The banker: once a financial anchor

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This was published 15 years ago

The banker: once a financial anchor

Kate Jennings laments how we keep setting ourselves up for financial catastrophe.

By Kate Jennings

We all have obsessions, and among mine, considered strange for someone literary, are the financial instruments known as derivatives that are at the centre of the economic meltdown we are experiencing. Derivatives are commonly defined as a financial contract where the value is derived from an underlying asset.

These contracts cover the buying and selling of a wide variety of goods, ranging from currencies and agricultural products to oil and metals to stocks and bonds. They are not inherently bad. Indeed, the commodity markets are based on futures, which is a form of derivative that has been around since the Sumerians.

We've landed in our current mess through the misuse of unregulated derivatives that became ever more ornate, ever more synthetic - frequently called bells-and-whistles securities but more like gimcrack and paste in the credit markets, which includes the mortgage industry.

My interest came about by accident. I went to work at Merrill Lynch as a speechwriter in the 1990s under the aegis of one of the directors. I needed money because my husband was ill. The boys in the communications department were none too happy to have a 50-year-old "left-wing bohemian poet" who didn't know a stock from a bond, and so they fed me to an executive who not only had an alligatorish face but the habits of one. He liked nothing better than to feast on communications staff. "Stay off his radar screen!" He terrified them.

The executive had to give a speech in Tokyo to the International Swaps and Derivatives Association, known as ISDA, and I had to write that speech. Armed with a list of the firm's bankers to interview, I was pushed into the deep end of finance. Once the speech was completed, it was distributed to all the top executives for comments.

I remember entering one's office, bigger than my apartment. He had a highly polished desk and a photograph of his wife, a blonde X-ray, standing in solitary splendour on a credenza behind him. As I approached, he asked, holding up the speech between his thumb and forefinger, "What's a nice young girl like you doing with rubbish like this?"

It was, shall we say, a transformative moment. I could have left his office, left the building, left the firm. But I wasn't young: I was 50 with a husband with Alzheimer's. And some might say I'm not even nice. I can take paint off a barn door if the occasion calls for it. As well, I was getting curious about bankers. They weren't, as I'd been led to expect, boring men and women in suits. I chose not to be intimidated. I replied, "Let's go over the rubbish." And sat down.

Derivatives were imprinted indelibly on my mind. The speech was given in Tokyo and deemed a success. The fearsome executive didn't eat me and spit out the gristle, much to the chagrin of my new colleagues. But when I left Wall Street seven years later and sat down to sort out my thoughts and write a novel about my experience there, I realised the speech was rubbish. It was stuffed with the standard banking frontiers-of-finance, mitts-off line on "innovative" structured products.

Financial-industry family trees - who lands where - are always interesting. For example, the trading desks of the financial products unit that got the insurance giant AIG into such trouble by venturing into derivatives were staffed by traders from Drexel Burnham Lambert, the company that went under in the 1980s because Michael Milken and Ivan Boesky pushed the junk-bond envelope. The alligatorish executive is now on the do-nothing board of AIG; the savvy one is wearing a white hat at the Financial Stability Institute, established as a clearing house on worldwide banking regulation.

I began to keep a scrapbook on derivatives. In went Alan Greenspan's speech to the Futures Industry Association in March 1999. Derivatives should remain unregulated, he said, despite the "trauma of the past 18 months". Those months saw a number of crises, but he was referring in particular to the Long Term Capital Management fiasco. Long Term Capital was a cutting-edge hedge fund heavily weighted in derivatives that went bankrupt in 1998, forcing the government to come to the rescue because so many Wall Street banks had large exposures.

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Then, on December 13, 2000, a tiny article on the business pages announced the imminent passing of the Commodities Futures Modernisation Act, which allowed banks to continue to self-regulate derivatives.

Brooksley Born, the head of the Commodity Futures Trading Commission, had gone up against Greenspan, the Treasury secretary, Robert Rubin, and the Securities and Exchange Commission head, Arthur Levitt, for two years after Long Term Capital failed, imploring them to regulate the "dark markets". She testified 17 times before Congress, to no avail.

The bankers had an ally, the Republican senator Phil Gramm, known latterly for giving John McCain boneheaded economic advice and telling Americans they are a nation of whiners. As the influential chairman of the senate banking committee, he called for "regulatory relief", saying we "would do well to remember the Lincoln adage that to ask a society to live under old and outmoded laws - and I think you could say the same about regulation - is like asking a man to wear the same clothes he wore as a boy". Even though Born is a real fighter - Greenspan and company called her "strident" in public and no doubt worse in private - she didn't stand a chance against the banking lobby. The Commodities Futures Modernisation Act came with a Gramm rider that allowed derivatives to flourish unchecked with minimal capital requirements - that is, the money banks should retain as a backstop in case anything goes awry.

We're done for, I remember thinking. Clipped it, pasted it in my scrapbook.

I first heard the phrase "moral hazard" when writing speeches for a JP Morgan executive. I asked if he made it up. He explained it was an insurance industry term - if a house is insured, appropriate care might not be taken to stop it from going up in flames - that had migrated to banking where it means, simply, that if bankers know government will save their franchise - their bacon - they will become careless in regard to due diligence and risk assessment.

The British comedians John Bird and John Fortune have made hay with the term. The interviewer asks, "Can we talk about moral hazard?" The obtuse banker goes blank: "About what?"

"Moral hazard," repeats the interviewer.

"I know what hazard means," says the banker, "but what's the other word?"

The concept of moral hazard was formulated by insurers in the 1600s, but the phrase didn't come into use until the 1800s. At first it had pejorative connotations, with the moral hazard of insuring dubious characters and certain ethnic and social groups. The Merriam Webster defined it as: "The possibility of loss to an insurance company arising from the character, habits, or circumstances of the insured."

With time, its use became more value-neutral, showing up in banking in the 1920s when deposit insurance was first considered. In the 1960s economists latched onto the term which, these days, can be found wherever risk is offloaded. A good argument can be made that moral hazard enabled the mortgage industry to lower its standards because brokers could pass the risk to lenders, lenders to banks, banks to investors. No one thought themselves responsible. No one had any skin in the game.

In insurance and economics, the term will lead you into statistical mazes. In banking, it has become a governing principle. Do we let errant bankers continue in business or do we sit back and allow the survival of the fittest, come what may? There are partisans on both sides of the moral-hazard divide, some arguing that ignoring it has brought us to the current sorry pass, the other side saying that it's an antiquated concept that has no place in modern banking. The term is still value-neutral, although our attitude toward the employment of it and toward bankers isn't.

Time and again, argue moral-hazard fundamentalists, both Republican and Democratic administrations have ignored moral hazard and averted financial sector crises by one means or another, and time and again the only lesson that bankers have learnt is that they pay no penalty for bungling. These bail-outs have rendered them not just reckless but stupid about risk.

The fallout when moral hazard is ignored was made plain recently by Roger Lowenstein in a New York Times article marking the 10th anniversary of the Long Term Capital meltdown. Lowenstein lamented that no one learnt anything from what was "a small dress rehearsal" for the chaos now enveloping us. The lessons are all too familiar: the danger of unregulated derivatives, the perils of excessive leverage, and the fallibility of financial models. As investor Warren Buffet, the Sage of Omaha, likes to say, "Beware of geeks bearing formulas."

Opponents would argue that stopping financial contagion is much more critical than heeding moral hazard. Contagion breeds panic, and panic can bring down institutions that have done nothing wrong. They would also say that some bail-outs, such as the Long Term Capital one, don't involve taxpayers' money. And it didn't. The government brought bank chiefs into a room and banged their heads together to make them agree to buy it and unwind its positions, just as JP Morgan did to end the 1907 financial panic. No harm, no foul.

When Long Term Capital went bust, I was, naively, astonished to see bankers who fervently espoused free markets unwilling to let it go south because they had skin in the game. The hypocrisy was galling. In the Long Term Capital case, a few heads rolled, but top bank executives and boards of directors stayed in place. In this recent round some chief executives were ousted but walked off with a king's ransom in compensation. The buck never stops. No culpability, no penalty - that's the harm.

The same people who let the government stop them from falling into an abyss violently opposed regulation that might have prevented them from falling into an abyss in the first place. After that first speech I wrote many others that claimed that bankers could police themselves. As I laboured over the message, I couldn't help but think what nonsense.

There is an obvious human propensity towards deceit, especially when money is involved. I also heard repeatedly that regulators, those poor stumblebums, were 10 years behind investment bankers in their thinking. Turtles trying to catch up with racehorses et cetera. All they did was hinder financial ingenuity. Appears now the bankers were the stumblebums, albeit in custom-tailored suits.

The situation is so out of hand that moral hazard, mooted when the crisis first began and heeded belatedly in the case of Lehman Brothers, has been ditched even as a theoretical principle and replaced by a policy that's best described as print money and throw it wildly, indiscriminately, and see if it sticks, creating layer upon layer of moral hazard.

It's been clear for some time that banking couldn't continue in its present form for one reason: computers. They allow such gigantic flows in and out of markets at such breathtaking speed that it's impossible to control risk. Markets, which require a degree of order and balance to function, become unmanageable when "here comes everybody". Diverse surprises, yes, few of them good.

Computers have enabled financial products to proliferate and be leveraged every which way to Sunday. Computers amplify information and rumour, a vital market engine, to thunderous proportions. They turbo-charge greed, stupidity and lemming-like behaviour, never in short supply, and the cream prudence gets dispersed, pushed to the bottom. A banker friend says the thought we can control risk in these circumstances is a besetting and dangerous vanity. A complete rethinking is due.

Be prepared, though, for the banking industry to argue against regulation despite everything that has happened, to blather, po-faced, about the integrity of the free markets. Back in April, Josef Ackermann, head of the Institute of International Finance, which represents the world's largest financial companies, acknowledged mistakes but warned it would be "completely wrong" for authorities to impose greater regulation: "We want to demonstrate that we can do a better job within the industry."

Bankers can be brazen. Confidence in them will be harder to restore than in the markets. As Ogden Nash wrote, "Consider the banker; he was once a financial anchor." Past tense.

This is an extract from Kate Jennings's Quarterly Essay, American Revolution: The Fall Of Wall Street And The Rise Of Barack Obama, published on Monday.

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