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Demons on Wall Street

Author: Sebastian Mallaby, Paul A. Volcker Senior Fellow for International Economics
March 24, 2008
Washington Post

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One year ago, with spectacular timing, a Wall Streeter named Richard Bookstaber published a book on financial engineering. He called it “A Demon of Our Own Design,” and his argument was that a new breed of “quants”—or “quantitative” number-crunchers like him—had created a system too complex to be manageable. The risks embedded in swaps and options were understood by only a handful of math geeks, and a miscalculation in one corner of the markets could send shock waves globally. Until a week ago, Bookstaber seemed unduly glum. But in the wake of Bear Stearns, modern financial engineering has become harder to defend.

Bookstaber seemed too pessimistic because he understated the ability of Wall Street players to check and balance one another. Yes, modern finance had an alarming tendency to load debt upon debt, so the effect of a mistake was magnified. But the financial engineers who created these tottering cash towers had an incentive to stop building before the whole thing keeled over. If a bank borrowed too much, lenders would shut off the taps and clients would refuse to buy its swaps, options and synthetic bonds: Nobody wants to do business with a bank that is one shock away from bankruptcy. So financial engineers would certainly take risks. But scrutiny from fellow engineers at other firms would prevent them from overdoing it.

Even a year ago, reasonable people disagreed about whether these checks and balances were sufficient. After all, they failed periodically. A decade ago, a hedge fund named Long-Term Capital Management borrowed so much that it could not withstand the shock of Russia’s default, and the Federal Reserve had to organize the fund’s fire sale to its bankers. Two decades ago, a fancy new product known as portfolio insurance promised investors protection from a crash. But when the crash came in 1987, the insurance not only failed but also contributed to its severity.

So the case for financial engineering depended on a fine balancing of risk and reward. The risk was that Bookstaber’s demons could wreak serious chaos. Mercifully, the economy had recovered rapidly after Long-Term Capital and the ‘87 crash, and neither episode cost taxpayers a dime—in contrast to disasters involving little or no financial engineering, to wit, the savings and loan crisis. But perhaps the next time would be nastier. Bookstaber was reporting from inside the laboratory, and he was yelling that something was about to blow. It seemed crazy not to listen.

On the other hand, financial innovation also yielded rewards. Most of the time it controlled risk, reduced the cost of capital, and helped businesses and consumers. Securitized mortgages allowed banks to spread the risk of lending and therefore to charge less for loans, lowering barriers to homeownership. Swaps could make certain types of risk virtually disappear. In a financially primitive world, an American exporter to Europe and a European exporter to the United States each shoulders exchange-rate risk. But thanks to swaps organized by banks such as Bear Stearns, the two can trade their currency exposures so that they can lock in future profits in their home currencies.

But whatever the balance of risk and reward was a year ago, it is now a couple of shades gloomier. It’s not so much that we face a property bust and a recession: Put that down to excessively loose monetary policy from 2002 to 2004 and a failure to regulate low-tech abuses such as no-doc loans with no down payments. Rather, the blow to the case for financial engineering comes from the implosion of Bear Stearns—and from the Fed’s necessary response. Those crucial checks and balances have been weakened.

This may sound odd, because two types of stakeholders in Bear Stearns were made to pay for their excessive risk taking. Shareholders have lost their shirts and thousands of employees will lose their jobs, which should teach Wall Street a grim lesson. But two other types of stakeholders have been given a huge break. As of 10 days ago, Bear’s lenders did not expect to get their money back in full; thanks to a $30 billion credit line from the Fed, the lenders now look comfortable. Equally, Bear clients who had bought swaps and other derivatives faced the prospect of their contracts being rendered worthless; that danger has receded. Moreover, the Fed has announced that it is ready to provide emergency loans to other investment banks. The incentive for private lenders and buyers of derivatives to monitor banks’ risk has to some extent been blunted.

This is a subtle shift, not a dramatic revolution. Lenders and derivatives traders have been bludgeoned in recent months; it’s not as though they have zero reasons to be cautious. But the shift is disturbing nonetheless. The case for financial engineering was questioned by serious people even before we landed in this mess. And we have no good way of turning back the clock.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here.

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