In 2005, while running a financial-software company, Charles Morris became convinced that credit markets were heading for a crash. He found a publisher who was willing to take a gamble and began tracing the roots of the yet-to-unfold crisis. However up to date it may seem, this book is no rush job. Mr Morris deftly joins the dots between the Keynesian liberalism of the 1960s, the crippling stagflation of the 1970s and the free-market experimentation of the 1980s and 1990s, before entering the world of ultra-cheap money and financial innovation gone mad.
He puts the eventual bill for the financial follies of the past few years at some $1 trillion—if all the excessive leverage (or borrowing) is wound down in an orderly fashion, which he considers unlikely. Thanks to securitisation, poor-quality mortgages are marbled through the entire global credit system. And there is more to come: commercial property, credit cards, corporate debt, credit-default swaps. For the most exposed institutions, it will be death by a thousand cuts.
Changes in the structure of the markets add to the problem. Unlike commercial banks, investment banks and hedge funds tend to increase their leverage during booms and shrink it in rough times. Since these two groups now account for half of all credit, their accelerated deleveraging is likely to make the credit contraction much worse than in past cycles. Mr Morris sees hedge funds—spared the worst at the start of the crisis but now suffering as their lenders demand more collateral—as the next weak link.
He describes three trends converging to create the bubble. By 2006 the growing trend towards deregulation had pushed three-quarters of all lending outside the purview of regulators. Securitisation created a serious agency problem, leaving loan originators, who were paid up-front, with no incentive to avoid bad credits and every reason to piggyback inappropriate products onto good ones (in one particularly depressing tale, a retired postal worker whose mortgage is almost paid off is switched to an interest-only product that leaves him in danger of losing his home). Banks and rating agencies were gripped by the pretence that all finance can be calculated by risk-modelling eggheads. It did not help that many investors blindly accepted the rating agencies as a kind of “financial Supreme Court”.
“The story has no single villain, but Alan Greenspan comes close.” — review of The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash, by Charles R. Morris.
The story has no single villain, but Alan Greenspan comes close. Under him, the Federal Reserve fuelled the housing boom by sharply cutting the cost of short-term money. Mr Greenspan ignored warnings about subprime excess, while eagerly championing “new paradigms”, from hybrid mortgages to credit derivatives.
By November 2007, when the narrative ends, it was already clear to Mr Morris that this crisis was much more serious than the last big crunch, the 1998 Russian debt default and the bail-out of Long-Term Capital Management, an American hedge fund, by a group of banks under the Fed’s direction. “In 2008 there is no one to call a meeting, there is no conference room big enough to hold the parties, and no one knows who should be on the invitation list,” he says.
Ominously, Mr Morris sees a closer parallel in the great Japanese asset bubble of the 1980s. He worries that the extent of the problem will tempt America to paper over losses and keep sickly lenders on life-support, as Japan did. If it does, then, like Japan, it is likely to suffer a lost decade.
He offers a raft of suggestions: originators should retain the riskiest portion of securitised loans; prime brokers should stop lending to hedge funds that fail to disclose their balance sheets; trading of credit derivatives should be brought onto exchanges for the sake of safety, even if this raises costs; and some version of the old Glass-Steagall act, which separated commercial banking and capital-markets activities, should be re-introduced. Ultimately, he argues, after a quarter-century of “market dogmatism” it is time for the regulatory pendulum to swing the other way.
There are risks in any such roll-back. Mr Morris admits that even the biggest bubbles contain innovations that endure: think of collateralised mortgage obligations, which suffered a meltdown in 1994 but later transformed the industry, saving borrowers billions. However, his provocative book is, by and large, a well-aimed opening shot in a debate that will only grow louder in coming months.
The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash. By Charles R. Morris.
PublicAffairs; 224 pages; $22.95 and £13.99