Business postsFriday September 25, 2009
On James Stewart's "Eight Days"
For the second time this year, The New Yorker has given us a must-read article that's only available online by subscription. Haven't read it? You should subscribe. You also might still find it on shelves. Hell, you can borrow my copy. It's from the Sept. 21st issue, and it's called "Eight Days" by James B. Stewart. All about those eight days last September when the world financial system teetered, creaked, raised dust, but didn't...quite...fall. A lot of good inside information. A lot of good reporting. Key sum-up graph for me, about halfway through (italics mine):
The Treasury official described the situation: "Lehman Brothers begat the Reserve collapse, which begat the money-market run, so the money-market funds wouldn't buy commercial paper. The commercial-paper market was on the brink of destruction. At this point, the banking system stops functioning. You're pulling four trillion out of the private sector"—money-market funds—"and giving it to the government in the form of T-bills. That was commercial paper funding GE, Citigroup, FedEx, all the commercial-paper issuers. This was system risk. Suddenly, you have a global bank holiday."
I'd recommend laissez-faire folks in particular read the piece. You still hear them from time to time—maybe more insisently now that last September is a memory and folks have pitchforks out for bankers and brokers. They should've let Bear collapse. They should've let A.I.G. collapse. Let the market be the market. But letting Lehman Bros. collapse was bad enough. If A.I.G. had collapsed, everything would have collapsed. Is this "bailing out Wall Street"? To an extent. Trouble is we're all connected to Wall Street. We're all connected to institutions we don't know about until they fail. Tim Geithner: "It's not Wall Street that suffers when you 'teach people a lesson.'"
We're definitely at an impasse. The momentum my entire life has been toward merging big companies into bigger companies into behemoths that can compete on a global scale. But then you wind up with a company too big to fail. Last September showed why we can't have that. So something's gotta give.
Global Financial Meltdown 101
Last May, in his essay “The Death of Kings” in The New Yorker, Nick Paumgarten, among other tasks, looked for the worst offender in the Global Financial Meltdown, a “sin eater,” he says, then writes:
So far, Bernie Madoff, John Thain, Dick Fuld, Joseph Cassano, and even Jim Cramer, to name a few who have been cast in the role, have proved insufficient.
Michael Lewis, author of “Liar’s Poker” back in the day, and “Moneyball in a more recent day, says not so fast. His piece on A.I.G. in the July Vanity Fair, “The Man Who Crashed the World,” not only offers one of the clearest pictures of this huge, vague mess, it offers up that worst offender: the aforementioned Joe Cassano, head of A.I.G. F.P. (Financial Products.)
Because of Lewis’ connection with Wall Street—as a trader for Solomon Brothers in the 1980s—he became (initially, an unwilling) confidante first to A.I.G’s Jake DeSantis, for whom Lewis opened the doors to the New York Times Op-Ed page, and then to a host of mostly anonymous A.I.G. F.P. employees. who gave him the inside story of A.I.G. F.P. in the 2000s. It’s a familiar story to almost anyone who’s had an idiot, micromanaging boss. The difference is in the damage this particular boss did.
Read the entire article. Lewis gives us a quick background on how A.I.G. became Wall Street’s designated insurer for what were still perceived to be fairly risk-free mortgage securities. He writes:
The risks it ran were probably trivial in relation to its capital, because the risks that the financial system wanted to lay off on it were, in fact, not terribly risky.
Then the clouds darken:
At the end of 2001 its second C.E.O., Tom Savage, retired, and his former deputy, Joe Cassano, was elevated. Savage is a trained mathematician who understood the models used by A.I.G. traders to price the risk they were running—and thus ensure that they were fairly paid for it. He enjoyed debates about both the models and the merits of A.I.G. F.P.’s various trades. Cassano knew a lot less math and had much less interest in debate...
But A.I.G. F.P. was a subdivision of A.I.G. How did the parent company allow someone who knew little about the product, wasn’t interested in debate, and punished those who didn’t agree with him come to power? The long answer is that they always do. The short answer is here:
A.I.G. F.P.’s employees for their part suspect that the only reason [A.I.G. Hank] Greenberg promoted Cassano was that he saw in him a pale imitation of his own tyrannical self and felt he could control him. “So long as Greenberg was there, it worked,” says one trader, “because he watched everything Joe did. After the Nikkei collapsed [in the 1990s], a trader in Japan lost 20 million. Greenberg personally flew to Tokyo and took him into a room and grilled him until he was satisfied.” In March 2005, however, Eliot Spitzer forced Greenberg to resign. And, as one trader puts it, “the new guys running A.I.G. had no idea.” They thought the money machine ran on its own, and Cassano did nothing to discourage the view. By 2005, A.I.G. F.P. was indeed, in effect, his company.
But almost every company has guys like this. You’ve probably worked for guys like this. And they’re not bringing down the entire financial system. Something else had to be going on:
The more subtle change inside A.I.G. F.P. occurred not long after Cassano assumed control. ... The banks that used A.I.G. F.P. to insure piles of loans to IBM and G.E. now came to it to insure much messier piles that included credit-card debt, student loans, auto loans, prime mortgages, and just about anything else that generated a cash flow. ... Because there were many different sorts of loans, to different sorts of people, the logic applied to corporate credit seemed to apply to this new pile of debt: it was sufficiently diverse that it was unlikely to all go bad at once. But then, these piles, at least at first, contained almost no subprime-mortgage loans.
Here’s the telling stat:
The combination of the dot-com bust and the 9/11 attacks had led Alan Greenspan to pump money into the system, and to lower interest rates. In June 2004 the Fed began to contract the money supply, and interest rates rose. In a normal economy, when interest rates rise, consumer borrowing falls—and in the normal end of the U.S. economy that happened: from June 2004 to June 2005 prime-mortgage lending fell by half. But in that same period subprime lending doubled—and then doubled again. In 2003 there had been a few tens of billions of dollars of subprime-mortgage loans. From June 2004 until June 2007, Wall Street underwrote $1.6 trillion of new subprime-mortgage loans and another $1.2 trillion of so-called Alt-A loans...
And here, to a certain extent, is why this was happening:
Perhaps the biggest reason for this [booming demand for housing and a continued rise in house prices] was that the Wall Street firms packaging the loans into bonds had found someone to insure against what turned out to be the rather high risk that they’d go bad: Joe Cassano.
A.I.G. F.P. ... went from being 2 percent subprime mortgages to being 95 percent subprime mortgages. And yet no one at A.I.G. said anything about it...
I like stories of the guys who figure it out early and who complain to deaf ears. Gene Park was one such guy:
He suspected Joe Cassano didn’t understand what he had done, but even so Park was shocked by the magnitude of the misunderstanding: these piles of consumer loans were now 95 percent U.S. subprime mortgages. Park then conducted a little survey, asking the people around A.I.G. F.P. most directly involved in insuring them how much subprime was in them. He asked Gary Gorton, a Yale professor who had helped build the model Cassano used to price the credit-default swaps. Gorton guessed that the piles were no more than 10 percent subprime. He asked a risk analyst in London, who guessed 20 percent. He asked Al Frost, who had no clue, but then, his job was to sell, not to trade. “None of them knew,” says one trader. Which sounds, in retrospect, incredible. But an entire financial system was premised on their not knowing—and paying them for their talent!
Eventually, thanks to Gene Park, Joe Cassano figured it out before most others and A.I.G. F.P. stopped insuring the risky sub-prime mortgage bonds. But it was already too late. Worse, in 2006 and 2007, Wall Street took on the risk themselves, resulting in hundreds of billions of dollars in losses there. Then the earlier, A.I.G.-insured subprime mortgages began to default, too.
The system was built on the premise that everyone wouldn’t, couldn’t default at the same time; then, to continue making easy money in down times, everyone went about making sure that this unlikeliest of scenarios became more and more likely.
On Nick Paumgarten's "The Death of Kings"
As I was reading Nick Paumgarten’s New Yorker article “The Death of Kings” last week (late to the party again: it’s from the May 18th issue), I kept wondering why it wasn’t a topic of conversation everywhere. Besides the obvious reasons: It’s long, about finance, in the New Yorker. On the other hand: It’s well-written, deep, scary. Maybe those are the same hand. A Google search on the terms “The Death of Kings” and “Nick Paumgarten” brought up less than a thousand hits. I don’t expect viral, I don’t expect Adam Lambert saying he’s gay or what’s painted on Sarah Palin’s toes, but can’t it at least be a little communicable?
Compounding the problem: It’s only online as a small excerpt on the New Yorker’s site. For subscribers like myself, yes, you can read the whole thing, but in .pdf form, making it difficult to copy and share. I understand the rationale—buy the magazine already—but it does limit its impact in our lazy, online world.
Shame. It’s an article that should be read. It’s about Paumgarten’s search for a wise man in the global financial meltdown. Someone who knew early and who might know early again where we’re heading. It’s a gloomy ride. It begins with unnamed insiders recounting when they knew the jig was up (watching a commercial for a subprime lender, studying debt vs. GNP graphs, learning that their cleaning woman in New York bought a house in Virginia to flip), and then wonders, from the center of the storm, how big the storm is and how much damage it will cause:
This doesn’t look like anything yet. The cities aren’t crumbling; the Plains aren’t turning to dust; your four grandparents are not sharing a bed...
What’s our original sin? How many years are we paying for? Since W.? Since Reagan? Since FDR? Since McKinley? Reading, you almost get a sense that our entire economic system has been funded on an illusion that kept us afloat, as surely as Wile E. Coyote’s illusion that he’s on land keeps him running on air. When realization sinks in, hold up a sign: Bye-bye.
One of his wise men is Colin Negrych, a private market philosopher/trader, who was in that 1985 Salomon Brothers’ training session portrayed in Michael Lewis’ “Liar’s Poker,” and who, among his aphorisms, quotes singer Robbie Fulks: “It’s a full-blown chore overlookin’ what’s plain to see.” What have we been overlooking? Debt. “Debt is the story,” he says. Later he adds: “What constituency is there for pessimism? People believe optimism is necessary, an American right. The presumption of optimism is the problem. That’s what creates the debt we have now.”
He’s full of pithy advice. “This whole culture has been set up to see stocks and homes as annual riskless investments. They most assuredly are not.” So that “whole culture” is, what, 10 years old? More? But not pre-1970s. Homes used to be places to live, jobs places to work. Both were stable.
“What has also run aground,” Paumgarten writes, “is a revolution in financing dating back to the nineteen-seventies.” He’s talking about all the stuff I don’t get, or am only beginning to vaguely get: the end of Glass-Steagall, which separated commercial from investment banks; the creation of interest-rate swaps; new ways to securitize debt:
They pooled assets that yielded a regular flow of payments (mortgages, car loans, credit-card receivables, etc.) and then divided the pool into tranches, ranked according to the order of repayment. Pieces of each tranche are sold to investors as securities—a claim on a portion of the payments. The senior tranches get paid back first but yield less. The equity branches, last in line, get paid more to take on the higher risk of not being paid at all. The idea is to spread and therefore mitigate the risk of lending, and in turn lower the cost of borrowing.
OK, I still don’t get it. Once money goes abstract I’m lost. But I remember the horror I felt watching that “60 Minutes” episode last fall in which Steve Kroft described how there were basically bets on all those failing subprime mortgages and no money to cover the bets. I imagined bankers rolling dice in a backroom. I still do. I kept thinking: Is this legal? Should it be?
Paumgarten writes the piece with short, terse sentences, as if he’s holding his breath, as if he’s waiting for something else to collapse. How fragile is the entire system now? How much are we overleveraged? Wasn’t it 20-1? Is it still?
We get stories from the front lines about unnamed bankers and traders. The jobs lost. The lessons learned. The walls closing in. There’s a search for a villain, too, a face to embody the whole horrible mess. Even as Paumgarten fails in this task—dismissing Madoff as too small, Lehman and Bear as mere portions, and Greenspan as not pernicious enough—I wonder over its efficacy. Paumgarten feels a villain is necessary but I don’t. The very point of the system was its abstractness. What’s happened to my loan? Who’s playing craps with it where? It deserves an abstract villain.
Now It’s our very culture that’s abstract, diffuse, difficult to pinpoint. We’re all over the place. Which is why “The Death of Kings” isn’t a topic of conversation everywhere. But it should be. Libraries probably have the piece if you want to check it out. If they're still open.
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