Panic! The Story of Modern Financial Insanity
WW Norton & Co
Review by Christopher Silvester
This is an intriguing anthology about the four major financial crises of modern times, starting with the 1987 crash on Wall Street, which reverberated around the world but which, while it registered a steeper fall in a single day than the 1929 Wall Street crash had done, nonetheless had remarkably benign consequences by comparison.
Then there was the 1998 Asian currency crisis, provoked by the devaluation of the Thai baht, which caused a painful contraction of the Indonesian economy and spilled into the Russian government’s fiscal collapse, which in turn resulted in the collapse of the US hedge fund Long-Term Capital Management.
Once the Federal Reserve had persuaded a consortium of leading investment banks to bail out Long Term, the world’s financial system and also the emerging markets made heroic recoveries.
The bursting of the internet bubble in 2000 is probably the simplest panic to explain and even excuse, since it was fuelled as much by an idealistic delusion as by greed, although it did expose the corruption of some Wall Street analysts whose firms were beholden to suspect stocks for IPO and related work.
Finally, there is the current economic crisis brought on by the collapse of the sub-prime mortgage market and the resultant credit crunch, which is perhaps best described as a series of separate but related panics.
The editor, Michael Lewis, wrote the classic business books Liar’s Poker (1989), about his time at Salomon Brothers in the period spanning the 1987 crash, and The New New Thing (2000), about the internet bubble.
He has written a general introduction as well as mini-introductions to each of the four sections, and has justifiably included, given the quality of his analysis and the panache of his prose, no fewer than eight examples of his own reporting and commentary. (All proceeds from this book are pledged to funds for rebuilding hurricane-ravaged New Orleans.)
Although there are a couple of dry extracts from official reports, the bulk of Panic! consists of ground-breaking reports, enlightening interviews and supple commentary. It even includes a couple of satirical pieces, one by syndicated columnist David Barry about the follies of the property-ownership obsession that swept the United States since the 1980s.
The fourth section of the book, ‘The People’s Panic’, addresses the real-estate bubble, the sub-prime mortgage crisis, the shaming of the credit-ratings agencies and the collapse of Bear Stearns, but the final extract dates from April 2008, so the story is left unfinished, missing the fall of Lehman Brothers and the government bailouts.
That last extract is Gregory Zuckerman’s Wall Street Journal profile of John Paulson, the hedge-fund trader who made $3.7 billion betting against the sub-prime mortgage market.
An anthology without footnotes, however useful for showing how events unfolded at the time, inevitably permits a certain absence of context. For example, Lewis includes the opening statement of Senator Christopher Dodd, chairman of the US Senate Committee on Banking, Housing, and Urban Affairs, at the committee’s March 2007 hearing on the causes and consequences of mortgage-market turmoil, in which Dodd lambasted financial regulators for failing to protect sub-prime borrowers from predatory lending.
What Lewis doesn’t explain in his mini-introduction to the section on this most recent of panics is this: because Senator Dodd believed sincerely in extending home ownership to his nation’s poor, he resisted efforts to tighten regulation on the mortgage-finance firms Fannie Mae and Freddie Mac, both of which made more donations to his office and campaigning expenses over a ten-year period than to any other congressman’s establishment.
However, Lewis does include a James Surowiecki essay from The New Yorker which argues that ‘focusing on lenders’ greed misses a fundamental part of the sub-prime dynamic: the overambition and overconfidence of borrowers.’
There are parallels between these various panics. First is the common factor of what Alan Greenspan once famously called ‘irrational exuberance’.
Asset prices had become inflated before the 1987 crash; the dotcom panic of March 2000 was preceded by a period of unbridled euphoria; and the sub-prime mortgage panic which led to the credit crunch followed an unprecedented real-estate boom.
Similarly, there is the theme of misplaced faith in systems, rational strategies or statistics. The 1987 crash showed that the Black-Scholes options-pricing model (named after a pair of academics), whereby investment managers would create put options by selling short the stock market index as it fell, does not work in a panic because, as Lewis explains, ‘if no one is willing to buy, it’s impossible to sell short.’
This was a lesson that had to be learned anew by hedge-fund managers last year.
In the same way that many had erroneously believed prior to 1987 that computerised programme trading offered portfolio insurance to institutional investors in falling markets, so in 1998 the geniuses behind the Long-Term Capital Management hedge fund believed they had devised a mathematically perfect method of avoiding risk in currency speculation.
Similarly, the ratings agency Moody’s believed during the sub-prime boom that it had devised a foolproof statistical method of evaluating the risk of CDOs based on historical patterns of default.
As Lewis explained in his excellent 1999 New York Times article on the Long-Term Capital panic, the fund’s founder John Meriwether and his colleagues ‘had been engaged in an experiment to determine how far human reason alone could take them.
They failed to appreciate that their fabulous success had made them, quite unreasonably, part of the experiment. No longer were they the creatures of higher reason who could remain detached and aloof. They were the lab rats lost in the maze.’
Another common theme is the lack of liquidity. The Asian currency crisis led to a ‘liquidity crunch’ in the Thai financial and real-estate markets (this, the earliest use of the actual term ‘crunch’ within these pages, dates from a 1997 Los Angeles Times report). The crisis that followed the 1987 crash, from the central banker’s point of view, was a shortage of liquidity.
‘In a position like that everything dries up, everybody pulls back,’ the then NYSE chairman John Phelan is quoted as saying in an extract from Eric J Weiner’s What Goes Up. ‘The financial crises in the ’80s, and in the ’90s as well, have been liquidity crises. The question is always, how will people react?’
The same has proved to be the case with the credit crunch that began in August 2007, though this time the consequences have been infinitely worse.
Lewis argues that the crash of 1987 ushered in ‘the Age of Financial Unreason, when panic became just another, quotidian aspect of financial life’. As financial markets grow ever more complex, we should get used to ‘cycles of euphoria and panic [that] have become more and more thrilling.’
Since Panic! came out in the US before December, the spookiest passage — given what we now know about him — is one that refers to Bernard Madoff as a wise ‘market veteran’ for dropping four dotcom stocks at the height of the internet bubble.
It also quotes Madoff on the subject of the 1987 crash, when he was the chairman of Nasdaq. ‘I had to field all the unhappy phone calls when people felt the Nasdaq market had pretty much shut down,’ he said. ‘My attitude was, I do not want to relive that event.’ Somehow he has since managed to top this as an awkward experience.