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Thursday, February 11, 2010

Whoops! Why everyone owes everyone and no one can pay

As we stagger out of recession, we might forget how close our cosy, liberal democracies were to imploding. It’s easy to ignore the trillions of dollars poured into the ether, the billions of dollars of national debt nobbling our future.

"To use a technical economic term," writes Lancaster, " we are screwed." The aim of his excellent book "Whoops!" is to explain how we got to this place where the only financial sunny side is that we’re not Icelandic. He is an outsider — not an economist, a financial reporter or a navel-gazing banker, but a novelist. This detachment is hugely useful in his quest to demystify the arcane world of banking. Those too close often fail to ask the right questions for fear of seeming stupid; and that has been part of the problem.

Lanchester argues that the credit crunch emerged in a peculiar climate: the post-Cold War victory of capitalism. The West’s ideological triumph spawned a rampaging version of laissez-faire capitalism. The leading proponents of this wild west capitalism, the bankers, had enormous political influence, in London and Washington, and encouraged the “aggressive deregulation” of financial markets.

Into this climate came sub-prime mortgages and the mis-pricing of the risks attached to the product. This is where Lanchester’s masterly prose comes into its own. All those of us who reported the early days of the credit crunch swap tales of trying to untangle the acronyms and tell the story in layman’s terms. It was a time of late nights and tortured rewriting of stories; of sinking exhausted into a vat of wine; of dreaming of collateralised debt obligations (CDOs) and structured investment vehicles (SIVs). So it was with awe, and a little professional envy, that we read Lanchester’s lucid untangling of these complex financial instruments. This book, aimed at the non-expert, carries the reader through the derivatives market, without need of booze or towels.

The crux of the story is this: how did a semi-fraudulent business selling home loans to those who could not afford them turn into a multibillion-dollar merry-go-round between the world’s biggest financial institutions, which nearly brought us all to our knees when the music stopped?

First, then, there are the home loans. Loosening the US mortgage rules in the 1980s opened up the so-called sub-prime market — loans aimed at those too poor or saddled with poor credit histories to qualify for a normal mortgage. As long as the risks are properly assessed, this is, in theory, a reasonable business. If a borrower is higher risk, the lender charges more interest.

While this market was developing, the bankers were in search of new ways of making money. Post-Enron, and the dot-com crash, shares were looking moribund and bond markets in a low-interest-rate era were scarcely any sexier. House prices, however, were rising; and the mortgage market looked like a good place to play.

Here comes the first acronym. Mortgage-backed CDOs already existed. A CDO is, Lanchester explains, “a pool of debt being paid back by a group of borrowers, which is added together and then sold on as a set of bonds paying a range of different interest rates”. The advantages are threefold — CDOs spread the risk of the debts turning bad and there are two streams of revenue, a fee for setting it up and one from the repayments on the bonds.

These CDOs were attached to conformist mortgages, ones where the risk of default was low. But the growth market was in sub-prime loans, which came with a different range of risks. Another financial innovation — securitisation — came into its own. This allowed the bankers to package the debts and rely on safety in numbers and default averages. Once a mathematical whizz-kid had come up with a formula to securitise sub-prime mortgages, the banks were away. The market in sub-prime mortgage-backed CDOs grew extraordinarily quickly, until it resembled an inverse pyramid. A giant market in CDOs was propped up by a mob of unscrupulous, commission-hungry mortgage salesmen selling increasingly toxic loans to America’s poor.

As Lanchester says: “The whole business was set up to lend ... [generating] huge amounts of sub-prime debt so that the industry could create all the CDOs it wanted.”

Another central tenet of Lanchester’s argument is that the dominance of mathematicians and financial modelling in these markets completely distorted notions of risk. The maths said that the CDOs were safe as US treasury bonds. The maths said that there was no risk. “A part of my brain follows the explanation,” Lanchester writes. “But a larger part is left reeling with incredulity that anyone could be so stupid/clever as to believe that human fallibility could be engineered into non-existence.”

He tops it off with the best description of the 15-year evolution of the credit derivatives, in a single sentence: "It's as if people used the invention of seat belts as an opportunity to take up drunk driving."

Then, Lanchester argues, the regulators, in Britain and in the US, totally failed to recognise the dangers inherent in this explosion of complex financial instruments. The culprit, he believes, is the assumption that markets will always effectively price risk. The regulators, Alan Greenspan chief among them, did not believe that they had to police these risks because the markets would do it for them.

Lanchester’s central thesis is uncontroversial. This is unashamedly a book for beginners; an informed outsider’s explanation of a series of extraordinary events. Its strength lies in its wit, and Lanchester’s underlying outrage at the moral failures that allowed the capitalist cowboys to break the bank.

It is not, however, the credit-crunch masterpiece. While Lanchester is brilliant on the origins of the crisis he is less thorough on the second half of the credit crisis — the bit when all the assets backed by toxic debt began to infect the assets backed by solid debt. The credit crunch also encompassed the total freeze on borrowing between banks, the breaking of thousands of deals that went beyond the CDOs and into other markets. It was about a corrosive atmosphere of fear and mistrust that destroyed the web linking the world’s economies and financial institutions.

Lanchester is also less than satisfying on why the crisis happened. The credit crunch, for all its origins in flawed mathematical formulae, was a very human debacle. Mathematicians are used to discounting common sense — any complex maths tells us that the true nature of the physical world runs contrary to intuition. Time and space warp and bend; the maths tells us it is so, yet our common sense revolts at the notion. Our fallibility was not factored into the equations. It is blindingly obvious that in a non-mathematical world, CDOs were structurally flawed. Why did that fact not matter to anyone involved?

The answer lies in the people involved in the drama — you and me with our thirst for debt and housing; the lenders, the bankers, the salesmen, the economists, the regulators and the mathematicians. All of us colluded in a debt bubble, with varying degrees of ignorance and cynicism. It’s too simple to say that bankers were clever but ruthless, regulators were stupid and we were innocent victims. The real picture is infinitely more nuanced. Lanchester sees this, but the absence of flesh-and-blood characters on his pages leaves him trying to capture the nuances with generalisations. Bankers “treated the rules as things designed by thick people to slow them down and hamper their rightful profitability”.

The book of the credit crunch will, I would bet, be a novel. The choice at present is between explicatory works of nonfiction, and a breed of confessional “I was too busy taking coke and spending my bonus on hookers”-type bank-lit.

The book that has come closest to explaining the “why” of the credit crunch was written 132 years ago. In "The Way we Live Now", the fictional account of a bubble in railway shares, Anthony Trollope draws exquisitely the dance between Augustus Melmotte, the financier who believes his own hype, and the politicians and investors who want to trust him. Trollope writes of the increasingly arrogant Melmotte: “It can hardly be said of him that he had intended to play so high a game, but the game he had intended to play had become thus high of its own accord. A man cannot always restrain his own doings, and keep them within the limits which he had himself planned for them.”

We are still looking for a modern Trollope to chronicle this crisis and its architects.

P.S. I bought my copy from the Book Depository who ship worldwide POST-FREE! Here you can watch other people shopping at the Book Depository.