Sunday, September 28, 2008

Mystified Druids

The most recent New Yorker ran a piece about the current fiscal problems. Its emphasis was on the consequences to New York, but within it I found a very brief primer on why we're in this mess.

Any attempt to find causation or fault for what happened last week is fraught. So many things have gone wrong; so many people are to blame; so many people are now screwed. Often, the media exaggerates the significance of the ups and downs of the financial markets, while the sophisticates in the marketplace take them in stride. Not this time. Last week, the most farsighted market players were flabbergasted, even as they comprehended that they were witnessing a capitulation to some kind of greater truth—that Wall Street had got caught up in a pyramid scheme of its own devising. (The market soon recovered its truth aversion by demonizing short-sellers. Attorney General Andrew Cuomo, of New York, called them “looters after a hurricane.” Jim Cramer, on CNBC, took to invoking terrorists. The regulators, here and in London, clamped down....)

Over the past thirty years, Wall Street has honed the art of creating and selling financial products with an increasingly tenuous connection to reality. It has been an extraordinarily creative period—a modernism of money, with an equivalent trend toward abstraction. Relatively simple derivatives evolved into ever more arcane contrivances. The risk and the leverage piled up, and, in the short term, the billions rolled in. This is over now.

Glenn Greenberg, a value investor who started as an investment banker in the nineteen-seventies, thinks that Wall Street has been chastened. “It’s kind of like when you get in a big mess and you say, ‘Please, God, if you let me off this time, I’ll never do it again,’ ” he said.

One problem is that the contrivers mistook their art for a science. A pre-modern money manager explained last week, “They looked at it all as a science experiment.” They tested each new product—each hypothesis—against a bunch of historical precedents, running computer models to see how the product would fare under the conditions of various bygone catastrophes. “The problem was, they didn’t have any historical precedent for when it all melts down. The historical precedents they used are not relevant.”

In fact, it wasn’t science at all. It was more like what anthropologists and psychologists call magical thinking—the tendency to believe that wishing it so makes it so. For years now, people have clung to the conviction that you can have outsized returns with little risk, leverage without recoil. This is what the clever financiers claimed that their inventions could do. Their colleagues and clients wanted to believe them. They all wanted to believe that their credit-default swaps could continue to insure against debt defaults.

It’s hard enough to understand credit-default swaps when you know what they are; if you don’t know, forget it. But since they are one of several inventions that may sink this city, and maybe the country, into a new era of penury and thrift, if not downright depression, let’s have a go: a credit-default swap is a financial contract between one party and another which protects against a default on a debt. The trick on Wall Street has been to negotiate and trade them like crazy; there are sixty-two trillion dollars in credit-default swaps outstanding. The question of their worth has mystified even the druids who created them, especially because, it turns out, the swaps haven’t really insured against anything.

The article can be found here.

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