Fools Gold & The Great Crash 1929 reviewed together
This past Christmas, someone gave me Fools Gold to read. It occurred to me that I should review now as the sequel to The Vandals Crown. Gillian Tett’s excellent narrative of the rise and fall of the CDS swaps market naturally picks up the story of risk management and financial innovation. Writing book reviews takes a back seat to paying business, of course…so the review was delayed. Along the way, I read The Great Crash 1929 by John Kenneth Galbraith. Its narrative held so many parallels to the topics covered in Fools Gold that this review addresses both books.
Why would anyone care to read about ancient history…much less publish book reviews about it on the day that the U.S. Congress finalizes U.S. financial reform legislation and the G20 prepares to meet in Toronto? Because these books discuss and analyze recurring patterns in financial market behavior that merit attention today. When mariners navigate the oceans by looking at the stars, technically they are looking backwards in time at light emitted many many years ago. So it is with financial risk management and regulatory policy. Recurring patterns and commonalities over the years should enable us to learn from our mistakes. At least that is the hope.
This review encompasses a paragraph or two on each book. It closes with some reflections of common themes and observations that may be relevant to today’s risk managers seeking to craft stronger scenario analysis capabilities as well as senior executives seeking to craft strategic directions for their asset and liability management policies as financial regulation reform barrels forward.
For better or for worse, I can review Fools Gold from the vantage point of personal experience. During most of the time period covered by this book, I was working as the chief advocate and regulatory policy strategist at the IIF. This means that I helped the risk management community and senior bankers craft regulatory policy proposals associated with moving towards a world where credit could be traded and credit risk models could be understood better as tools for measuring and managing risk responsibly.
Tett obviously had unfettered access to the JP Morgan financial engineers that created the credit derivatives business. This provides a richness to the narrative that few could match. She captures well the optimism and objectives of the early days in the CDS business. She highlights portions of the story that are often lost in the political shuffle but help explain some of the outcomes in Congress this past week. Two particular historical facts merit a spotlight:
1. The CDS market was created to address the need in the corporate sector for more flexible credit arrangements. Tett provides excellent, plain English explanations for how these instruments were designed to operate that do not require a PhD in finance or physics to understand.
2. Commercial banks (financial firms that accept deposits) were effectively dragged into this business. The gradual shift of the banking business towards trading-oriented revenue streams is instructive for how an initially obscure instrument came to dominate banks’ bottom lines and change their perspectives and priorities.
The narrative also describes well and in some detail how the CDS business became the Achilles Heel of the banking framework.
I would have liked to see more discussion of the ancillary benefits that the underlying models provided to risk managers and the rise of the risk management discipline. I would also have liked to see more detail on how the discipline of risk management failed to live up to its risk control promise.
It is beyond the scope of the book, and thus probably unfair to ask for it, but I personally would like to have a seen a discussion of why some independent hedge funds (but not bank risk managers!) were able to comb through data on mortgage defaults and understand the weaknesses inherent in the investment vehicles and risk management products created after Congress lowered U.S. lending standards. In addition, BIS economists have done an excellent job over the last 18 months describing the structural shifts and weaknesses in European bank funding structures. Given the role that these banks played on the buy side, and the still delicate issue of why European banks would need so much dollar funding, it strikes me that there is more to the story of why demand for CDS products grew in parallel with demand for securitization products within global banking markets.
Many may find the story too sympathetic to financial engineers. Some may agree with me that ex-post reflections by some of the CDS pioneers sound disingenuous after the fact. Risk managers looking for insight into what went wrong even within an institution that otherwise managed the crisis situation well (JP Morgan) will have too look for a different book. I will continue to search.
Therefore, this is probably not the definitive book on the great crash of 2008. We probably need a few years and some perspective for that book to emerge. But it does provide good insights into the rise of the CDS market and how certain market participants experienced the great crash of 2008 and makes for good reading. The definitive book on the crash that has yet to be written, however, will pair assessments of the information technology and financial innovation issues with an assessment of the buy side issues that to date have remained relatively unaddressed.
If the review stopped here, we would have a nice morality play about the evils of financial engineering and the failures of risk management. Many would draw the conclusion that the CDS business was flawed from the start and different at many fundamental levels from anything that came before it. Many today believe that the Fed’s crisis management tools used in 2007-2008 and its recent renewed support for European financial markets were new. These readers are encouraged to pick up Galbraith’s book. They might be surprised to learn:
- The US had a shadow banking system in the 1920s as well: The short version of the crash of 1929 was that the magnitude was amplified by margin lending, and this justified increased regulation of the banking and securities sector to clamp down on this lending. However, banks were not the principle purveyors of margin credit to the financial system: “By early 1929, loans from these non-banking sources (corporations) were approximately equal to those from the banks. Later they became much greater. The Federal Reserve authorities took for granted that they had no influence whatever over this supply of funds…(The power to fix margin requirements was eventually given to the Federal Reserve Board by the Securities Exchange Act in 1934, a year in which the danger of a revival of speculation about equaled that of a renascence of prohibition.)” p. 31-32.
- SPVs were a major fixture of the financial landscape in the 1920s: Consider the following description of the collective investment vehicles created to facilitate stock market participation and consider what other market structures today could fit within this narrative: “Many of the early trusts were trusts – the investor bought an interest in a specified assortment of securities which were then deposited with a trust company…The investment trust became, in fact, an investment corporation. It sold its securities to the public…the sponsor ran the investment trust, invested its funds, and received a fee based on a percentage of capital or earnings. Were the sponsor a stock exchange firm, it also received commissions on the purchase and sale of securities for its trust. Many of the sponsors were investment banking firms, which meant, in effect, that the firm was manufacturing securities it could then bring to market. This was an excellent way of insuring an adequate supply of business.” P. 48-51. “Knowledge, manipulative skill, or financial genius were not the only magic of the investment trust. There was also leverage. By the summer of 1929, one no longer spoke of investment trusts as such. One referred to high-leverage trusts, low-leverage trusts, or trusts without any leverage at all.” P. 56.
- US support for European markets is nothing new: “In the spring of 1927, three august pilgrims – Montagu Norman, the Governor of the Bank of England, the durable Hjalmar Schacht, then Governor of the Reichsbank, and Charles Risk, the Deputy Governor of the Bank of France – came to the United States to urge an easy money policy. (They had previously pled with success for a roughly similar policy in 1925). The rediscount rate from the New York Federal Reserve Bank was cut from 4 to 3.5 percent. Government securities were purchased in considerable volume with the mathematical consequence of leaving the banks and the individuals who had sold them with money to spare…The view that the action of the Federal Reserve authorities in 1927 was responsible for the speculation and collapse which followed has never been seriously shaken. There are reasons why it is attractive. It is simple, and it exonerates both the American people and their economic system from any substantial blame…Yet the explanation obviously assumes that people will always speculate if only they can get the money to finance it. Nothing could be farther from the case. There were times before and there have been long periods since when credit was plentiful and cheap – far cheaper than in 1927-29 – and when speculation was negligible. Nor, as we shall see later, was speculation out of control after 1927, except that it was beyond the reach of men who did not want in the least to control it.” P. 10-11.
- The level of market interconnectedness (amplified by technological communications) today is not unprecedented. As someone who has been accused of having an iPhone attached to her hand constantly and who is addicted to information feeds from news sources via Twitter, iPhone apps and emails from friends, it is useful to consider that the 21st century does not present the first instance of technology and connectivity increasing dramatically the velocity of financial market activity. Galbraith’s descriptions of the ticker tape (precursor to the Bloomberg/AP/Reuters/CNBC news feeds and experienced in a similar manner at the time) and stock market volumes shows that the means may shift but market participants to connect and find new ways of sharing information is a perennial if not primodial need. The volumes recorded on the New York Stock Exchange (and related settlement challenges) leading up to the 1929 crash (including the mini-crash of March 1929) were just as stunning in their day (and just as challenging to existing technology) as today’s flash trading velocity. It suggests that efforts to slow down market activity or limit information connectivity are at best misguided and at worst counterproductive to the need for investors of all stripes to access relevant and timely information.
The book is less than 200 pages long. It can be read very quickly despite the fact that it covers much more territory than summarized above…all of it relevant to understanding today’s market dynamics. It should be required reading for anyone who cares to understand well the precedents and perennial challenges that trading markets and their regulators (not to mention the central banks) face today when seeking to establish some stability and a new foundation for intermediation in global markets.
The only major missing piece in the narrative is the contribution that bank failures (and the lack of deposit insurance) played to exacerbating the fallout from the 1929 stock market crash. It discusses in some detail the aftermath of the crash well into the 1930s and some economic aspects of the Great Depression without once mentioning the failure of Creditanstalt in Austria in 1931 and only once mentioning the rate of bank failures in the United States.
Reading this book while the U.S. Congress deliberated in conference on financial reform left me with the uneasy sense that many of the underlying components generating fragility today are not being addressed. European governments have created their own SPV to craft a debt-financed stabilization mechanism for troubled economies. I wish them well. I do not think anyone wants to live in a world where a major European sovereign defaults at this stage. But history and current economic data suggest more challenges are on the way before we can definitively say that the system has worked to contain and manage fragility, much less deliver solid growth and jobs. In the U.S., media reports this morning indicate that corporates engaged in hedging will not be required to clear their derivatives transactions centrally, making me wonder what the definition of “hedging” might encompass after the Goldman Sachs hearing this spring. Recalling that AIG’s devastating derivatives activities were conducted through a separately capitalized subsidiary, I wonder whether requiring commercial banks to run their newly constrained derivatives activities through separately capitalized subsidiaries will generate the desired goal of financial stability or instead will only increase opacity and transactions costs in a still-fragile economy.
I do not believe that history is destiny. Nor do I believe that recurring behavioral patterns always manifest themselves in the same linear progression. However, I do believe that the challenges presented by new financial technologies and ways of thinking about risk over the years hold lessons for those of us seeking to make sense of current events regarding complicated financial policy issues.
My impression from reading these books now is that we are merely on the front edge of a much larger shift in financial market structure and its regulation that will last at least another 3 years, assuming no more major meltdowns occur. Today’s action by Congress will spawn numerous regulatory rule-making activities. It will also intensify the international negotiations underway under the auspices of the G20, the BIS, the IMF, and numerous sectoral global regulatory bodies. Staggered implementation of new rules will generate additional challenges for global and national economies, whose resilience remains shaky at best.
Anyone who believes that the regulatory reform initiatives are nearing their endgame after today’s Congressional actions and this weekend’s G20 meetings has not read their history and misunderstands the nature of the global policy process. They are encouraged to read these two books side-by-side and consider carefully the uncharted waters we are about to enter.
Buy this and other related books