Inside Job II

And the nomination for best Perp Walk goes to…

Today’s Financial Times’ articles: “Goldman president warns on bank rules” (Jan 26), “Financial crisis report to blame Wall Street” (Jan 26), “US Crisis Inquiry Points to Widespread Failures” (Jan 27)

Now comes the Financial Crisis Inquiry Commission report, the sequel to Oscar nominee “Inside Job”, the movie. Once again, all the players are here. Once again, a morality tale: “lax risk management, distortive bonuses, predatory lending, and insufficient regulation.” Once again, essentially a sub-prime credit fuelled housing bubble story, with leverage and derivatives as a putative amplification mechanism.

But wait.

From what I have read (I am about half way through the 622 page report) there is a disconnect between the conclusions of the report at the front and the wealth of detail in the body of the report. Perhaps the commissioners wrote the conclusions and the staff wrote the report? Never mind, the point is not to be put off by the up-front conclusions. Read the report.

Here is what the up-front conclusions say the storyline will be:

“While the vulnerabilities that created the potential for crisis were years in the making, it was the collapse of the housing bubble—fueled by low interest rates, easy and available credit, scant regulation, and toxic mortgages—that was the spark that ignited a string of events, which led to a full-blown crisis in the fall of 2008.”

Explicitly considered and dismissed are three other alternative narratives: “capital availability and excess liquidity, the role of Fannie Mae and Freddie Mac (the GSEs), and government housing policy.” But supporters of these alternative narratives will find supportive evidence inside the report, and that evidence supports another narrative as well, as I will be detailing in my next post.

In the press conference to launch the report, Phil Angelides emphasized several times that “the facts speak for themselves”. Of course facts never speak for themselves; what he is really saying is that everyone should read the report and connect the dots for themselves.

Of all the conclusions stated in the report, to my mind the most important is this:

“Our financial system is, in many respects, still unchanged from what existed on the eve of the crisis.”

This I read as a statement of fact about the state of the financial reform process. The Commission explicitly wants to think of itself as the financial market analogue to the National Transportation Safety Board (p. xii) which means that it makes no policy recommendations. Nevertheless, it is quite clearly saying that we are not at all done with reform; in fact we have hardly begun. We should all read the report and think about what kind of reform it implies.

Let me assure you that the report is not a hard read at all. Somebody at FCIC knows how to construct a story, and also how to write compelling prose. “Money washed through the economy like water rushing through a broken dam.” “Like a science fiction movie in which ordinary household objects turn hostile, familiar market mechanisms were being transformed.”

In this respect the report compares favorably to my previous favorite, the UBS shareholders report, a dry document but deeply informative, amply repaying the effort required to digest it. Swiss regulators insisted that the company come clean, explaining to the world how it managed to lose so much money.

When the UBS report came out, I wondered “Where is the analogous Citibank shareholders report?” Now we have it, and it reads like a financial thriller.

The early chapters build the suspense even as they take the reader on a journey through the strange and wonderful world of structured finance. The occasional pedagogical aids—well-conceived figures and beautifully drawn diagrams, including a recurring concrete deal CMLTI 2006-NC2—enter unobtrusively and at exactly the right moment.

Chapter 8 “The CDO Machine” is a key point of inflection in the narrative, the moment when the central dramatis personae make their entrance: Bear Stearns, Citibank, AIG, Goldman Sachs, Moody’s, and the SEC. After that it is “All In”, “The Madness” and “The Bust”. And only then, in Part IV “The Unraveling”, does the narrative turn chronological, beginning with “Early 2007” and Goldman Sachs’ prescient and fateful decision to get rid of its subprime exposure and go short.

Against the background of the Report, I read the remarks at Davos of Gary Cohn, president of Goldman Sachs, as warning that it can all happen again, indeed that it is already happening again. Current reform efforts are focused in the wrong place, on the traditional banking system not the parallel shadow banking system.

He warns about the future, but his warning suggests also an alternative narrative of the past. The global financial crisis is not just the collapse of a subprime bubble, but rather a stress test of the emerging new global financial (and monetary) system.

To be continued…

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