Regular visitors to this page will know that well before global economies began imploding, I never subscribed to the ‘masters of the universe’ label attributed to investment bankers. This is not to imply that Wall Street, the City and other financial centres are jam-packed with idiots; they are peppered with some incredibly intelligent folk who are as familiar with complex quantitative theories as our MPs are with claiming dodgy expenses.
However, theory is one thing, practice another, and if proof were needed that this truism extended to credit and derivative markets, it is offered in spades throughout Gillian Tett’s excellent book, Fool’s Gold: How an Ingenious Tribe of Bankers Rewrote the Rules of Finance, Made a Fortune and Survived a Catastrophe.
Although the title is a bit of a mouthful, Tett shows that while theories underpinning the unprecedented boom in forms of lending such as collateralised debt obligations were technically sound (and became regarded as foolproof, because for a while they appeared to work), they could not possibly negate all risk, for they failed to take human nature and reactions into account.
Despite this rather obvious flaw, it did not prevent seemingly intelligent bankers from focusing solely upon the positive side of such theories when extending credit at breakneck speed to anyone who wanted it — and to some who probably did not.
Significantly perhaps, the bank responsible for creating many of these credit derivatives, JP Morgan, did appreciate their inherent risk and, although they were incredibly lucrative, it decided to sit on the sidelines while others were getting deeper into sub-prime mortgage-based instruments.
Once the true extent of sub-prime exposure became apparent, it was inevitable that banks such as Lehman Brothers and Bear Stearns would fall to earth. Only colossal injections of capital by the state prevented many of Britain’s leading banks from failing.
So who were the people behind the statistical theories that appeared to eradicate risk?
Among JP Morgan’s staff was Blythe Masters, a name that could have been plucked from a bodice-ripping novel found in an airport lounge.
Masters’ theories relating to debt markets were seized upon by investment bankers who promptly became debt salesmen, extending credit to hedge funds and venture capitalists with which to fund leveraged buy-outs, and to other banks, who in turn made mortgages available to people who had no chance of repaying them.
In effect, the bankers/salesmen were little more than gamblers seemingly on to a good thing, apparently secure in the knowledge that their risk, if it did exist, was negligible.
For a while it worked, but when the music stopped, the system began to unravel.
How highly-leveraged buy-outs would work if business plans were not adhered to had been given little consideration.
More significantly, perhaps, the reaction of people who lose their jobs and the impact this has upon them repaying their mortgages was unknown. Quantitative theories take no account of human nature, even though old-fashioned bankers could.
In many respects, it is a good job JP Morgan is still in business, to explain precisely what happened during this unprecedented period of cheap credit.
As for the rest — are they masters of the universe? Hardly — more like lemmings whose practices threatened our economic system and continue to cost us billions.
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