I’m afraid that, while too little innovation can stultify financial markets and retard economic growth, the present market adventure shows that one can have too much of a good thing. The rocket scientists who have kept coming up with ever-more complex instruments in order to cure the investors’ various financial ailments have produced a cocktail of ‘cures’ which have the result of endangering the life of the patient. Not for nothing does the FDA, the regulator in actual charge of the vital industry which engendered this metaphor, require companies to demonstrate to its satisfaction not only that the new drug actually ameliorates the disease for which it is intended, but also that it does not produce side-effects worse than the disease in question. During last week’s market meltdown, one or two more perspicacious bloggers suggested that something like the FDA with its exhaustive testing procedures should be required of new financial products. The suggestion has some merit.
Until last week, the financial services industry had become as enthusiastic a proponent of innovation as the computer industry. Firms which used to look askance at any credential more academic than the basic M.B.A. were suddenly raiding the mathematics departments of the nation’s elite universities. The sine qua non of any new product was a Ph.D. who was the only person alive who could explain how it worked. Everyone wanted to have complex quantitative strategies which earned wafer-thin positive returns on vast piles of capital, and the more esoteric and unintelligible the strategy, the prouder the folks in the executive suite. The point was, that unlike classical investment strategies, these were all supposed to be low risk, and this justified the commitment of far more capital to them than ever would have been dedicated to any business which management actually understood. Boards were fobbed off with the avowal that those capable of understanding the math had examined the strategy and swore that the risks were miniscule to nonexistent, and that if, by some incredible mischance, the risks ever appeared to rise, the operation would be shut down.
Dozens of central bankers, hundreds of veteran investors, and old farts everywhere repeatedly warned that derivatives and all the strategies based upon them were making markets too levered, the investment business too much like a casino. They were all hooted down, and as the markets continued to rise, they were eventually persuaded that they had been wrong, or were simply cowed into silence. Warren Buffett, whose success has been so great it has been impossible for investors to ignore, called derivatives “financial weapons of mass destruction,” and growled that they made regulations defining margin requirements “a joke,” but no one stopped for more than 10 seconds to consider if he was speaking to them. Each bank was protected by an army of mathematicians, statisticians, and risk analysts, who would guarantee that Buffett must be speaking of someone else. Their bank would be protected if a crunch ever came. When it did come, no one was more surprised than the directors and senior executives of the banks which had profited most from the innovations. That they might have been imprudent allocating 50% of personnel and 80% of capital to one business line or set of related business lines had never occurred to them, because they had been assured by those responsible for dealing in the new line that the business in question was “low risk.”
The investment banks and insurance companies had flocked to all these innovations because their traditional businesses had been gutted by the banks’ very customers. They were engaged in a relentless competition less with each other than with the investors to whom they were providing their services. The only analogy which comes to mind is that of the auto components industry. These independent suppliers are each charged with manufacturing a given component for a lower cost each year, and their most savage competitor is the customer. But there are important differences: the primary auto manufacturer sets the criteria for the component in question, designs it (perhaps with the collaboration of the component supplier), and subjects it to its own quality testing. The financial consumer does none of that, until and unless the product fails. Instead, the financial services intermediary designs new products which will have better margins because the customers have negotiated away the margins in the older products and services. “You want to trade for less than two cents a share? Tell you what: we’ll deal net, and you’ll never have to be bothered again by how much we make.” “Don’t want to pay us for research any more? Try our new proprietary hedging service: we charge only two percent of capital protected.” “Want to buy bonds from each other and cut us out? Try our Structured Investment Vehicles instead: so much more sexy, so little risk.” “Want our bankers to work on your deals on spec? I’ll tell you what: we’ve got a little company you won’t want to resist, we’ll warehouse the stock for you, write options to protect your terms on the deal, we’ll only charge you half our usual fee, and we’ll even invite you to the little staff party we have down in Tahiti to celebrate its completion.”
The result of this ceaseless search for new ways to make the old profits was that the banks got bigger and bigger, richer and richer, and more and more fragile. Risk capital used to be, in the legendary AndrÃ© Mayer’s formulation, money that was back in the box by four o’clock. Investment banks gave advice, period. Wire houses got their commissions and took as few risks as possible. Underwriters tried to make sure that the stock was sold the moment the deal came. Wall Street and the City were both populated by more firms and more specialties than anyone could possibly name offhand, after the Great Crash of 1929 margin requirements were strict, pyramiding trusts were forbidden, and the danger that one failure could set off a whole wave of collapsing firms was virtually nil. Of course, the size of transactions was very much smaller, even allowing for the effect of inflation. No one could become rich from a single year’s bonus, and it might take twenty or even thirty years to make a fortune in finance. By the ‘seventies, many of the best minds at business schools had little desire to go to work on Wall Street. Better to go to work for an industrial conglomerate instead.
But the natives grew restless from such unallayed boredom, institutions saw an opportunity to stick it to those smug guys in the pinstriped suits, the SEC was not worriedâ€”nobody of any size had failed in yearsâ€”and so negotiated fees were born. The industry’s response was block trading. Relationship banking began to collapse, and so the bought deal came into being. Each of these innovations, however, required a greater commitment of capital, and so banks and trading firms had to combine to survive. The greater costs had to be covered by a higher volume of deals, which meant that the investment banks had to churn their customers more, to turn them into transactional junkies. Research became first more trading oriented, then more deal oriented, as plain sensible advice came to be less and less profitable. Firms set up proprietary trading desks to compete with their own customers, trying to get to the alpha first, then to dump their used ideas on the institutions. They also began to offer financial products aimed at the small investor, who was not able to negotiate down fees the way the big institutions were. Of course, the banks howled, screaming that Wall Street and the City were impinging on their turf, and that the barriers between investment banking and commercial banking were being subverted. They were of course, but the cure was not to re-erect them, but to tear them down completely, so that banks became investment houses and investment houses became banks. Thus, the whole economy was assured that if anything went wrong, (but nothing couldâ€”there were all those mathematical geniuses to guarantee that this could not happen again) it would affect everyone, and not just those involved in a limited sector.
The Great Crash of 1929 was not the cause of the Great Depression, but a result of an economic contraction which had begun in the farming sector as early as 1925, had begun to weaken the labor market, and had begun to affect industrial profitability and foreign trade by the Spring of 1929. The market was belatedly reacting to signs of danger such as the impending passage of the huge Smoot-Hawley Tariff, which was to lead to a global round of retaliation in 1930 and 1931. The market crash caused silly central bankers to decide to tighten up on the money supply as punishment for the obvious excesses of the previous period of credit expansion, and turned what would have been a nasty recession into the worst economic decline the world had seen since records began being kept. By contrast, the events of 2008 have been largely internal to capital markets. The actual decline in the housing market had been relatively constrained until midsummer, especially given the grossly over-stretched valuations of that market, and if the mortgage banks had not been so levered, would not have required them to withdraw credit to such a degree as to exacerbate the decline and increase the number of repossessions.
If this market crisis does spread to the rest of the economy and does cause a prolonged downturn or worse, much of the blame will attach to those who should have been paying more attention to the risks being taken by the financial services industry: the senior executives and directors of the banks and investment funds which made it happen. At bottom, this is a failure of governance: the failure of those who had no need to gamble with their firms to rein in those who had too much incentive in being reckless. Those who were charged with the responsibility of protecting their franchises, their shareholders, and their employees, should have regarded each new innovation in industry practice which raised leverage with a wary eye, and not allocated more capital to it than they could afford to lose. The sellers of snake oil have every reason to be ashamed. But so do the buyers, who cheered them on, bought their products, bought their shares, insisted upon unsustainable rates of growth, and then based their own investment strategies upon products whose viability and sustainability had never been tested.