The worm in the bud

I finally read Gillian Tett’s Fools Gold, an account of the development of the derivatives industry centered on credit default swaps (CDS) and collateralised deposit obligation (CDOs) that collapsed so spectacularly last year. The discussion is excellent, but still, I think, too charitable to these instruments and their creators. Tett’s main source is the group at JP Morgan who pioneered many of these derivatives and, largely, got out before the crash. Their line, unsurprisingly, is that the problem was not with the concept as they developed, but its abuse by latecomers.

But a close reading of Tett’s account yields a different story. These innovations were defective from day one.

The crucial thing that made all these deals work was the so-called ‘super-senior’ tranche of debt that was supposed to be almost completely immune to failure (until, of course, it failed). This stuff was rated better than AAA, with the result that lots of banks were willing to carry it on their own books, using Enron-like special investment vehicles to skirt the Basel 2 requirements for capital adequacy. The alternative was to find a supposedly risk-free backer, such as an insurance company (AIG) or that contradiction in terms, a “monoline” municipal bond insurer willing to diversify into insuring exotic derivatives (Ambac and MBIA). The JP Morgan crew were never comfortable carrying huge volumes of debt, even allegedly riskless debt on their own books, and that’s why they ultimately left the field to others. But according to Tett, the very first deal that was done involved transferring the super-senior debt to none other than AIG, whose threatened collapse forced the Fed into the trillion dollar bailout of 2008. So, the worm was in the bud – there never was a sound basis for the whole idea.

Another important implication is that, thanks to the massive size and complexity of modern financial markets, fundamentally defective innovations need not be weeded out quickly, and can grow to astronomical size before they are. Bernie Madoff’s Ponzi scheme is a straightforward illustration of this. When it was exposed, quite a few commentators suggested that no one could run a Ponzi on this scale for nearly 20 years, as Madoff did. The alternative explanation, which was shown to be baseless, was that Madoff must have initially run a speculative strategy, turning to a Ponzi only when that ran into difficulties.

This is one instance of a more general point emerging from discussion of the financial crisis. As Felix Salmon observes, the extraordinary profitability of investment bank can most plausibly be explained by the hypothesis that risk is being shifted, without compensation, to someone else. Salmon focuses on the case of ignorant buyers, sold products they don’t understand. But, as Arnold Kling observes, an equally important source of investment banking profits is regulatory arbitrage at the expense of governments, and, ultimately, the public at large.

There are two main ways these problems can be resolved. To protect both ignorant buyers and the public, it would be necessary to regulate investment banks in the same way as other banks, and much more tightly than either was regulated pre-crisis. In particular, the idea of letting Goldman Sachs get the protection of a commercial banking license while operating as an investment bank is an obvious example of the kind of regulatory arbitrage that needs to be stopped. Properly done, regulation of this kind would kill off investment banking of the kind with which we are familiar.

The alternative is to assume that the buyers of investment bank products can look after themselves, and focus on protecting citizens from being made to repeat the bailout disasters of last year. The only way to do this is to reinstitute a much tougher version of Glass-Steagall, raising high barriers to all kinds of transactions (ownership, financing, joint venture) between investment banks and the core financial system guaranteed by government. Something of this kind will have to be done with respect to hedge funds and similar outfits if we are not to have a repeat of LTCM somewhere before long.