Good reading: Too Big To Fail: How Wall Street and Washington Fought to Save the Financial System—and Themselves

Good reading: Too Big To Fail:  How Wall Street and Washington Fought to Save the Financial System—and Themselves by Andrew Sorkin (Viking, 2009) 544 pp.

Four years have passed since the collapse of Bear Stearns, which ushered in twelve months of economic recession and financial market upheaval. To historians of the economic history of the United States and its financial markets, the importance of this period is rivaled only by the Crash of ’29 and the Great Depression. The causes and consequences of the 2008-09 crisis will be debated and continue to be controversial for decades to come, but the definitive narrative will likely remain Sorkin’s Too Big To Fail. In 544 pages of gripping day-by-day description of the major participants and developments, Sorkin admirably captures the pulse of Wall Street and Washington during these unforgettable months. The passage of four years provides a fresh perspective for a re-read of this to-be classic, and the book should be required reading for young professionals entering the investment industry.

The most dramatic and historic events of this chaotic year occurred in September of 2008.  In less than 30 days, the financial landscape was forever altered. Mortgage giants Fannie Mae and Freddie Mac were taken over by the government. Lehman Brothers filed for bankruptcy. Merrill Lynch was sold to Bank of America in an eleventh-hour rescue. American International Group, the largest insurance company in the U.S., was put on government life support. Morgan Stanley and Goldman Sachs, in a desperate effort to avoid a similar fate, rushed to become bank holding companies thereby gaining unlimited access to the Federal Reserve’s discount window. The failure of Reserve Primary Fund triggered a panic run on money-market funds that threatened to disrupt the entire financial industry. The Dow Jones Industrials commenced a plunge with unprecedented volatility that by March of 2009 measured 50%.

Sorkin’s narrative centers on the indefatigable and at times frantic efforts of Treasury Secretary Paulson, Fed Chairman Bernanke, and New York Fed head Geithner to steer the financial system through this perfect storm. As they were painfully aware, their actions constituted the biggest intrusion of the U.S. government into free-market capitalism in the country’s history. For this they were and continue to be condemned by many politicians and market commentators. Their defense is that their actions were necessary to prevent financial and economic Armageddon. Bernanke stated in a critical meeting with skeptical congressional leaders:  “I spent my career as an academic studying great depression. I can tell you from history that if we don’t act in a big way, you can expect another great depression, and this time it is going to be far, far worse.” In an oval office meeting with President Bush, Paulson said:  “If we don’t act boldly, Mr. President, we could be in a depression deeper than the Great Depression.”  Sorkin sides with Bernanke and Paulson:  “To be sure, if the government had stood aside and done nothing as a parade of financial giants filed for bankruptcy, the result would have been a market cataclysm far worse than the one that actually took place.”  

If Paulson, Bernanke, and Geithner were driven by a determination to save the U.S. economy, the heads of the major Wall Street firms and U.S. Banks were motivated by less lofty considerations.  These titans of American finance worshipped at the altar of personal status, money, and power.  On occasion they expressed concern for their shareholders and employees, but there is no mention of a desire to protect the public good. An example occurred in October, when the CEO’s of the 9 major firms were summoned by Paulson, Bernanke, and Geithner to a make-or-break meeting to approve an injection of taxpayer money into the financial system as a desperate step to restore stability. With tens of millions of American jobs at stake, the initial reaction of Merrill-Lynch CEO John Thain was to complain that such a step might result in changes in Wall Street executive compensation policies.

In an insightful epilogue penned in 2009, Sorkin offered the sober conclusion that the big Wall Street firms and banks remained too big to fail. He asserted further that ego, greed, and a “vulture capitalism” that abuses clients, which were a major ingredient in fomenting the turmoil, were still salient characteristics of Wall Street. Nevertheless, much has changed since the years and months leading up to 2008, and the likelihood of a similar financial upheaval is now remote. The overheated housing market and abuses in the mortgage industry, which precipitated the crisis, now seem to be a unique phenomenon of the past. The banks and investment firms are much better capitalized, much more sensitive to risk, and far more heavily regulated. The government has also learned from the experience, and is far more vigilant and better equipped to identify and respond to excesses before they imperil the entire financial structure. In retrospect, the cataclysm of 2008-09 created widespread economic suffering for millions of Americans, but it also provided a beneficial wake-up call. Sorkin’s book will be a reminder to generations to come of how perilous the situation was and thereby serve as a deterrent to a future crisis.     

Good reading: The Big Short

Good reading: The Big Short: Inside the Doomsday Machine by Michael Lewis (W. W. Norton, 2010), 264 pp.

In an immensely insightful, entertaining, and readable book, Michael Lewis chronicles the meteoric rise and catastrophic fall of Wall Street’s subprime mortgage market misadventure. This is a sorry saga of gargantuan greed perpetrated by unscrupulous Wall Street firms that in the end plunged the U.S. economy into the worst recession since the Great Depression and threatened a total demolition of the global financial system. Lewis’ vehicle is to spotlight a relatively small and obscure group of quirky investors who separately concluded that the U.S. housing market was a train wreck in the making. They recognized the opportunity for massive profits for those investors courageous enough and patient enough to bet against, i.e. short, the mortgage backed securities invented by Wall Street firms to feed their own avarice.

Lewis is highly critical of almost all the parties connected to the subprime mortgage market (including the mortgage firm executives and their sales forces, the rating agencies, American International Group and other insurance companies, the hedge funds, the U.S. Congress, the Federal Reserve, et.al.), but he reserves his harshest condemnation for Wall Street bond traders. This is a theme first developed 20 years ago by Lewis in his classic Liar’s Poker, which describes the Gordon Gekko investment world of the 1980’s. Once again Lewis reminds readers that the stock market may be the focus of media attention, but it was in the bond market “that it was still possible to make huge sums of money from the fear, and the ignorance, of customers.” Here, in this sparsely regulated and dimly lit cave of opacity and complexity, reptilian traders preyed on their naïve institutional investor victims: “An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons.”

In order for the Wall Street firms to exploit their customers, it was first necessary to dupe the rating agencies (Standard and Poor’s and Moody’s). In Lewis’ words, this was not much of a challenge: “Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain dead guys making high five figures a year the highest possible ratings for the worst possible loans.” The irony is that all of the major banks and investment houses on Wall Street eventually failed to recognize the risk involved in manufacturing toxic collateralized debt obligations (CDOs) and suffered fatal multi-billion dollar losses. Lewis asserts that were it not for the U.S. Government and the U.S. taxpayer “all of them, without exception” would have gone bankrupt.

Lewis provokes some interesting investment questions. Let us begin with the observation that it is not true, as some cynics claim, that investing is just another form of gambling in which the odds always favor the Wall Street house. Rather, investing involves the assessment of a security’s risk vs. reward with the understanding, often forgotten by professional investors as well as amateurs, that there is no free lunch on Wall Street. How could highly intelligent, trained, and compensated institutional investors abandon their homework and accept the soothing assurances of Wall Street traders that putting a rating agency’s lipstick on a bond pig suddenly made it beautiful? How could they commit such huge sums of money to recently invented collateralized debt obligations (CDOs) and credit default swaps (CDSs) when their risk and liquidity had not been tested over years of changing economic and market conditions? There seems to be no answer. Why did the Wall Street firms, overflowing with self-proclaimed geniuses, open themselves to such risk thus hastening their own demise? Lewis suggests it was because Wall Street was so busy gorging itself in a profit feeding frenzy that even the suggestion that it might collapse was tantamount to heresy. He adds that many of the top executives had not a clue as to how these new securities were constructed or what risk they entailed and/or they were lied to by their bond trading desks. This is a congenial if not convincing explanation.

The Big Short will not be, and was not intended to be, the comprehensive history of the great financial crisis of 2007-2009, but it is must reading for investors seeking an understanding of what went wrong. Readers will especially appreciate his lucid description of the nuances of the subprime mortgage market and his artful, if overly repetitious, explanation of the complexities of CDOs and CDSs. Most of all, Lewis brings to his narrative a provocative understanding of the driving energy of Wall Street and a gift for telling his story in a very entertaining way. The book is good reading.

Good Reading: Lords of Finance

Good reading: Lords of Finance: The Bankers Who Broke The World by Liaquat Ahamed (Penguin Press, 2009), 505 pp.

For investors tracking the ongoing efforts of governments and central banks to battle recessionary pressures and engineer a global economic recovery, we recommend strongly Ahamed’s informed and captivating Lords of Finance. The book focuses on the largely successful efforts of the central bankers of the U.S., England, France and Germany to restore economic and currency stability following the chaos of World War I and their subsequent policy mistakes that helped bring on the Great Depression. These bankers were men of sharply divergent backgrounds and personalities, and they were committed to the sometimes conflicting interests of their respective countries. Nevertheless, they managed at critical moments in the 1920s to coordinate policies, overcome the obstacles thrown in their path by the politicians, and weather one crisis after another. The glue that held them together was a near-religious faith in the gold standard, which they managed to restore after World War I and to maintain for a tumultuous decade. Ironically, the author argues that it was their slavish adherence to this inflexible gold standard that ultimately triggered the Depression and in the process tragically ruined their careers and reputations. For the author, who is no fan of the gold standard, the heroes of the book are John Maynard Keynes, the brilliant and controversial English critic of these central bankers, and Franklin Roosevelt, who rejected the insistent advice of his economic advisors and took the U.S. off the gold standard at the depths of the Depression in 1933.

Readers will enjoy and profit from Lords of Finance even if they are not sophisticated in economics or historians of the Great Depression. Ahamed, whose background includes a stint at the World Bank, patiently and expertly explains the formation of the Federal Reserve and its inner workings through the 1920s and 1930s. He also provides a clear explanation of the gold standard with its benefits and limitations, and places the economic and currency crises within a broader political and social historical context. Readers will also appreciate the ability of the author to paint personality portraits of the major protagonists. The book is a useful antidote to the currently fashionable thesis that seismic economic events, such as the Great Depression, are the consequence of largely impersonal and unavoidable political, social and demographic trends.

In a very instructive epilogue, Ahamed compares the Great Depression with the 2008-2009 global economic and financial crisis. Although he acknowledges the two events share many of the same characteristics, he concludes that the differences outweigh the similarities. His major point is that The Depression was the consequence of the misguided policies of politicians and central bankers; modern policy makers, enlightened by the errors of their predecessors, are now pursuing a contrary set of policies that will result in a more favorable conclusion.

The book deserves its accolade as the Financial Times and Goldman Sachs 2009 business book of the year.