If you’re like most Americans, you probably don’t understand why the economy is such a mess. What you do know is that gas costs almost $4 a gallon, every trip to the grocery store is a shock, your neighbor’s house is in foreclosure, your 401(k) is shrinking, and you didn’t go to Europe this summer because the dollar plummeted. You may have heard that something called Bear Stearns collapsed, and that heads are rolling on Wall Street, but you don’t know a hedge fund from a privet hedge or a credit default swap from a parish swap meet. The cascade of bad economic news feels both overwhelming and mystifying.
If that’s you, then Charles R. Morris’s The Trillion Dollar Meltdown is a book you need to read. A lawyer and former banker, as well as a distinguished writer on business and finance (and Commonweal contributor), Morris cuts through the bafflements of modern finance to explain why the credit markets crashed in October 2007. In the process, he demystifies financial terms and jargon, linking them in an overarching narrative that extends from the Nixon administration to today and offering a brilliant analysis of how the ideological paradigm of free markets and deregulation contained the seeds of its own destruction.
The Trillion Dollar Meltdown is objective, but not dispassionate. Morris is justifiably indignant about the short-sightedness, foolish optimism, and downright stupidity displayed not only by sophisticated market players, but by institutions with regulatory responsibilities, such as the Federal Reserve Bank. His analysis of how reckless financial practices and Republican tax policies have produced gross economic inequality makes for a bitter indictment. Market booms are fueled by greed, and Morris relates how the recent credit bubble swelled monstrously as greed overwhelmed prudence. The credit market started to freeze in October 2007, when lenders began to fear that large institutional borrowers would not be able to repay their debts, or that the securities offered as collateral were illiquid. The trust between institutions controlling the vast, largely unregulated credit markets evaporated. An interplay of greed and fear burst the credit bubble, causing a catastrophic collapse.
From a moral perspective, the pain that has resulted may seem like fitting punishment for predatory lenders, faithless fiduciaries, over-clever financial engineers, and investment bankers who conjured personal fortunes from other people’s money. Even ordinary Americans, maxed out on their credit cards and home equity loans, unwilling to save, but eager to buy houses they could not afford, seem to be getting what they deserve. Yet, casting recent financial history as a tale of greed and punishment misses the complexity of the situation. As Morris shows, our dilemma is as much the product of good ideas and good intentions gone sour—overconfidence in ideological assumptions and technological innovation amplifying failure in unexpected ways—as it is of greed.
The Trillion Dollar Meltdown traces our current financial crisis back to the 1970s and the inflation triggered and sustained by Nixon’s and Carter’s Keynesian approach to managing the economy. As the era of Keynesian consensus expired ignominiously, a counter-ideology became the dominant economic paradigm. Morris argues that this ideology, associated with University of Chicago’s department of economics, lies at the root of the present troubles. “Chicago School” economics, of which Milton Friedman was the most influential exponent, emphasized the capacity of free markets to produce efficient, wealth-maximizing outcomes and the tendency of government intervention to produce inefficient ones. Friedman and others advocated the deregulation of financial markets, a policy embraced enthusiastically by the Reagan administration.
Sometimes deregulation had positive effects. It facilitated, for example, the leveraged buy-out (LBO) boom of 1982–89, which involved the creative use of debt (leverage) to acquire and dismantle uncompetitive companies, freeing up their productive assets to maximize their value. LBOs, the predecessors of today’s private equity deals, were an ingenious financial technology that created wealth on a broad scale and set the stage for the dramatic restoration of American competitiveness in the ’90s. But they also had perverse consequences. After the spectacular success of the first wave of LBOs, investment bankers started to do deals that made no economic sense, but paid enormous fees. The amounts of leverage used to finance company acquisitions reached staggering heights, leaving the acquired companies saddled with too much debt to survive. The bad deals swamped the good ones. At the end, financing for LBOs disappeared and the LBO bubble burst. What began as a great idea with positive economic effects turned into a market mania that collapsed because of the lemming-like behavior of market players.
This would happen again, as Morris shows. The tendency of unregulated markets to develop bubbles surfaced in the 1980s’ savings-and-loan debacle, a direct consequence of the elimination of legal restraints on self-dealing by S & L owners and managers. In the 1990s, the dot.com bubble grew out of something real—the Internet revolution—but soon developed “irrational exuberance,” in Alan Greenspan’s famous words. (Greenspan, whom Morris calls “something of an anti-regulatory zealot,” soon abandoned his reservations about the dot.com boom, “refus[ing] to tighten stock margin rules to take some air out of the tech bubble,” much as he chose not to curtail bank lending for highly leveraged LBO transactions until it was too late.)
The risk of bubbles became even more acute with the rise of derivative debt securities. These securities, whose value is derived from pools of underlying debt obligations of many different types, including mortgages, represent bets on whether the value of the underlying obligations will rise or fall. They are by definition speculative, but they created new markets for mortgages on real estate and many other kinds of debt. By turning garden-variety home mortgages into securities (“securitization”), investment banks generated a flood of new money into the real-estate market. The securitization of debt coincided with low interest rates and the largest run-up of real estate values in history, a combination that sucked more and more money into real estate. Debt securitization brought great benefits to the credit markets-but also great risks. The exponential growth in the use of debt derivatives, Morris demonstrates, led directly to the great credit crash of 2007.
The mechanics of that crash, and how mortgage debt propelled it, are complex. The securities that cratered so disastrously were derived in part from subprime mortgages, which represent loans on residential real estate with a high risk of default. These mortgages were bundled into packages called collateralized debt obligations (CDOs), which proliferated and were sold around the world, particularly to large banks and other institutional investors, spreading risk of default to investors hungry for a higher return on what were supposedly safe investments in highly rated debt. These investors also were reassured by the availability of default insurance. That type of insurance, however, was originally designed to protect only against rare municipal-bond defaults; when insurers also began to offer protection against possible CDO defaults, they generated massive new exposures that they could not cover, putting themselves and everyone relying on default insurance at great risk. Meanwhile, novel instruments known as credit default swaps were designed to hedge against defaults on CDOs and other asset-backed securities derived from pools of credit-card, student-loan, and auto-loan obligations, allowing large institutional investors to trade the risk of default with other such investors. The huge swaps market, virtually unknown to the general public, exposed participants to mind-blowing levels of liability. Finally, banks aware of the risks of investing in securitized debt stuck their asset-backed securities in off-the-book “special investment vehicles” or SIVs, so that their losses on those instruments would not be counted against the capital that regulators require banks to maintain. Those banks were like patients required by their cardiologists to stick to low-fat diets who calculate their fat consumption without including the daily luncheon cheesesteak.
CDOs and similar instruments were designed through complex, computer-based mathematical models that purported to allocate risk and return with perfect precision. To Alan Greenspan and many others, debt derivatives created a new credit paradigm that facilitated the flow of debt capital and spread risk efficiently to minimize the consequences of default. But the new credit paradigm proved to be a delusion. As the flow of debt into real estate drove prices to unsustainable heights, the Fed’s unconscionable decision to maintain excessively low interest rates made money virtually free to lenders and facilitated massive amounts of risky lending. From 2003-2006 credit standards declined precipitously. It was the era of “NINJA” loans, when you could get a residential loan even if you had “no income, no job, and no assets.” Mortgage originators would sign up virtually anyone, and get themselves off the hook by bundling mortgages together and selling the bundles to investment banks, who in turn would create complex CDOs bundling hundreds of mortgages of all types, and sell them into the securities markets. This process not only virtually destroyed credit standards, because mortgage originators cared only about their fees and not the likelihood of repayment, but also spread the subprime virus throughout the financial system to institutional investors who had no idea that they were exposed to the collapse of the subprime market.
And that collapse was only part of the problem. An overriding issue was that the amount of default exposure was almost impossible to calculate. CDOs and other asset-backed securities had become so complex that in a time of widespread defaults and the evaporation of the market for them, no one knew how to value them. They could not be “marked to market” because there was no longer any market price for these now-illiquid securities. If they could not be valued, they could not be used as collateral for the type of routine borrowing that kept financial firms such as Bear Stearns afloat. Soon fear and distrust overwhelmed the financial world, credit dried up, hedge funds were wiped out, and financial institutions around the world faced massive losses. As Bear Stearns’s huge bets on CDOs and other asset-backed securities were lost, its lenders refused to lend to the firm, and only a Fed-backed acquisition by J. P. Morgan Chase prevented bankruptcy and the total loss of its equity. The credit merry-go-round shuddered to a halt, and at least a trillion dollars in wealth evaporated. The Great Unwinding had begun.
Morris’s exposition of all this is as lucid as discussion of such complexities can be. He does not foresee an early end to the problems created by the collapse of the credit bubble. Sure enough, while credit has freed up somewhat, the bad news keeps coming. Worldwide, financial companies have written down the value of their assets by $380 billion. (Seven of America’s largest financial companies alone account for $107.2 billion of that write-down.) At the end of the second quarter of 2008, Goldman Sachs and Morgan Stanley announced additional write-downs, and more are expected from the other large firms. Even worse, major companies such as the venerable investment banking house Lehman Brothers and Washington Mutual, the nation’s largest S & L, are teetering on the brink. And now a “second wave” of the credit crisis has developed, engulfing Fannie Mae and Freddie Mac—the government-sponsored entities that have long provided broad access to residential loans and mortgages—and requiring federal intervention. Merrill Lynch has just dumped billions of dollars of mortgage-backed securities at 22¢ on the dollar, and considers itself lucky. For the foreseeable future, even debt programs as fundamental as the student-loan program will be at risk, eroding what the American middle class regards as one of its core entitlements—higher education for its children.
The collapse of the credit bubble could not have come at a worse time. Internationally, the United States must now face the growing economic strength of the BRIC countries (Brazil, Russia, India, and China), adjust to higher oil and commodity prices, restore the value of its staggering currency, reduce its dependence on foreign investors to finance its deficits, and rebuild global confidence in our financial system. Because of our own folly, we must do all that as a poorer, more vulnerable, less self-sufficient and less confident country.
Yet there may be more cause for optimism than Morris’s bleak assessment suggests. To some extent, the financial turmoil triggered by the credit bubble’s collapse remains detached from the “real” economy—the production of goods and services sold both here and abroad. The disruption of the financial world has exacerbated risk of recession in the real economy, but that economy has proven surprisingly resilient. Global markets are now the dog wagging the American tail; the cheap dollar is fueling increased demands for American exports, and manufacturers are finding it cheaper to manufacture in the United States than abroad. Once the losses of the credit crisis are absorbed, credit standards restored to rationality, and profit expectations readjusted, financial markets and the real economy should re-engage, and the great engine of globalization should yield a new era of growth—as long as we forget the delusions that Morris has exposed in this masterful and sobering book.
Related: After the Meltdown, by Charles R. Morris