his term): a significant rise in materialistic values, a new popular interest in the culture of business, expanded media coverage of business news, optimistic forecasts, increased levels of trade, and twenty-four hour trading over the internet. Most traditional economists generally account for such trends in technical terms, purely economic factors as if it were a closed system. But it is hard not to see a link with the collapse of communism as we look back over the past twenty years.
The threat of WW III suddenly evaporated, the strategy of Mutual Assured Destruction became irrelevant, we no longer needed to divert so much of our productivity into the arms race, and we started talking about a “peace dividend.” What Philip Bobbitt called “the long war,” the ninety-year conflict between the opposing promises of capitalism and socialism, had suddenly been resolved. The unplanned, unregulated forces of the market had won decisively. The theory of “efficient markets” became an ideology, an article of faith.
This not only led to a surge of investor confidence but it spawned several enterprises that embodied the cocky confidence of investors and speculators in their ability to exploit financial markets through financial engineering. In the early 1990’s, for example, a group of brilliant mathematicians and economists founded Long-Term Capital Management, an investment firm based on sophisticated arbitrage calculations. They attracted several academic superstars, including Robert C. Merton and Myron Scholes, who eventually won Nobel prizes in economics for their theories about the precise calculation of risk. In its first year, 1994, a bad year for most investors, Long-Term earned a 28% return. By the end of its second year, the firm’s equity capital had virtually tripled to $3.6 billion, its assets grown to the extraordinary sum of $102 billion.
Scholes commented at the funds inception: “We’re not just a fund. We’re a financial technology company,” reflecting their belief that they had reduced risk to precise, scientific calculations. (When Genius Failed, p. 65) For four years it seemed to work, as they took greater and greater risks, emboldened by belief in the certainty of their “scientific” discoveries. When it stopped working in 1998, as the markets failed to act in accordance with its models, Long-Term’s exposure was over $1 trillion. It took the combined efforts of most of Wall Street’s major firms under the guidance of the President of the New York Fed to prevent the collapse of Long-Term from producing a meltdown of financial markets. Among economists and financial journalists, this has been viewed as the precursor to the financial bailout of the big banks in 2008.
An even bigger and better known example of financial hubris leading to disaster is Enron. Starting out as a relatively small producer of natural gas that had diversified into gas pipelines, a number of brilliant financial minds transformed it into a company that essentially traded in contracts for gas futures. That is, by swapping contracts with other suppliers and hedging against variations in the market through options, they offered to deliver future supplies of natural gas at set prices, a middleman smoothing out the risks and irregularities in the market. Moreover, the contracts they offered could be traded themselves, much like the SIV’s of the big financial firms that had smoothed out variations in the mortgage market. But, of course, just like an investment banker, Enron ran the risk of being stuck with contracts and obligations, exposing it to considerable risk if the underlying values were not sustained.
Enron expanded into trading electric power, pollution rights, and eventually broadband capacity, using exceptional ingenuity to create new financial instruments and markets. It developed a reputation for hiring only the best and brightest, and for six consecutive years was named Fortune’s “Company of the Year.” Its stock price soared.
An underlying problem that eventually let to its demise is that it had essentially no assets of its own. When the value of the contracts if traded fell, it had no backup to rely upon. Moreover, it expanded into areas where it had little actual experience, making a number of bad bets, no doubt emboldened by its track record of juggling financial figures to repackage and disguise risk. They had to keep proving that they were more and more profitable as their own stock values were, in effect, their only asset. Their weakness or vulnerability would cause other firms to move in on their business and also call back loans that had been extended.
This did not matter, of course, so long as markets continued to rise, but when they fell, Enron resorted to more and more “creative” accounting gimmicks to disguise those losses, practices that in retrospect were clearly illegal, and eventually led to jail terms for its top executives. The whole bubble collapsed in a breathtaking couple of months in late 2001.
Both Long-Term Capital and Enron exemplify the use of creative financial strategies in the service of profits. Enron’s bundling of energy contracts, like the securitization of mortgages, was actually a useful way of managing and spreading risk. Long-Term’s use of sophisticated risk models, similarly, was creative and useful. It was their excessive use, together with their arrogant neglect of more common sense measures that led to their demise. In other words, it was not the ideas themselves but the manic over-confidence they gave rise to, the denial of risk that they fostered, that resulted in the collapse.
The second broader social and political issue that is relevant here is the failure of our system to distribute the benefits of our heightened productivity throughout this same period. While the managers of investor capitalism gained immense wealth, the middle classes stagnated. The concept of the “Ownership Society” and the funding of consumer spending from the credit bubble was our way of obscuring the widening gap between rich and poor, enabling middle and lower-class Americans to improve their lives by buying homes, borrowing against assets. Essentially our wealth was massively redistributed.
Peter Goodman summed it up in Past Due: “as the economy mostly grew in the years [70’s. 80’ 90’s], average weekly earnings dipped below $260 by 1996 [from $330 in 1973], a slide of more than one/fifth over twenty-three years. By October 2008, those same weekly earnings had only inched up $279, roughly the same level as 1983. In short, a quarter-century had come and gone with the average American stuck in place.” (Past Due, p. 10) He summarized, “the bottom line is clear: while the economy has grown and the rich have prospered, most Americans have seen meager improvement in their material well-being over the last quarter-century.” (Past Due, p.11) His conclusion: “Easy money filled the gap.” (Past Due, p. 11)
Elizabeth Warren wrote: “The crisis facing the middle class started more than a generation ago. Even as productivity rose, the wages of the average fully-employed male have been flat since the 1970s. But core expenses kept going up. By the early 2000s, families were spending twice as much (adjusted for inflation) on mortgages than they did a generation ago — for a house that was, on average, only ten percent bigger and 25 years older. They also had to pay twice as much to hang on to their health insurance.
“To cope, millions of families put a second parent into the workforce. But higher housing and medical costs combined with new expenses for child care, the costs of a second car to get to work and higher taxes combined to squeeze families even harder. Even with two incomes, they tightened their belts. Families today spend less than they did a generation ago on food, clothing, furniture, appliances, and other flexible purchases — but it hasn’t been enough to save them. Today’s families have spent all their income, have spent all their savings, and have gone into debt to pay for college, to cover serious medical problems, and just to stay afloat a little while longer.”
It’s a dispiriting picture, obscured for most of us because we were aware of the local picture alone. For some, professional advancement has compensated, sometimes a housing windfall kept a family afloat, occasionally an inheritance. But usually it was relatively cheap money, and debt. First the Clinton administration, then Bush, adopted the goal of home ownership for all, pressuring Fannie Mae and Freddie Mac to offer sub-prime mortgages – and that took off with the packaging and securitization of debt we noted earlier, the illusion of risk management allowing the process to evolve to disastrous levels.
One consequence of this debacle is that the rationalist theories of efficient markets have been largely discredited. The Chicago school of Milton Friedman and his disciples do longer dominates economic discourse. But what will take its place? Behavioral finance has been struggling to be heard, and now indeed there is far more interest in it than before as the ironclad certainties of perfect markets, consisting of perfectly informed and perfectly rational investors no longer carry much weight.
But the investors themselves, deprived of those theories, seem unfazed. As Sorokin notes: “ego is still very much a central part of the Wall Street machine. While the financial crisis destroyed careers and reputations, and left many more bruised and battered, it also left the survivors with a genuine sense of invulnerability at having made it back from the brink. Still missing in the current environment is a genuine sense of humility.” (Loc. 10345-48)
Moreover, the federal bailout has created a precedent in effect: some institutions are now seen as indeed too big for the government to allow them to fail. The ”moral hazard” implicit, then, in not making them accountable for their own failures can easily become a license for them to take further risk. If we add to this, the fact that Congress seems to have little appetite for passing legislation to enact significant financial reform, it is hard to believe that we have any safeguards against a repeat of the same scenario.
If there is a bright spot at all, it lies in the fact that a spotlight has been shed on the irrationality of markets. This gives those of us interested in exploring unconscious motivation of social and economic events some greater credibility. Homo economicus is debunked.
John Cassidy, How Markets Fail, New York: Farrar, Strauss and Giroux, 2009.
Justin Fox, The Myth of the Rational Market, HarperCollins e-books, 2009.
Peter C. Fusaro and Ross M. Miller, What Went Wrong at Enron, Hoboken: Wiley, 2002.
Peter S. Goodman, Past Due: The End of Easy Money and the Renewal of the American Economy, New York: Times Books, 2009
Andrew Ross Sorokin, Too Big to Fail, New York: Viking, 2009.
Robert J. Shiller, Irrational Exuberance (first edition), New York, Broadway Books, 2001
Irrational Exuberance (second edition), Princeton, Princeton University Press, 2005.
Gillian Tett, Fool’s Gold, New York: Simon and Shuster, 2009
 Typically, banks and other firms that invest have to keep a certain amount of cash on hand to cover demands for payment. Another way of putting this is that there are constraints on how much they can leverage their assets. Conservatively, for example, banks might keep 20% of their assets available to cover demands for cash or to cover losses. That meant they would only need to keep one million dollars safely on hand to cover five million dollars of investments at risk. They could play with the rest to make more money for their customers and for themselves. The more they could leverage their assets, the more they could risk and the more they stood to gain.