Contents
Author’s Note
Introduction
Chapter 1 : Fold Sides to Center
Commercial Banks
Savings and Loans
Securities Firms
Transferring Risk
End of an Era
Chapter 2 : Result, Turn Over
The Three Derivatives
Options
Futures
Swaps
Chapter 3 : Fold Sides to Center, Again
Changing the Rules
A New Environment
Investing in Mortgages
Banker Incentives
Chapter 4 : Fold Tip to Point
Other People’s Money: Equity
Agents Transferring Risk Become Principals Taking It
Chapter 5 : Fold Point Back
Rules, Refold, Rave, Ruin
A New Environment
A New Risk
Chapter 6 : Fold in Half
Mortgage Origami
Subprime Origami
The Rating Game
Banker Incentives
Manufactured Product
Chapter 7 : Pull Neck Upright
Low Volatility, Low Risk
The CDS Market Develops
More Insurance Than Needed
Opaque Markets
Other People’s Money: Debt
Chapter 8 : Pull Head to Suitable Angle
Vindicating Greenspan
How, Not Will, You Pay?
Broken Markets
Chapter 9 : Complete
What’s Wrong with Wall Street?
Government-Sponsored Enterprises
Government-Sanctioned Credit-Rating Agencies
Banks
What’s Right with Wall Street?
Epilogue
Notes
About the Author
Index
Since 1996, Bloomberg Press has published books for financial professionals, as well as books of general interest in investing, economics, current affairs, and policy affecting investors and business people. Titles are written by well-known practitioners, BLOOMBERG NEWS® reporters and columnists, and other leading authorities and journalists. Bloomberg Press books have been translated into more than 20 languages.
For a list of available titles, please visit our Web site at www.wiley.com/go/bloombergpress.
Copyright © 2011 by Brendan Moynihan. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.
Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com.
Library of Congress Cataloging-in-Publication Data
Moynihan, Brendan, author.
Financial Origami : How the Wall Street Model Broke / Brendan Moynihan.
p. cm
Includes index.
ISBN 978-1-118-00181-3; ISBN 978-1-118-03030-1 (ebk); ISBN 978-1-118-03031-8 (ebk); ISBN 978-1-118-03032-5 (ebk)
1. Financial engineering. 2. Financial risk. 3. Securities industry—United States. 4. Global Financial Crisis, 2008–2009. I. Title.
HG176.7.M69 2011
332.601—dc22
2010049551
To Kristiana, John, and Matthew
Author’s Note
It’s been said that lower-class people talk about people; the middle class, things; and the upper class, ideas.
This book presents a few, simple ideas that explain the main events that shaped financial markets, firms, and products over the past 40 years and broke Wall Street over the past three. It examines the evolution of Wall Street, shows the logical sequence of events that brought us to this point, and presents some ideas for how to fix it.
Anyone looking for another book based on hours of interviews with anonymous people offering titillating tidbits about Washington and Wall Street will be sorely disappointed in the pages that follow. A similar letdown awaits anyone looking for another rehash of personalities, idiosyncrasies, expensive houses and cars, helicopters, and vacations. No “furrowed brow,” “thought to himself,” or “adrenaline coursing through her slender body” in this book.
Introduction
The simplicity of Wall Street has often been masked by the supposed complexity of the products it “engineers” and peddles to investors. “Engineer” is a big word, conjuring slide rule and pocket protectors for those of us old enough to remember them, and programmable calculators with built-in equations for those too young. What Wall Street calls financial engineering, I call Financial Origami, the art of paper-folding that uses a few, basic folds to shape pieces of paper into decorative models. Wall Street takes a few, basic pieces of paper stocks, bonds, and insurance contracts and folds their attributes together to make “new products,” sometimes to skirt regulations, sometimes to meet investor needs, and always to boost profit. All of Wall Street’s “innovations” are a function of how the attributes of these pieces of paper have been folded into something considered “new.” Although the products look and sound complex, there is nothing new under Wall Street’s sun. Grasping the origami involved in folding the same old pieces of paper will make understanding Wall Street and what happened in 2007–2009 easier than you think, and it will offer some insights on how to fix some of its problems.
Wall Street firms performed Financial Origami on more than just the products it has offered over the years. For decades through the 1960s, the firms had for the most part carried out distinct functions within the securities industry. Some specialized in advising and underwriting, others in sales, and still others in trading. Gradually, though, at punctuated points in time when the overall regulatory environment was changing, they began to refold the separate functions of the securities industry into single firms. But that’s not all. They also refolded their business charters from private to public companies. And they would eventually unfold the mortgage origination process as well. All of these actions served to create conflicts of interest that reached epic proportions in the dot-com mania ending in 2000, and that reached Biblical proportions in 2007–2009. As we’ll see, self-interest and conflicts of interest lie at the center of the financial crisis and hold the key for avoiding similar episodes in the future.
Former Federal Reserve Chairman Alan Greenspan started to address the topic in testimony before the House Committee on Oversight and Government Reform on October 23, 2008, and made what on the surface appeared to be a shocking admission:
I made a mistake in presuming that the self-interest of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms. And it’s been my experience, having worked both as a regulator for 18 years and similar quantities in the private sector, especially 10 years at a major international bank, that the loan officers of those institutions knew far more about the risks involved in the people to whom they lent money than I saw even our best regulators at the Fed capable of doing.
Lawmakers, pundits, and bloggers interpreted Greenspan as repudiating his free-market ideology. A New York Times headline screamed “Greenspan’s Mea Culpa.” The man most credited for the longest U.S. economic expansion in history was now the most blamed for the subprime crisis. And it’s nonsense. Not only did they misunderstand what he said, but they also missed a huge opportunity to address the role that self-interest and conflicts of interest played in the crisis.
During his 18 years as chairman of the Federal Reserve Board, ending in 2006, Alan Greenspan developed a reputation for delivering congressional testimony in so-called “Fedspeak,” an opaque style of talking that seemed to baffle more than enlighten. He’s been quoted as saying, “I know that you think you know what I said. But I’m not sure whether you understood that what you heard is what I meant.” The October 2008 remarks are worth a closer examination. Organizations don’t have self-interest; people do. An old axiom of economics is that people respond to incentives, and everything else is commentary. The individuals, salespeople, traders, loan officers, and CEOs were acting in their respective self-interest, prodded by the incentives in place at the time.
The month before Greenspan’s testimony on the subprime crisis of 2007–2008, Lehman Brothers Holdings Inc. filed the largest bankruptcy in U.S. history, six times the size of the previous record-holder, Worldcom Inc., and ten times bigger than then second biggest, Enron Corp. Lehman’s bankruptcy ended an era on Wall Street, one that stretched back more than the two or five or ten or even twenty years most have occupied themselves with when examining the financial crisis of 2007–2009. Identifying the right time frame is critical to understanding what happened on Wall Street and how we arrived at the financial crisis. Arbitrary designations will not do. Wall Street has odd notions about time. Measuring “year-to-date returns” is an arbitrary convention, and so is lumping together decades as though 10 years defined a unit with specific attributes: the eighties, nineties, or oughties, for example. Equally flawed are such starting points as contained in: “Stocks have returned an average of 10 percent a year since 1926.” I’ve never met anyone who was investing in 1926 who is still alive today. Just because we have data on the Standard & Poor’s 500 Index going back that far doesn’t mean that’s a relevant starting point for comparisons.
At a minimum, it makes much more sense to define cyclical periods by economic recessions and expansions. For example: How have stocks performed in expansions? What is the average performance during bull markets? It makes even more sense to define secular periods using changes in monetary regimes because that is the largest factor influencing all the other decisions people make in markets, business, and the economy. It’s logical to make broad statements about the post–World War II period because of the seminal financial regime changes that took place in 1946, right after the end of the war. The Employment Act of 1946 was a definitive attempt by the U.S. federal government to develop macroeconomic policy. The Bretton Woods Agreement bylaws establishing the international monetary system were adopted the same year, in the first global attempt at monetary cooperation on a permanent institutional basis.
At a maximum, perhaps, it makes sense to define secular periods in terms of the mobility of capital; that is, how freely does and can money circulate in the world economy. The most recent period of mobile global capital resembles the period starting in 1850 and ending in 1914,1 the start of World War I and the first meeting of the Federal Reserve. In between the wars, the international capital movements collapsed as capital controls were imposed. From 1946 through 1971, capital controls were gradually relaxed, accompanied by a gradual recovery and capital flows. Figure I.1 shows the macro inflection points of capital mobility since 1850.
In 1850 several European governments adopted a silver currency system, leaving Britain as the only major currency in the world on the gold standard, just as the California Gold Rush dumped increased supply onto the market. Lehman Brothers formed in the same year, as a cotton merchant in Montgomery, Alabama. Its collapse 158 years later would trigger the biggest financial and economic crisis in the United States since at least the original Great Depression, the one in 1873. It would not be the last time Lehman or gold helped define an era.