A little over a decade ago, I published a book called F.I.A.S.C.O.: Blood in the Water on Wall Street. I described the antics of the finance industry and criticised some egregious market excesses. Back then, the derivatives market was worth a quaint $50,000bn, collateralised debt obligations (CDOs) contained mostly corporate bonds and loans, and credit default swaps had just been invented.
Most people say the financial world today has been transformed radically since then.
But how much is really new? As the current crisis nears its end, or at least the beginning of the end, it is worth reflecting not only on the novelty of today’s markets, but also on the themes that have remained constant.
Of course, the recent credit crisis dwarfs the collapses of the 1990s. Then, billion-dollar losses at Orange County in California and Barings bank were startling front-page news. Today’s writedowns are dozens of times larger and far more frequent. The notional value of derivatives values is nearly a quadrillion dollars ($1,000,000bn).
The banking culture has changed, too, thanks to sexual harassment litigation and a brain drain. Today, a trader who wanted to pay a sales assistant $500 to eat a pickle covered with hand lotion would probably do so privately, not in the middle of the trading floor. Moreover, the best traders now are not at banks but at hedge funds, where they care more about making a billion dollars than demonstrating machismo.
Yet the same factors that dominated past markets rule today. The first is informational asymmetry, the knowledge gaps that perpetually lead to inefficiencies and crises. In the 1990s, flawed mathematical models were used to model prepayment risk. This time flawed models were used to model credit and liquidity risk. The markets were stunned in 1994 when Askin Capital Management marked its positions to market instead of model, and was suddenly insolvent. The same kinds of surprises emerged from financial institutions as they re-marked their derivatives positions. Not very many people can price complex financial risks accurately, especially those related to mortgages. Then or now.
Moral hazard also is a common theme. The 1990s structured note market flourished as banks used government-sponsored entities as studs to issue bonds linked to every financial variable imaginable. Today, subprime mortgage lending exploded because of the same implicit GSE guarantees.
A third commonality is regulatory arbitrage, the manipulation of legal rules for financial advantage. Here, credit rating agencies play the central role, just as they did a decade ago. Orange County in California bought inverse floating structured notes that were rated AAA but carried far higher risks. The same is true of modern purchasers of AAA-rated CDOs and SIVs. Today’s alphabet soup has a few new ingredients, but the recipe is the same. Highly rated structured finance instruments are incomprehensible to most investors. Then or now.
Even some of the players are the same today as before, and not just mortgage traders who graduated from losing money on IOettes and inverse floaters to, more recently, losing even more on super-senior CDO tranches. John Mack, one of the stars of F.I.A.S.C.O., plays the same role today that he played then, as head of Morgan Stanley. When the 1990s crises hit, Mr Mack rallied the troops with a cry of “There’s blood in the water, let’s go kill someone.” Today he advocates a similar response, although he is more careful about how he describes it.
We will emerge from this crisis, and then another will hit in a few years. The cycle will continue. Meanwhile, finance will remain one of the most lucrative professions, for the same reason it is one of the riskiest. Risk and return are related in industry as well as investments.
Indeed, the above three common themes, then and now, are the central reasons finance industry employees will continue to out-earn just about anyone else. Information asymmetry, moral hazard and regulatory arbitrage are the basic ingredients of high-margin finance. Soon the markets will be booming again, and the people who exploit these three themes will do the best, as they always have.
The writer is a professor at the University of San Diego School of Law