Michael Lewis has a must read article on the implosion of finance. He calls it the end of wall street. It’s an article so clear in its import that, upon reading it, the left wing Lepermessiah at the DailyKos writes:
Congress and/or Obama must stop these people from looting the treasury. The Bailout is the biggest bank heist in human history. It must be stopped.
Of course, telling a lefty to close the state coffers once they’ve been opened is like telling a rioter heisting a television to return that property to its rightful owner. Not gonna happen. And who are you to blow whistles at a party? Anyway, underlying all the layers of dogshit–the BBB rated subprimes, the CDOs built on them, the bond rating agencies that gave CDOs USDA approval, Freddie, Fannie, Marx, Ayn Rand, and L. Ron Hubbard–Michael Lewis identifies the seed of destruction as the principal-agent problem. Once investment banks went public, transferring responsibility for loses from a relatively small group of well-informed owners to a much larger and therefore diffuse set of shareholders, the long-term consequences of managing risk poorly became nil for the suits running the investment banks. (Those long term consequences become even more remote if you can count on the time-servers in government to bail you out.) But what’s particularly electrifying about Lewis’s article is that the principal agent problem leads him back to his old nemesis from Liar’s Poker, John Gutfreund, former CEO of Solomon Brothers. Lewis invites the old adversary to lunch and delivers this wonderful scene for us:
No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.
No partnership, for that matter, would have hired me or anyone remotely like me. Was there ever any correlation between the ability to get in and out of Princeton and a talent for taking financial risk?
Now I asked Gutfreund about his biggest decision. [to go public] “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game….
“No,” he said, “I think we can agree about this: Your fucking book [Liar’s Poker] destroyed my career, and it made yours.” With that, the former king of a former Wall Street lifted the plate that held his appetizer and asked sweetly, “Would you like a deviled egg?”
As they say, read the whole thing. It’s a tale full of idiots and the geniuses who benefited from their stupidity.
But oh yeah, one more thing. The illustrious journal Nature will soon publish this article by Jean-Philippe Bouchaud in which he states:
Surprisingly, classical economics has no framework through which to understand ‘wild’ markets…We need to break away from classical economics and develop completely different tools.
Someone should make that Frenchman elucidate how Lewis, using concepts at home in the reigning paradigm in economics, is wrong in his diagnosis.