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Books | US financial crisis has its origin in ’70s

Books | US financial crisis has its origin in ’70s
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First Published: Sun, Oct 19 2008. 10 22 PM IST

Updated: Sun, Oct 19 2008. 10 22 PM IST
Charles R. Morris combines legal and financial experience with literary craft. No ideologue, no partisan and certainly no salesman, Morris traces the roots of the 2007-2008 mortgage securities crisis to its distant origins in the 1970s. At the time, the US registered dismal economic growth, high inflation and a collapsing currency. One reason for this state of affairs was bad economic management: When currency traders attacked the dollar, President Richard Nixon reduced taxes, controlled wages and prices and closed the gold window, effectively destroying the Bretton Woods system. When the Fed increased the money supply, growth surged; but floating the dollar while increasing the monetary supply led to a debasement of the currency. By the late 1970s, inflation hit double digits, the dollar was tanking and economic output was falling.
Morris contends that the decline of America’s currency and business sector at that time led to the zeal for deregulation and Chicago-school economics supporting free markets that eventually took America by storm. Three 1980s and 1990s crises prefigured that of 2007: In 1987, complex financial models underpinned the so-called portfolio insurance. Major investors used these models to sell stock index futures to hedge against a possible fall in stock portfolio value. But with most major institutional investors using the same models, the effect was not so much to protect as to magnify the impact of market decline.
In 1994, about a decade after the advent of complex mortgage-backed securities, their market crashed when the values the models had predicted proved unrealistic.
Larry Fink and a team at First Boston invented the collateralized mortgage obligation, or CMO, in 1983. They transformed ordinary mortgages into bond-like instruments with a menu of yields and risk alternatives. Wall Street ran with the innovation. Mathematicians designed extremely complicated variations. Some securities were high quality but they always left behind a residual called “toxic waste”. Some hedge fund investors specialized in high-return, high-risk, toxic-waste securities. In 1994, a highly leveraged toxic-waste hedge fund ran into trouble after the Fed hiked interest rates. The hedge fund’s manager used models to calculate prices for these illiquid securities but the banks’ models set different prices. When the manager attempted to sell some of these securities, no buyers emerged.
Bear Stearns aggressively seized the fund’s assets, in a run that obliterated the fund and threw a wrench into the CMO market, a rout which cost $55 billion (about Rs2.6 trillion) and stalled the mortgage market for years. In the late 1990s, financial sophisticates at Long-Term Capital Management, a hedge fund established by the illustrious John Meriwether and his Nobel laureate partners, Myron Scholes and Robert C. Merton, failed stupendously, putting the entire financial system at risk. The fund’s elaborate models did not allow for correlations that became evident during crises in the Asian, Latin American and Russian debt markets. More worryingly, the hedge fund’s investors included numerous major banks. Regulators had no idea how much risk LTCM’s failure would pose to the financial system. The fund’s partners had $100 billion in positions but only $1 billion in equity.
These three crises broke in an era when even America’s most important financial regulator—Fed chair Alan Greenspan—was anti-regulation. Deregulation made it easy for financial industry entrepreneurs to reap profits while making the public pay the losses. Because their failure might endanger the financial system itself, their losses are socialized. America, Morris contends, must find a better way. GetAbstract found this highly readable book to be a trenchant and provocative read.
Rolf Dobelli is the chairman of getAbstract.
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First Published: Sun, Oct 19 2008. 10 22 PM IST