"The End of Wall Street"
by Roger Lowenstein, The Penguin Press, 2010
Reviewed by Bill Breakstone
Somers, New York, Tuesday, May 11 2010
Here is yet another chronicle of the 2008-2009 financial collapse. It is a thorough re-telling of the tragedy, and though much will be found repetitive by those who have read many of the other books on the subject (and there are plenty of them) it does offer some significant new insights or interpretations that other authors may have mentioned in passing, but not with the specifics that Lowenstein offers. Additionally, the author concludes the history with a stinging indictment of the American financial system, not just Wall Street, but the underlying theories that were espoused by economists and our economic leadership over a three-decade period leading up to the present time.
There were so many crises that our financial leaders at Treasury, the Fed, the SEC and other regulators had to face that, regardless of the mistakes that were made, they must be admired for their stamina, endurance and willingness to modify their solutions and new worries arose day after day, and sometimes hour after hour. They are all detailed here by Lowenstein, who is particularly adept at tying them together in relationship to each other. Just as Paulson, Bernanke and Geithner came up with a rescue of Fannie and Freddie ("the Sisters"), less than 24 hours later they were faced with the demise of Lehman Brothers.
At many times during the crisis, the subject of moral hazard arose. It has reared its ugly head again this morning, as economists, bankers and commentators are beginning to see the EU rescue of the Greek economy as possibly setting up a European repeat of the reliance upon governmental rescue as an excuse for national economic action by the individual states affected by the debt crisis.
Lowenstein elaborates on the changing solutions that the "financial triumvirate" (Paulson, Bernanke & Geithner) attempted to institute as a solution to American banking debt. Bear Stearns was saved from complete failure by a government- sponsored (or should we say forced) takeover, thus establishing early on the moral hazard mentioned above. Next came the quasi-nationalization of the Sisters. During the intervening 5-plus months, Lehman's finances deteriorated, its share price plummeted, and its management was encouraged to seek a merger partner or a buyer. Lehman's management moved at a snail's pace, until it was too late. Even up to those last days preceding the September 16, 2008 bankruptcy, there existed the hope of a rescue, which would have involved a government guarantee. But by that time, Paulson was dead-set against another "bailout" and refused Barclay's request for a temporary guarantee, one that would have bridged the gap for a period of less than a week until Barclay's shareholders could approve Lehman's purchase.
With Lehman's demise, the pressure mounted on every firm, as the trust so essential to the operation of capital markets evaporated. When our Triumvirate assessed the impact that AIG's failure would have on the world's economy, the "moral hazard" high-ground was quickly abandoned. As Bernanke said at the time, "There are no ideologues in financial crises."
Here is the irony of Lehman's demise. It had the b ad luck to be number one after Bear Stearns and before AIG. If the roles had been reversed, or if Bear had been allowed to fail first, Lehman might very well still be around.
As said above, the real meat of Lowenstein's book come with the final two chapters. Let's allow the author to speak for himself:
"The cost of the crash to ordinary citizens was astronomical. The total wealth of Americans plunged from $64 trillion to 5$51 trillion. Another cost-to be borne by future generations-was the huge growth in the federal deficit incurred to pay for the rescue.
The most punishing blow was the devastation in jobs, and for ordinary workers the pain continued long after the worst was over on Wall Street. In October 2009, unemployment hit double digits-10.2 percent. In California, cradle of the subprime loan, 12-1/2 percent of the population was out of work; in Michigan, devastated by the collapse in auto sales, 15 percent. As a measure of how disproportionate was the Wall Street scourge, Wall Street itself, presumably one of the prime agents of the bust, shed 30,000 jobs; the entire United States lost a total of eight million. Never, since the end of World War II, had so many jobs disappeared so fast, and never had the power of finance to inflict damage on the society it serves been so painfully clear. By the recession's end, the economy had lost all the jobs that had been added during the boom years, and more. Even with a population that was 20 million larger, the job market was smaller. In sum, the U. S. spent nearly a decade losing ground-a decade that, according to the country's highest sages, was to have ushered in an era of nearly uniformly advancing prosperity. The subprime binge that Bernanke had supposed was a contained problem turned out to be a symptom of a full credit mania. Ultimately, it destroyed the American workplace. Such was the bitter fruit of Wall Street's folly."
The final chapter continues:
"The crash put paid to the intellectual model that inspired, and to a large degree facilitated, the bubble. It spelled the end of the immodest faith in Wall Street's ability to forecast. No better testimony exists than the extraordinary recanting of Alan Greenspan, the public official most associated with the thesis that markets are ever to be trusted. Ten days after the first round of TARP investments, Greenspan appeared at the House of Representatives to, effectively, repeal the credo by which he had managed the nation's economy for seventeen years:
In recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts supported by major advances in computer and communications technology. A Nobel Prize was awarded for the discovery of the pricing model that underpins much of the advance in derivative markets. This modern risk management paradigm held sway for decades. The whole intellectual edifice, however, collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria. Had instead the models been fitted more appropriately to historic periods of stress, capital requirements would have been much higher and the financial world would be in far better shape today, in my judgment.
This remarkable proclamation, close to a confession, was the intellectual counterpart to the red ink flowing on Wall Street. Just as Fannie, Freddie, and Merrill Lynch had undone the labors of a generation-had lost, that is, all the profits and more that they had earned during the previous decade-Greenspan undermined its ideological footing. And even if he partly retracted his apologia (in the palliative that it wasn't the models per se that failed, but the humans that applied them), he was understood to say that the new finance had failed. The boom had not just ended; it had been unmasked.
Why did it end so badly Greenspan's faith in the new finance was itself a culprit. The late economist Hyman Minsky observed that "success breeds a disregard of the possibility of failure." The Fed both embraced and promoted such a disregard. Greenspan's persistent efforts to rescue the system lulled the country into believing that serious failure was behind it. His successor, Bernanke, was too quick to believe that Greenspan had succeeded-that central bankers had truly muted the economic cycle. Each put inordinate faith in the market, and disregarded its oft-shown potential for speculative excess. Excessive optimism naturally led to excessive risk.
The Fed greatly abetted speculation in mortgages by keeping interest rates too low. Also, the various banking regulators (including the Fed) failed to prohibit inordinately risky mortgages. The latter was by far the more damaging offense. The willingness of government to abide teaser mortgages, "liar loans," and home mortgages with zero down payments, amounted to a staggering case of regulatory neglect.
The governments backstopping of Fannie and Freddie, along with the federal agenda of promoting home ownership, was yet another cause of the bust. Yet for all of Washington's miscues, the direct agents of the bubble were private ones. It was the market that financed unsound mortgages and CDOs; the Fed permitted, but the market acted. The banks that failed were private; the investors who financed them were doing the glorious work of Adam Smith.
Rampant speculation (and abuse) in mortgages was surely the primary cause of the bubble, which was greatly inflated by leverage in the banking system, in particular on Wall Street. High leverage and risk-taking in general was fueled by the Street's indulgent compensation practices.
The system of securitizing mortgages lay at the heart of Wall Street's unholy alliance with Main Street, and several links in the chain made the process especially risky. Mortgage issuers, the parties most able to scrutinize borrowers, had no continuing stake in the outcome; the ultimate investors, dispersed around the globe, were too remote to be of any use in evaluating loans; these investors (as well as various government agencies) relied on the credit agencies to serve as a watchdog, and the agencies, being cozy with Wall Street, were abysmally lax. Wall Street's penchant for complexity was itself a risk. Abstruse securities were more difficult to value, and multitiered pyramids of debts were far more susceptible to ruinous collapse.
The banks' stock prices offered unsettling evidence of how thoroughly the market failed to appraise the possibility of loss. By 2007, the banks had all disclosed massive holdings of mortgage securities, and mortgage defaults were soaring. And yet, as late as that October, Citigroup was trading near its all-time high. That investors could be so blind refuted the strange ideology that markets were somehow perfect ("strange" because the boast of perfection is never alleged with respect to other human institutions). By analogy to the political arena, American society respects the will of the voters, as well as the institution of democracy, but it limits the power of legislatures nonetheless. Market referendums are no less needful of checks and balances.
Counter to the view of its apostles, the market system of the late twentieth and early twenty-first century did not evolve in a state of nature. It evolved with its own peculiar prejudices and rites. The institution of government was nearly absent. In its place had arisen a system of market-driven models, steeped in the mathematics of the new finance. The rating agency models were typical, and they were blessed by the SEC. The new finance was flawed because its conception of risk was flawed. The banks modeled future default rates (and everything else) as though history could provide the odds with scientific certainty-as precisely as the odds of in dice or cards. But markets, as was observed, are different from games of chance. The cards in history's deck keep changing. Prior to 2007 and '08, the odds of a nation-wide mortgage collapse would have been seen as very low, because during the previous seventy years it had never happened.
What the bust proved, or reaffirmed, was that Wall Street is (at unpredictable moments) irregular; it is subject to uncertainty. Greenspan faulted the modelers for inputting the wrong slice of history. But the future being uncertain, there is no perfect slice, or none so reliable as to warrant the suave assurance of banks that leveraged 30 to 1.
In particular, the notion that derivatives (in the hands of AIG and such) eradicated risk, or attained a kind of ideal in apportioning risk to appropriate parties, was sorrowfully exposed. . . . . . "
Lowenstein offers a few final salvos concerning the relegation of Keynesian economic theory to a premature historical rubbish pile, and the belief of Ronald Reagan and his intellectual sages that government regulation had become unnecessary, that as the former President famously said "government was the problem, not the cure."
Then the author's coup de grace: "Previous to the crash, it was casually assumed that no statutes or rules were needed to prevent banks from making foolish loans; after all, the theory went, why would institutions ever jeopardize their own capital This cornerstone of efficient market theory-the view of economic man as always rationally self-interested-was rather embarrassingly upended. Similarly, the faith that bankers know best, that they could be counted on to preserve their firms was shattered."