Credit crisis: the inside conversation in New York City
September 22, 2008
In the past few days I made it a point to talk about the crisis to as many people as I could. I spoke to an official at the Fed and an ex-colleague of Bernanke; I listened to the head of a rating agency, a hedge fund trader, a celebrity short-seller and several professors of finance at Columbia.
This post is about what they said and how I make sense of it.
I’ll start with a personal observation: it is one thing to read about a crisis –say, October 1987- and it is another thing to live through it. I live in New York. I have friends who worked for Bear and Lehman. My savings are in a Merrill account. The atmosphere was very charged at work last week. One MBA student… like many others, probably in business school for a chance at one of those leveraged banking jobs… lost his temper with me and a colleague in the elevator. Even at home, my Wall Street journal stopped being delivered because, the distributor said, “of the market disruption.”
Something strange happens when a crisis hits close to home. The media tells one story, you live through a different one. Despite the obvious differences with nowadays, I experienced this for the first time on September 11th. At the time, the CNN showed nonstop smoldering images of Ground Zero… while my neighborhood in upper Manhattan continued brimming with life. A crisis can create strange form of dissonance. Glued to the media at all times, cutoff from others (who don’t want to talk, do not know what to say, are too confused to say something), I ended up with a weird sense of disconnection and unreality. Hence my efforts this time to talk to everyone I could.
Of hedge funds and microbreweries
First, where are we? The references about “the end of Wall Street” miss an important point: Wall Street has already grown far beyond investment banks. The demise of these broker-dealers is actually one more step in a long-run trend towards the flattening of hierarchies in finance. Starting in the end of the 1990s, Internet put information in the hands of many. In the utopian heights of the New Economy, the rhetoric was that this transformation was going to happen at the retail level: plain people, buying and selling stocks online. The promise did not deliver, and day traders lost their shirt. But the flatter hierarchies came upon us in a different way, through the hedge fund industry. Hedge funds have grown from around 1,000 to 7,000 in the decade, and the greatest concentration of them is located in the New York area.
In effect, then, Wall Street is similar to the beer industry. Just as the rigidities encountered by the large generalist producers, Anheuser Busch, Budweiser, etc., led to a burst of smaller and nimble microbreweries, hedge funds have taken on much of the proprietary trading at the large investment banks.
Securitization and processed meat
Second, is this the end of securitization? The problems involved in valuing collateralized debt obligations have led some observers such as fellow blogger Peter Levin to lambast financial innovation. So will securitization disappear? To answer this question, one needs only ask whether tainted meat scandals ever led to the disappearance of the hamburger. In effect, CDOs and processed meat are ontologically not so different: take some parts, create a whole. Just as it is cheaper to do a single slab of hamburger meat out of different scrap parts, it is more efficient to combine mortgages in a bond that to finance them individually. It is no coincidence that the US –home of the hamburger and McDonald’s– gave the world securitization. But it is equally true that the magic of the hamburger — scrap bits turned into a decent dinner — makes it more difficult to keep track of what you’re eating.
Next, how did we get to where we are? Most of the written opinion in the media focuses on greed. But this is more of a denunciation than an explanation. Are people, after all, greedier now than one year ago? Are bankers at safe Goldman less greedy than those at bankrupt Lehman? Rather than blaming greed, the people involved in fixing the situation are more focused in the sheer complexity that financial innovation poses.
Watch out whom you buy your hurricane insurance from…
One question was in my mind all through these days. What do the economists at the Fed think of all this? Free market but active in intervention, they must be going through their own share of thinking… On this front, I found out about the bailout of AIG at dinner on Tuesday night. Halfway through the main course at a Mexican restaurant in Hell’s Kitchen, a friend who worked at the administration reached out for his Blackberry. “That’s it,” he said as he checked an incoming email, “we’re bailing out AIG.” The conversation obviously stopped on its tracks, and turned to the crisis. The key reason for the bailout, the official added, is that the company was itself providing safety for others as a major seller of credit default swaps. The companies that bought default insurance from AIG did not consider that AIG might go down just when insurance was most needed. “It is,” he said, “like buying hurricane insurance from a company headquartered at a major hurricane area. The buyers did not fully think this through.”
The Wall Street Lab: A social studies of finance diagnosis
Now, what parts need to be reformed? This crisis has made clear that Wall Street still lacks a good system to deal with Knightian uncertainty, and here is where the intellectual developments of the social studies of finance are important. Following the science metaphor to finance, think of Wall Street as a giant lab: the future, as we learnt this week, is fundamentally unknown. The price mechanism allows different parts to engage in controversies (just as scientists do) that let them resolve their differences of opinion. Unfortunately, some of the tools provided by the system conceal uncertainty by lumping pure hunches with agreed-upon facts.
1. Enron-type problems are still here
For instance, consider accounting. In a conversation with Tano Santos, colleague at Columbia’s finance department, I was struck by the similarity between Enron and the investment banks. In both cases, the root cause relates to accounting. In the case of Enron, the energy-trading firm rose to be America’s most admired company by bringing the future into the present. The firm booked profits on deals that were expected to take ten or fifteen years. (Obviously, their lock on the future was not so secure.)
The case of the investment banks is not so different. The key reason why Bank of American bought Merrill rather than Lehman, according to its triumphant CEO, was that “their marks are more similar to us.” Whereas Merrill had been selling their CDO assets at 22 cents to the dollar, Lehman’s own rescue plan was marking them at 56. On the surface, the fact that assets can be marked at such different valuations suggests that the epistemic status of these securities is quite different from that of, say, historical assets. But they’re all lumped into the same category. Like in a bad graduate student paper, the solid claims and the adventurous ones are all mixed together in some vain hope to convince while confusing.
2. Biases in research and rating
Second, consider the perverse incentives that bias credit rating. Everyone knows this by now: companies pay for their own ratings, biasing the result. And, indeed, this is a replay of the incentive problem of securities analysts in the early 2000s: it was the company being analyzed, not the reader of the reports, that was paying for it through IPO commissions.
But here’s what I find interesting. In a panel presentation by Sean Egan, a celebrated credit rating manager, I found out just how perverse the system is. (Egan is the only rating company that is paid for by the client, the institutional investor.) When Moody’s made its ratings more strict this past July, it actually lost business.
The underlying problem is about the value of knowledge. It is very difficult, it appears, to charge for valuable financial knowledge. The aftermath of the analyst settlement case, for instance, suggests cause for pessimism. As it turns out, the mandatory independent research imposed by the judges was not used much by institutional investors. More academic research on this front would be very valuable.
Looking ahead: the next open front in economic sociology?
Going forward, the existing situation is going to open many new opportunities, both financial and intellectual. The greatest source will be the new regulations being created. I expect to see investors who specialize in arbitraging the overlap between what David Stark calls two different “regimes of worth,” the market and the state.
Incidentally, Yuval and I have been thinking about this quite a bit: this intersection between politics and markets has, we believe, been much overlooked by orthodox economic sociologists, partly because of their deliberate attempts to stay out of politics and focus on networks or cognitive structures. But now, more than ever, we need to understand the political in markets. So, stay tuned, because Yuval and I are thinking about this for our next academic event. Details to come soon… in this blog.