Antiplanner’s Library: Fool’s Gold

As previously noted, the Antiplanner has been reading a lot of books about the financial crisis lately. Some have tried (but failed) to be comprehensive. Most cover just a slice of the crisis, such as Bear Stearns (House of Cards) or Lehman Brothers (A Colossal Failure of Common Sense)

One of the most valuable books of the latter sort is Fool’s Gold, which focuses on J.P. Morgan. Curiously, this book has gone through a series of at least four subtitles:

  1. How an Ingenious Tribe of Bankers Rewrote the Rules of Finance, Made a Fortune and Survived a Catastrophe
  2. How Unrestrained Greed Corrupted a Dream, Shattered Global Markets, and Unleashed a Catastrophe
  3. How the Bold Dream of a Small Tribe at J.P. Morgan was Corrupted by Wall Street Greed and Unleashed a Catastrophe
  4. The Inside Story of J.P. Morgan and How Wall St. Greed Corrupted Its Bold Dream and Created a Financial Catastrophe

Subtitle 1 is actually the best description of what this book is about. I suspect it is closest to the one written by the author, while the other three were written by publicists trying to sell more books.

In a nutshell, the story is that J.P. Morgan invented two financial tools that played key roles in the crisis. First, it developed credit default swaps, which allowed banks “to off-load the credit risk” of a loan “without selling the loan” (p. 47). A credit default swap is like insurance in that a bank pays another financial institution an annual fee–typically a small fraction of the value of the loan–for the life of the loan and the second institution repays the loan if the original borrower defaults.

For top quality, triple-A-rated securities, the annual fee for a 30-year loan might be a quarter of a percent. Over 30 years, the insurer gets paid 7.5 percent of the value of the loan. That might seem imbalanced since the insurer could have to pay out 100 percent if the borrower defaults, but only about one out of 330 triple-A-rated securities default in any 30-year period. If an insurer insures 330 such loans and one defaults, it still nets almost 25 times the value of each loan.

Then J.P. Morgan pioneered what came to be known as “synthetic collateralized debt obligations” (51). Instead of insuring each loan, one at a time, it combined hundreds of loans into one security. This was not original, since other banks had been combining mortgage loans into one security since at least the 1980s (53). J.P. Morgan’s innovation was to use credit default swaps to insure these bundle of loans.
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J.P. Morgan used these tools for loans to corporations. Other banks applied the same tools to mortgage loans. But they failed to adequately account for differences in risk between corporate and mortgage loans.

Most importantly, they misjudged the correlation of potential default rates for mortgages. For corporate loans, the correlation is low: just because General Motors defaults on a loan doesn’t mean the General Electric will. For mortgages, the correlation could be very high if, for example, housing prices become very volatile so that suddenly large numbers of homeowners are “underwater” (meaning the value of the homes declines to less than their remaining mortgage).

Under J.P. Morgan’s original program, only a fraction of the total bundle of corporate loans–say 7 percent–really needed to be insured because the chance that any more would default appeared vanishingly small. To satisfy regulators, J.P. Morgan persuaded AIG to insure the remaining 93 percent for a very low fee.

AIG initially insured mortgage loans the same way it had been insuring corporate loans. This left it exposed to hundreds of billions of dollars of liabilities when mortgage defaults turned out to be much higher than expected.

AIG actually wised up and stopped insuring mortgage-backed securities near the end of 2005. While there were others who continued to insure them, many banks–Citibank was one–only bothered to insure the supposedly high-risk part of the security (the 7-percent part of corporate loans, though probably a higher share of mortgage securities), and assumed the risk of the remaining supposedly low-risk portion themselves (205). This ended up costing Citibank tens of billions of dollars.

The real moral of the story is that J.P. Morgan and its CEO, Jamie Dimon, truly understood these risks, so it did not go heavily into the mortgage-backed securities market. It was under heavy pressure to do so in 2005 and 2006 because so many other banks were claiming huge profits from such securities. J.P. Morgan’s analysts couldn’t figure out how they could be earning such profits because they never imagined that the other banks would be failing to safeguard against the risk of defaults (pp. 140-142).

Thus the confusion over the subtitles, some of which make it sound like J.P. Morgan developed highly risky tools that led to the economic collapse. Instead, as subtitle 1 suggests, J.P. Morgan developed tools for minimizing risk that other banks failed to properly apply.

Contrary to subtitles 2, 3, and 4, greed was not the problem. Greed, after all, is a fact of life, perhaps especially on Wall Street, but that doesn’t mean that greed always leads to an economic collapse. It appears that the difference between J.P. Morgan and some of the banks that failed was that J.P. Morgan was run by a young CEO who was familiar with the strengths and weaknesses of these new tools. Other banks were run by older CEOs–Richard Fuld of Lehman Brothers was 10 years older than Dimon and had been CEO of his firm for longer than that of any other investment bank–or people who had never dealt with the risks of asset-backed securities.

Regardless of the subtitles, Fool’s Gold provided some important pieces of the puzzle of the economic meltdown. After I complete a few more books, I hope to put all those pieces together.

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About The Antiplanner

The Antiplanner is a forester and economist with more than fifty years of experience critiquing government land-use and transportation plans.

23 Responses to Antiplanner’s Library: Fool’s Gold

  1. bennett says:

    “Greed, after all, is a fact of life…”

    Anytime I read “fact of life,” or “human nature” or “just the way it is,” I chuckle, because it is always trying to take an important variable out of the equation.

    Sounds like a good read. Thanks for the report.

  2. bennett,

    To paraphrase Freeman Dyson, if we design our institutions as if people are greedy (Dyson used the word “crooks”) we will be better off than if we design them assuming they are altruistic (he used the word “gentlemen”). This is not, as Dyson says, simply because “crooks are more numerous than gentlemen” but because one greedy person can ruin a system designed for altruists while no number of altruists can harm a system designed for greed.

  3. Dan says:

    What Randal said. We’ve already learned this lesson over and over and over and over and over and over again. Still we forget every time.

    DS

  4. bennett says:

    I think I’m failing to make a connection here. Freeman Dyson seems to be the counterpoint to Mr. O’Toole’s conclusion. The other banks that “failed to properly apply” the tool, failed because they were not trying to minimize risk, but maximize profit. In a nutshell, they got greedy.

    To say “Greed, after all, is a fact of life,” to me is akin to saying we need to worry about something else.

    Point me in the right direction.

  5. bennett,

    My point was that the banks that failed did so not because they were greedy but because they failed to account for risk. The executives who ran Bear Stearns and Lehman Brothers all owned stock in their companies and lost billions of dollars when the companies went broke. That is hardly maximizing profits.

  6. bennett says:

    Mr. O’Toole,

    I think are viewpoints are not too far off. I wonder however, if the failure to account for risk was the result of lack of familiarity “with the strengths and weaknesses of these new tools,” or is risk simply easier to overlook when the gravy train is rolling in (It’s probably a combination of the two).

    When people overextend themselves with mortgage and credit card debt, are we to say it’s a simple miscalculation on their part, or do we say they should live within their means?

  7. msetty says:

    Randal, for the most part, those banks failed to account for risk because they were greedy.

    Failing to recognize Freeman Dyson’s point is also one of the intellectual shortcomings of typical libertarian dogma, which make libertarian dogma mostly impractical.

    Libertarians also typically fail to account for the massive power that can be sustained by huge corporations, who, realistically, will gain much political power, as they currently have. That is, lone individuals have no chance, as such (which is just one reason why labor unions are justifiable, despite how they’re hated and opposed by libertarians and garden-variety Republicans, for that matter.

  8. Dan says:

    Michael, in my reply above I actually thought Randal got it and had shed his dogma and recognized that people are greedy and will game the system if given the opportunity. Greed did in the banks and slammed our economies (well, not really did them in– we bailed them out and they continue unabated and unabashed, albeit at a lower level because they already took their profit and our economy overall is sluggish because of their greed). I think Randal is acknowledging that. Otherwise, yes.

    DS

  9. lgrattan says:

    Experts, ‘As the value of the Dollar continues to fall now, how many of you are now investing in real Gold, 20% or 30%??

  10. metrosucks says:

    You know what I really wonder about all this? How much of the banks’/investors’ exuberant behavior was driven by planners whose policies drove up the prices of land and houses on both costs?

    Oh, and no gibberish-based reply desired from either Dan or highwayman. Really.

  11. bennett says:

    They just made a mistake. Planners made them do it. Excuses, excuses. I think it’s time to own the fact that the greedy, aloof and amoral actions of certain private sector actors played a role in the economic decline of the last few years. There were many public sector contributors as well, but golly gee fellas, how many excuses are you going to make for the new era robber barons?

  12. Frank says:

    I think far too much blame is being placed on planners and not enough on banks, including the central bank (who are central economic planners, but not the type of planners being blamed here). I’m re-reading Rothbard’s America’s Great Depression, which explains the business cycle and its underlying cause: bank credit expansion. The Antiplanner has countered that if credit expansion were at fault, we’d be seeing bubbles everywhere. We are. Silver, which was below $10/oz before the burst, crossed $38/oz today. Look commodity prices: corn, soybeans, gold, copper, oil, coffee, sugar, you name it. They’ve risen

    This particular bubble and contraction has been exacerbated by government increasing moral hazard; only part of the Glass–Steagall Act was repealed; deposit insurance remained, however, and this gave banks and financial institutions license to let ‘er ride. After all, they’re ultimate gambling with money that isn’t their own. Why not take massive risks?

    Ending government deposit insurance and fractional reserve banking, which is essentially fraud, would go a long way to end the business cycle.

  13. metrosucks says:

    I agree Frank, but watch out; you’ll upset Highwayman.

  14. Dan says:

    Ending government deposit insurance and fractional reserve banking, which is essentially fraud, would go a long way to end the business cycle.

    This will actually cause more bubbles and more pain to the individual on lost deposits (like the 1930s). The exact opposite is true.

    But it will hasten the current transfer of wealth upward, which of course some people are all for and are acting now to ensure. So if you see the italicized happen, Banana Republic status is just around the corner and you’ll want to get your passport in order.

    DS

  15. metrosucks says:

    This will actually cause more bubbles and more pain to the individual on lost deposits (like the 1930s). The exact opposite is true.

    The Federal Reserve, in conjunction with the Bank of England, was responsible for the bubble, and subsequent crash, of the 20’s/30’s.

  16. Frank says:

    This will actually cause more bubbles and more pain to the individual on lost deposits (like the 1930s). The exact opposite is true.

    Please elaborate. How would more bubbles be caused? If a bank keeps 100% of DDAs on hand (therefore negating the need for deposit insurance) how could these deposits be “lost”?

    But it will hasten the current transfer of wealth upward, which of course some people are all for and are acting now to ensure.

    This is what’s already happening as banks take risks and the government bails out the wealthy bank owners, operators, and CEOs. As Rothbard explains:

    Banks are “inherently bankrupt” because they issue far more warehouse receipts to cash (nowadays in the form of “deposits” redeemable in cash on demand) than they have cash available. Hence, they are always vulnerable to bank runs. These runs are not like any other business failures, because they simply consist of depositors claiming their own rightful property, which the banks do not have. “Inherent bankruptcy,” then, is an essential feature of any “fractional reserve” banking system.

  17. Dan says:

    @16: having reserves means that depository institutions are more conservative (not in the current political meaning of the word) in their planning. Having deposit insurance means that depository institutions won’t leave Jane Q. Public stranded. That is why these controls are there.

    What happened with Glass-Stegall was that the wall between financial sectors was partially breached, allowing big banks to sell more products, which ended up allowing them to hide their chicanery. The banks who were gaming the system were much more than simply depository institutions.

    DS

  18. Frank says:

    “Having reserves means that depository institutions are more conservative (not in the current political meaning of the word) in their planning.”

    This does not answer my questions. Again, would 100% reserves cause more bubbles to be caused? How how could deposits be “lost” in a 100% reserve system?

  19. Frank says:

    Please insert “how” before “would” in my second sentence above.

    Thank you in advance for your detailed reply.

  20. Dan says:

    Why would anyone enact a 100% reserve system in the US? Why bring it up when fractional reserves was the original topic?

    DS

  21. Andrew says:

    “Why would anyone enact a 100% reserve system in the US? Why bring it up when fractional reserves was the original topic?”

    Well, it would certainly change the face of banking for the better.

    Loans could only be made by (1) selling bonds, (2) relying on funds supplied by long term non-demand deposits (like CD’s). If we really wanted to be radical, we would abolish usury at the same time and restore the silver dollar, which would effectively eliminate inflation.

    Why should bankers get the benefit of creating money out of nothing and getting the first crack at dollars before they are inflated away? And why should savers be punished by relentless and endless inflation?

    Anyone wanting to see how degraded the value of money has become need only consider the original value of the British Pound – which was one pound Troy of silver, or about $400 in todays money. The 240 silver pennies in a pound were worth somewhere north of $1.50 each, and even that was debased from the days of Rome when a denarius was 50 grains of silver, or about 2 pence in medieval British coinage.

    And to answer ahead of time everyone who objects to this line of thinking, America seemed to work perfectly well economically pre-1913 and the never ending Federal Reserve induced inflation of the dollar. Secondly, actual adherence to metallic money is the best antidote to war yet found. Governments cannot wage their ridiculous wars without the ability to inflate away the people’s earnings.

  22. Dan says:

    Right. But the bankers don’t want it. The genie is out of the bottle. If we couldn’t get reform two years ago, not gonna happen. We are some combination of plutocracy and corporatocracy, so your proposals will have the likelihood of flying about as much as Bessie the homely pig.

    DS

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