The Question Concerning Finance: Party Like It’s 1929? Or Prepare Like It’s 1957?
posted by Frank Pasquale
Another day, another story of Wall Street’s failure to allocate capital responsibly. Today’s installment appears on ProPublica, and describes how “Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history:”
Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses: They created fake demand.
A ProPublica analysis shows for the first time the extent to which banks — primarily Merrill Lynch, but also Citigroup, UBS and others — bought their own products and cranked up an assembly line that otherwise should have flagged. The products they were buying and selling were at the heart of the 2008 meltdown — collections of mortgage bonds known as collateralized debt obligations, or CDOs.
As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created — and ultimately provided most of the money for — new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those. . . .Because of Wall Street’s machinations, more mortgages had been granted to ever-shakier borrowers.
The article explains the details of the deals, whose byzantine structures should be numbingly familiar to anyone who’s read ProPublica’s earlier work on Magnetar, or chapter 9 of Yves Smith’s book Econned. Smith calculated that, “if you look at the non-synthetic component, every dollar in mezz ABS CDO equity that funded cash bonds created $533 in subprime demand” (Econned, 261). (If mezz ABS CDO means nothing to you, I highly recommend Smith’s blog, or John Lanchester’s I.O.U., the most stylishly written of the “crisis” books.)
Behind all the reticulated swaps of risk and reward, in article after article, the crash of 2008 is boiling down to a familiar story: endless leverage designed to support ever more fee-generating deals. It didn’t take genius to come up with these schemes; as Thorvaldur Gylfason writes, our bankers were about as creative as Mel Brooks. (Or, as Clive Dilnot puts it, “The Producers were more inventive, the stock-exchange games of the 1920s were more complex.”) Consider John Kenneth Galbraith’s chapter “In Goldman Sachs We Trust” in The Great Crash of 1929, which includes this excerpt on investment trusts:
In 1929 the discovery of the wonders of the geometric series struck Wall Street with a force comparable to the invention of the wheel. There was a rush to sponsor investment trusts which would sponsor investment trusts, which would, in turn, sponsor investment trusts. The miracle of leverage, moreover, made this a relatively costless operation to the ultimate man behind all of the trusts.
ProPublica’s Jake Bernstein and Jesse Eisinger describe a daisy chain of CDOs whose “incestuous trading . . . made the CDOs more intertwined and thus fragile.” They make it clear that “banks were lending money to CDO managers so they could buy the banks’ dodgy assets.” In the end, who cared what entity was ultimately responsible for assessing real asset values, as long as the fees and bonuses got paid. “A CDO called Octonion bought some of Adams Square Funding II,” then “Adams Square II bought a piece of Octonion;” like Enron’s imaginatively named off-balance-sheet-entities, the CDO shuffles permitted investment activity to become ever more unmoored from the real economy it is supposed to support. Indeed, as one longtime finance reporter puts it, “the ratings agencies . . . [whose] triple-A rating could compensate for the complexity of the products emerging from the CDO-creation pipeline. . . proved even more flawed in their ability to serve as some kind of guardian of the health of the financial system than the accountants who had blithely overlooked years of financial misstatements by the likes of Enron and WorldCom” (Suzanne McGee, Chasing Goldman Sachs, 285).
What’s next for finance? A number of legal scholars have penetratingly written about intertwined failures of technical and legal compliance systems in the financial system; I particularly recommend the work of Kenneth Bamberger and Erik Gerding. They have outlined commendable changes for the current regulatory framework.
Nevertheless, I worry that Wall Street dealmaking has become so rococo that something more than new regulation is needed. As Suzanne McGee suggests in Chasing Goldman Sachs, “pursuing the maximum level of profits and return on equity, without heed to systemic risk or the interests of all the stakeholders in the money grid,” is a recipe for future stagnation and crisis (306). Moreover, as Mahmoud A. El-Gamal and Amy Myers Jaffe write in Oil, Dollars, Debt, and Crisis, “energy policy, the regulation of financial markets and institutions, and international relations as they pertain to Middle East geopolitics are so closely intertwined that it makes little sense to contemplate any of the three without contemplating the other two simultaneously” (191). The fundamental question for critics of Wall Street now is: where should the capital misinvested in the MBS/CDO/CDS hall of mirrors have been allocated? Without a clear idea of the substantive answer to that question, all that we can reliably expect in the future is that capital will be allocated to whatever instruments lead to the highest fees for finance intermediaries. These fees bear no necessary relation to the long-term infrastructural and investment needs of society as a whole.
Smith has noted that Amar Bhide’s recent “indictment of modern finance” in the Harvard Business Review is “unlikely to get the traction it deserves because no new paradigm is waiting in the wings.” I think that there are such paradigms available, but their implementation would require either patient and public-regarding investors (who might do much more to promote green projects) or ambitious government actors (who could push the industrial policy already pursued by DOE, HHS, and DOD into new sectors of the economy, perhaps in part by making socially responsible investments more attractive than the mine-run of stocks and bonds). All are in short supply now. But the ever-increasing Chinese and European investment in green energy should be a Sputnik moment for America—that 1957 catalyst for collective action that spurred the nation to commit resources to enterprises likely to bear real and equitably distributed returns in the future.