November 2008

The Nation Reviewed

Ursa major

By Gideon Haigh
Illustration by Jeff Fisher.
Illustration by Jeff Fisher.

This year marks the centenary of an early classic of American finance: Fifty Years on Wall Street, by Henry Clews, a self-made speculative tycoon turned éminence grise. It is bookended by calamities. Clews first strolled the street during the Western Blizzard of 1857, when stock prices halved in a few days thanks to a crisis of confidence over the terms of trade; his 1000-page reminiscence closes with the Bankers' Panic of 1907, following the downfall of the Knickerbocker Trust Company and the near-bankruptcy of New York City.

Clews' tone when describing the latter scapegrace is disarmingly optimistic - he sounds, in fact, almost relieved. He had, it transpired, been fretting about the economy for some time: investors had been glutted with "watered" stock of dubious value; financial maladministration and price manipulation had become the New York Stock Exchange's predominant ends. Clews considers it a splendid development that the "outside public have lost the faith that they had in many of the stock-market leaders, the men who were once followed blindly in their schemes of inflation and regarded as omnipotent in their execution". Awareness of the depths of Wall Street's decadence, he concludes, will be entirely therapeutic.

The revelations of fraud, chicanery and excessive capitalisation that have been made in the courts and elsewhere, have undeceived even the dullest and most credulous believers in the schemes and schemers that took the country by storm in the days of Wall Street's wild and pyrotechnical speculation. Out of evil cometh good, and this change from blind credulity and inordinate inflation to discriminating distrust and severe contraction has exerted a wholesome effect in paving the way to a sounder, safer and generally better state of things both in and out of Wall Street.

A wealthy man, of course, can afford high-sounding sentiments. But Clews had some personal experience of the "wholesome effects" he foresaw: his reputation as the Sage of Wall Street derived partly from his having bounced back after personal ruin in the Credit Mobilier scandal of 1873. And surely part of the disbelief and dread accompanying the current sub-prime crisis has been the sheer unfamiliarity of a general broad-based bear market, from which no asset class appears immune.

The inauguration of the modern gilded age is usually dated, inauspiciously, to a Friday the thirteenth, in August 1982, when the US Federal Reserve cut short-term interest rates by 0.5%. The Dow Jones Industrial Average had closed the previous evening at 776.92; in October last year, it peaked at 14,163.53. There have been shocks between times: endogenous, like Black Monday, in October 1987, and the puncturing of the Internet Bubble, in April 2000; and exogenous, like the first Gulf War and September 11. But to have tangible experience of a certifiable financial crisis, you need to have been a market professional for more than a quarter-century - and how many of those are there in the neophilial securities industry?

The foreboding was evinced by the first and most pointless response to September's turmoil: the sudden draconian restrictions on short selling; that is, investing in such a way as to profit from the market falling. It was as though pessimism itself could be forbidden, or at least that it should not be permitted to lead on to profit. A generally rising equity market has become so integral to the backdrop of capitalism that a long-term dislocation seems to imperil the whole project; to bet against it bordered on the treasonable.

Nobody loves a bear. The most legendary, Jesse Livermore, described Wall Street as a "giant whorehouse", in which the brokers were "pimps" and the stocks "whores" - not a view to endear him to anyone, even brothel keepers. The first great bear in literature is Gundermann in Zola's Money, the "executioner-in-chief of the Israelite banking world", a "man-numeral" with "his phlegm, his frigid obstinacy". In perhaps the best bear-market novel, Christina Stead's House of All Nations, the chief protagonist is a parasitic private banker in Paris, Jules Bertillon, who waxes fat on the financial chaos of the Great Depression. "Bet on disaster, Comtesse," he characteristically counsels one wealthy client. "The world's like an old pope: it's dying with a hundred doctors in attendance. It's dying of everything at once, because they kept it alive too long." (Although even Bertillon cannot live by this principle alone: he is long sterling, and it ruins his bank - although, mysteriously, not him, for his life of gravity-defying privilege continues uninterrupted. "You know how it is," he explains airily to a curious journalist at the end. "The money just went.")

Markets, however, can't live by boosters alone. And if ever a boom originated in a conjunction of guilelessness and opportunism, this has been it. For all the rhetoric about a post-partisan political future, the fate of the sub-prime market attests, first of all, the shortcomings of consensus. Both the Clinton and Bush administrations signed up to the apparently laudable objective of increasing home ownership, and were praised for doing so. Indeed, it was difficult to object to growth in the share of Americans owning homes between 1997 and 2005, from 65.7% to 68.9%, when the chief beneficiaries were the historically disadvantaged: those with below-median incomes, blacks and Hispanics.

It is five years this month since the chairman of Bush's Council of Economic Advisers, Gregory Mankiw, advocated legislation aimed at more stringent supervision of the "government-sponsored enterprises" (GSEs) already engorged with sub-prime mortgages, Freddie Mac and Fannie Mae. Saying that "even a small mistake" in managing their risks "could have ripple effects throughout the financial system", Mankiw pointed out that the companies' federal charters left them with no incentive to avoid risk. On the contrary: "The perception of a government bailout if things go wrong surely enhances any firm's willingness to take on risk and enjoy the associated increase in return."

Yet there was no stomach for reining the GSEs in on either side of politics. Barney Frank, the preening Massachusetts Democrat who has sought to make himself a hero of the bailout, lambasted the Bush administration for being obsessed with financial safety and prudence: "These two entities - Fannie Mae and Freddie Mac - are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing." Having championed, in scarcely intelligible fashion, the "ownership society", Bush was ill placed to demur.

But sub-prime mortgages only ever verged on the "affordable", and barely constituted "ownership". All that transpired was that vulnerable Americans, inexperienced with debt and susceptible to economic dislocation, were cajoled into taking up a financial proposition that no experienced investor would seriously contemplate: that of tying up all their worldly resources in a highly leveraged exposure to a single, immoveable, illiquid asset, of a class whose historical behaviour was very poorly understood. For when the American economic historian Robert Shiller wanted to add a discussion of the housing boom to an update of his classic text on investment bubbles, Irrational Exuberance (2005), he learnt something extraordinary:

To my surprise, everyone I asked said that there were no data on the long-term performance of home prices - not for the US, nor for any country ... If the housing boom is such a spectacular economic event, wouldn't you imagine that someone would care if this kind of thing had happened before, and what the outcome had been? ... This is at once a lesson in human behaviour and a reminder that human attention is capricious. Clearly no one was carefully evaluating the real estate market and its potential for speculative excess.

No one was evaluating because everyone was benefiting - albeit mainly on Wall Street. In 2006, the financial sector, which represents only 3% of American GDP, accounted for a third of American corporate profits. That year, Goldman Sachs, toniest of investment banks, distributed US$16.5 billion in bonuses among 26,000 employees. Last year, even as other financial institutions began hitting the buffers, its CEO, Lloyd Blankfein, earned a street-record US$68.7 million - though perhaps ‘earned' is not quite the right word.

In some respects, sub-prime mortgages were ideally suited to Wall Street's modern capabilities. Financial markets used to be geared mainly to moving money; they are now, through the design and application of derivatives products, overwhelmingly involved in making risk fungible. This is a highly specialised and increasingly abstruse activity, difficult to supervise, awkward even to manage, in which medium and long-term arrangements are made by individuals on impossibly lucrative short-term incentives; it is a trading rather than an investing culture. Thus, the Wall Street joke: What is the difference between the buy side and the sell side? The buy side says, "Fuck you," then hangs up; the sell side hangs up, then says, "Fuck you." This was always a scenario pregnant with profane possibilities; to perceive them required only a modest imaginative leap.

For, in the end, all it took were a few checks to the environment of low interest rates and ever-expanding credit, then for borrowers to begin defaulting as mortgages reset from their initial ‘teaser' rates: imaginations promptly ran riot. Like Lady Ashley Brett's fiancé, Michael, in The Sun Also Rises, the American financial-services sector went broke "gradually and then suddenly". Between 2000 and 2007, employees in the relatively small London office of AIG, which specialised in a form of mortgage-securities insurance called credit-default swaps, earned themselves US$3.56 billion. When that office's prodigality brought AIG to the brink of collapse in September, the Federal Reserve had to lend the firm US$85 billion. So far the 158-year-old Lehman Brothers - driving force behind RCA and the birth of television, patron of enterprises from Pan Am and TWA to Sears and Macy's - has been the most venerable casualty. The monocled banker in Monopoly is based on Otto Kahn, driving force in Kuhn, Loeb & Co., Lehman's 1977 merger partner; in this instance, there was no Get Out of Jail Free card.

All manner of reckonings flow from this twilight of American finance's idols. At the very least, it portends an end to financial innovation for its own sake, and to financial regulation by its own kind. After all, if ever a regulator has proven accurately designated, it is the Office of Federal Housing Enterprise Oversight: oversight by name, oversight by nature. Nobody but nobody, meanwhile, feels anything for the displaced of Wall Street, even other businessmen. Long before the present discontents, GE's Jack Welch, officially the twentieth century's most admired chief executive, was complaining that "there are more mediocre people making more money on Wall Street than any other place on Earth." Mind you, this gripe, and many like it, has a back-story: GE's foray into investment banking, through Kidder, Peabody, was an expensive shambles. And if Wall Street was a bastion of mediocrity, it was a mediocrity that lionised Welch and his chief-executive generation, and that set the standards by which commercial success was judged.

Whose standards apply now? They will surely look different. In the 20 years or so that business has successfully made its welfare a paramount concern of government, chief executives, boards and senior management have come to regard economic conditions conducive to profit growth as a right rather than a privilege - an assumption now freely in question. The allegedly objective measure of their talents has been the stock market, its forces harnessed for their benefit by outrageously generous equity-based compensation schemes - a racket now in no little peril. Seven years ago, in his book The Mind of the CEO, Jeffrey Garten, then Yale's dean of management, noted: "Today's CEOs have no first-hand knowledge of a full-scale economic depression and most have limited experience with operating in a serious recession. Vietnam excepted, war is not part of the personal history of any of them." Whether Iraq and Afghanistan have rendered the second assertion redundant, the sub-prime crisis is set to undermine the first. Mortgage-backed securities, then, are not the only overvalued assets ripe for a write-down. Henry Clews was right: not every development in a bear market is to be scorned.

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