The Trillion Dollar Meltdown by Charles Morris

Yesterday I discussed Kevin Phillips' Bad Money, which was the first book on finance I turned to after the shock of this fall's crises on Wall Street. While the book had its strengths, it was really a regurgitation of Phillips' theories of American politics and economics as previously examined in several other books he has written, with a single chapter on securitization added in to tie his theories to current events. That chapter succinctly summarized the problem, but did not delve deep enough into the causes and consequences for my satisfaction.

The next book I turned to was Charles Morris' The Trillion Dollar Meltdown. Like Phillips' text, this was written in the aftermath of the credit crisis of summer 2007. But while it predates the bailout of Bear Stearns to the takeover of Fannie Mae and Freddie Mac to the collapse of Lehman Brothers, Morris' book provides such a cogent analysis of the underlying currents of the crisis that those who read it when published in March were surely not surprised by the events that followed.

Morris starts the book with a chapter titled "The Death of Liberalism," in which he gives a brief outline (including a reference to Kevin Phillips' The Emerging Republican Majority) of the decline of Keynesian liberalism, with "its central premise... that an economic intelligentsia could reliably employ government lever to achieve specific outcomes in the real world." In its place comes the rise of Milton Friedman's monetarism:

Monetarists taught that the supply of money was the product of the stock of money--just the sum of spendable coins, bills, checking accounts, etc.--times its turnover rate, or its velocity. Friedman's historical research showed that velocity was roughly constant, so government policy need concern itself only with the money stock.

As such, government regulation of anything other than the amount of money in the system was unnecessary at best, and more likely counterproductive. So the monetarists would have us believe. Morris takes us through the supposed triumph of the free-market after a sharp 1978 capital gains tax cut (which conservatives credit with the rise of venture capitalist investment; Morris says it was the growth of pension funds in the 70s) and Reagan's elimination of oil price controls (which conservatives credit with the fall in oil prices; Morris says it was the market doing its job over the course of the previous decade through efficiency gains and a recession). This faith in the free market was bolstered by a blinkered view of the economic gains made in the 1980s and 1990s, ignoring the lessons learned from the end of the leveraged-buyouts and the S&L crisis.

Morris lays out this history as an extended introduction to the new types of "investment technologies" that were largely responsible for a variety of economic crises from the late 1980s to late 1990s:

The new "quants" could carve up and reassemble old-fashioned asset classes so they were custom-fit to investor needs. Large-volume computerized trading could exploit tiny changes in stock prices or interest rates. Very broad new classes of complex, structured investment instruments revolutionized wholesale banking. All the new technologies and strategies harbored dangerous flaws that tended to reveal themselves only at points of great stress. Bigger, better, even more far-reaching versions of these strategies have now, in 2008, placed the entire global economy at risk.

Morris details the three "practice runs" that fit this model, from the 1987 stock market crash (portfolio insurance) to the 1994 mortgage crisis (collateralized mortgage obligations) to the 1998 collapse of Long-Term Capital Management (mathematical arbitrage models). Morris explains what ties all three crises together:

In the first place, all three of the crises developed in market pockets that were mostly outside the oversight of federal authorities. The relentless deregulation drive that started during the Reagan administration steadily shifted lending activities to the purview of nonregulated entities, until by 2006, only about a quarter of all lending occurred in regulated sectors, down from about 80 percent twenty years before...

A second fault line is a worsening of the "Agency" problem--or the problem of ensuring that an employee, a contractor, or a company performing a service doesn't act against your interest... But the new generation of mortgage banks sells off mortgages in weeks or months, brokers are usually compensated strictly from the fees they generate, and they often work with a customer entirely by e-mail or phone... As financial machinery fragments, Agency problems abound; in the brave new world of absolute markets, it is not only dangerously naive to trust your mortgage broker, but based on recent scandals in college tuition lending, even your student aid counselor...

Finally, a third dangerous trend is the increased dominance of investment decisions by mathematical constructs. The mathematics of big portfolios analogizes price movements to models of heat diffusion and the motions of gas molecules, in which uncountable randomized micro-interactions lead to highly predictable macro-results... But the analogies break down in times of stress.... Humans hate losing money more than they like making it. Humans are subject to fads. even the most sophisticated traders exhibit herding behavior... In other words, as all three of this chapter's crises suggest, in real financial markets, air molecules have a disturbing knack for clumping on one side of the room.

In the following chapter, Morris indicts Alan Greenspan's insistence on keeping the funds rate low (in fact, cutting it further to 1.00% for a full year) even after the second quarter of 2003 showed strong growth that would continue through 2004. He also goes after Greenspan's "resolute insistence on focusing only on consumer price inflation, while ignoring signs of rampant inflation in the price of assets, especially houses and bonds of all kinds." This became known as the "Greenspan Put," in which the Fed cuts interest rates any time the financial sector screws up and sends us toward recession: "No matter what goes wrong, the Fed will rescue you by creating enough cheap money to buy you out of your troubles."

With that in mind, Morris tackles the housing boom of 2000-2005. Unlike most housing booms, which are caused by demographic shifts (either increased birth rates, immigration, or mobility), Morris posits that the "2000s real estate bubble may be one of those rare beasts conjured into the world solely by financiers." But how did they do it?

Since houses are so leveraged, their prices are hypersensitive to changes in interest rates. As long-term rates trended steadily downward in the second half of the 1990s, the big banks plunged headlong into the refinancing, or "refi," business. It took a couple of years for consumers to catch on--extracting money from your house was an exotic concept. Banks mount lavish advertising campaigns to stoke their enthusiasm. Refis jumped from $14 billion in 1995 to nearly a quarter-trillion in 2005, the great majority of them resulting in higher loan amounts. Lower interest rates let you borrow more for the same monthly payment, pay off your old loan, and buy a new car with the difference.

That explains how consumers got on board, but that leaves the question of how banks got involved. Morris goes through the litany: automated credit scoring, automated underwriting allowing higher loan-to-income ratios, trimmed-back documentation requirements, and the advent of "devices to make housing more available to marginal credits" like ARMs, piggyback loans, and subprime loans. As we all know, this story does not end well:

As of the end of 2007, the industry borders on catastrophe. The housing boom is over: The widely followed Case-Shiller index of home resales shows that real home prices have fallen steadily throughout 2007. (As late as 2006, the forecasting consensus was that house prices never fall.) Delinquencies have been rising rapidly and, given the very low quality of recent-vintage loans, can only accelerate... Lender bankruptcies, with their attendant legal tangles, are spreading among the industry's erstwhile roman-candle growth stars.

All of this I can understand. This is relatively straightforward bad business practice, taking advantage of cheap money and loose regulations to pump up fees and commissions. But it also seems like a manageable problem. As Morris says, "[s]ubprime and similarly risky mortgages... still account for no more than 15 to 20 percent of all outstanding mortgages. Even assuming a high rate of delinquencies within that group, in the context of a $12 trillion economy, it looks like small potatoes." Exactly. Which is why it came as such a shock to me when this housing crisis started tearing down the giants of Wall Street.

To understand that "takes us to the heart of the giant credit bubble that we have so willy-nilly constructed." Morris outlines the creation of commercial mortgage-backed securities, followed by asset-backed securities for any asset that could be valued, and then collateralized debt obligations. The capstone to all this ingenuity, however, was the credit default swap:

To take a simple case: Suppose US Bank decides it is underexposed to credits in Southeast Asia. The old way to fix that was to buy some Asian bank branches or partner with a local bank. A credit default swap short-circuits the process. For a fee, US Bank will guarantee against any losses on a loan portfolio held by Asia Bank and will receive the interest and fees on those loans. Asia Bank will continue to service the loans, so its local customers will see no change, but Asia Bank, in Street jargon, will have purchased insurance for its risk portfolio, freeing up regulatory capital for business expansion.

Note the distinction of "regulatory capital," which refers to capital which is subject to a variety of government regulations. But the reason credit default swaps are called swaps, rather than insurance (which is what they are), is because insurance is highly regulated. Swaps are not. So all of this is going on with little or no supervision. To make matters worse, the only people who were asked to put their stamp of approval were the credit agencies:

The public may think of them as detached arbiters of security quality, like a financial Supreme Court. In fact, they were building booming, diversified, high-margin business. Between 2002 and 2006, for instance, Moody's doubled its revenue and more than tripled its stock price. Their core customers, however, were the big banks and investment banks, and since CDO bond ratings were usually heavily negotiated, it seems clear that the agencies slanted their ratings to please their clients.

The result of all this was to essentially take a tangible set of questionable debts (residential mortgages), repeatedly repackage them in dozens of complicated securities, the riskiest tranche of which the hedge funds would stake out absurdly leveraged positions (e.g. for every dollar of its own capital, the fund invests four more borrowed from one of its prime broker banks; in a risky tranche, this can multiple exponentially). Then, to get some protection from this risk, the banks and hedge funds sell each other credit default swaps and are on the hook for each other's risk; but since its not insurance, it does not have to be reported the same way.

In a sense, everybody's money was tied up in the same small subset of extremely risky loans; this led to great profits in the boom times, and the near destruction of the industry in the bust. Morris saw what was coming, and laid out a variety of end-game scenarios, including recession, and a credit meltdown, For those who read this book in March 2008, the events that followed were surely little surprised. Lehmann Brothers did not go bankrupt just because homeowners were not repaying the loans Lehmann Brothers made to them (though its ownership of subprime lender BNC Mortgage exacerbated the underlying problem). It went bankrupt because it left itself overexposed to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages (e.g. it kept the riskiest pieces for itself and sold the rest) and was tremendously over-leveraged, even beyond healthy levels of Wall Street leverage.

The only question is where it all stops. Morris points out a variety of issues still unresolved today, including credit card debt and credit default swaps. He also discusses other underlying problems facing the U.S. economy as it tries to stabilize and recover, including the "dramatic shift of taxable incomes toward the wealthiest people" over the past 25 years and the continued socialization of Wall Street risk. In a brief chapter entitled "Recovering Balance," he emphasizes the need for renewed regulation, and interestingly, the need for an overhaul of our health care system. These are little more than bullet points at the end of the book, but Morris hits the right tone, which is that if nothing else the current crisis requires "coming face-to-face with the past quarter-century's ruling ideology that expanding public resources is always wrong."

On a side note: in a twisted bit of irony, the events of this year were so cataclysmic that when Morris' book is published in paperback in February 2009, it will be titled The Two-Trillion Dollar Meltdown.