The Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System

436 Pages·2010·6.62 MB·English

by  Kevin Dowd

Alchemists of Loss
How Modern Finance and
Government Intervention Crashed
the Financial System
KEVIN DOWD
and
MARTIN HUTCHINSON
ffiWILEY
A John Wiley and Sons, Ltd, Publication
This edition first published in 2010
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ISBN 978-0-470-68915-8
Set in Bembo by Sparks - www.sparkspublishing.com
Printed in the United States by Courier Westford
Contents
Acknowledgements & Dedication v
~oreword VI
Part One: Past Successes and Disasters 1
1 Introduction 3
2 Pre-Modem Finance 17
3 Lessons from Past Financial Crises 33
Part Two: The Modem Financial Theory Engine 63
4 Theoretical Foundations of Modem Finance 65
5 Modem Financial Theory's Hideous Flaws 87
6 Risk Management: Daft Theory, Dodgy Practice 111
Part Three: Interactions with the Real World 137
7 The Real World Becomes Modem Finance-friendly 139
8 Modem Finance Captures Wall Street 159
9 And Wall Street Metamorphoses 199
10 Derivatives and Other Disasters 225
IV ALCHEMISTS OF LOSS
Part Four: Policy Accommodates Modern Finance 245
11 Loose Money 247
12 Government Meddling in the Financial System 269
Part Five: Gotterdammerung 295
13 Bubble, Burst, and Panic 297
14 The Slope Down Which We're Heading 331
Part Six: Charting a New Way Forward 349
15 The Math of Proper Risk Management 351
16 Back to the Future - A New Vision of Finance 373
17 A Blueprint for Reform 389
18 Lessons to Take Away 403
Bibliography 407
Index 413
Acknowledgements &
Dedication
It is a great pleasure to thank the many people who have contributed to
this book. We thank the former editor of Financial Engineering News,Jim
Finnegan, who first brought the two of us together. We thank Martin
Walker for his splendid Foreword, and Philip Booth, Jim Dorn, Steve
Hanke, Alberto Mingardi and Andrew Stuttaford for their generous
endorsements. We thank the Wiley and Sparks teams, especially Pete
Baker, Aimee Dibbens and Viv Wickham, for their work and support in
this project. We also thank the following for all manner of diverse con
tributions: Mark Billings, David Blake, Carlos Blanco, Chris 0' Brien,
Andrew Cairns, Dave Campbell,John Cotter, Roger Field, Chris Hum
phrey, Anwar Khan, Duncan Kitchin, Bill Lee, Anneliese Osterspey,
Dave Owen, Stan Szynkaruk, Margaret Woods, Basil Zafiriou and Mar
tin's colleagues at Reuters BreakingViews and Agora Publishing, both
fertile sources of good ideas and inspiration. Finally, thanks to Heather
Maizels, whose inspiration led to the cover design. Most ofa ll, we thank
our long suffering families - most especially Mahjabeen Raadhiyah and
Safiah on Kevin's part, and Anna and Rumen on Martin's.
***
Dedication
Kevin: to Mahjabeen, Raadhiyah and Safiah.
Martin: To Brian, Jean, Virginia, Anna and Rumen,
the Hutchinson family.
***
v
Foreword
This book will startle readers. So it should. The scale and breadth of
the latest financial crisis justify a fundamental re-assessment of the way
that economic affairs are managed. And there could hardly be anything
more fundamental than the authors' recommendations. They advocate
a return to the classic form of banking developed in 18th century Scot
land; the abolition of state guarantees of bank deposits and of home
mortgage tax relief; the eradication oft he Wodd Bank and International
Monetary Fund and a return to the gold standard, or some commodity
based equivalent. They also propose a tax on US banks whose assets are
greater than $360 billion (2.5% ofU S GDP), in order to shrink them to
manageable size. The six largest US banks are their target.
They do not suggest that Wall Street and the City of London will
disappear. They do, however, maintain that their fate will resemble
that of the American rustbelt; Wall Street will be like the Cleveland,
Ohio, of the 1970s and they see its skyscrapers becoming ghost build
ings. London is condemned to become the Youngstown, Ohio, of the
1980s, "an excellent market for rottweilers, wire mesh and tattooed
thugs." The author's pungent opinions, uncompromising analyses and
muscular prose style make this an entertaining and provocative as well
as an instructive read.
Perhaps the most striking feature of this book's full-blooded de
fense of genuine free market economics is that so many ofi ts proposals
VI
FOREWORD vu
have already been espoused by more conventional economists. Its call
for a tax on financial transactions to discourage trading was originally
framed by the Nobel prize-winnerJames Tobin. Its insistence that no
bank should be permitted to become too big to fail has been echoed
by the former chief economist of the IMF, Simon J ohnson, who also
maintains that the profound political influence of the big banks in the
American political system can be seen as a kind of coup d' etat. Like
another Nobellaureate, Paul Krugman, this book argues that the fi
nancial sector had become a classic example of rent-seeking. And the
gold standard has many defenders, including former Federal Reserve
chairman Alan Greenspan. He is hailed in this book for calling the
bubble fifteen years ago with his warning of "irrational exuberance,
and excoriated for doing nothing about it. In that, too, these authors
are in good company.
It should come as no great surprise that serious economists, whatev
er their political leanings, can agree on crucial issues. There are absolute
truths in economics, and it is the great merit of this book to restate
them, and to recall to mind that Ur-text ofe conomic wisdom, Rudyard
Kipling's poem 'The Gods of the Copybook Headings.' It reminds us
of the wisdom of our grandmothers, who warned us that all that glitters
is not gold, that we should save for a rainy day, and that if something
sounds too good to be true then it probably is. A mortgage for 125
percent ofa house's value, with no deposit and amounting to six times
the applicant's annual income, is certainly too good to be true. And
yet these were the terms being advertised by the British bank North
ern Rock shortly before its collapse and rescue by the British taxpayer.
There could have been few clearer signs of an unsustainable bubble.
There were many such signs. The fall of the US personal savings
rate below zero in 2006 was one. The rise in personal debt to over 100
percent of national income was another. The way chronic imbalances
between Chinese surpluses and US deficits became routine should
have been yet another. The dangers of a European monetary union
without the assurance ofa responsible sovereignty to support it was yet
another. The emergence of "the Greenspan put," in which financiers
were encouraged to assume by the Fed that any financial crisis would
be met by a rescuing surge ofliquidity, should also have sounded an
alarm. It changed the essential balance between risk and reward. To put
it another way, it encouraged greed while reducing fear. It encouraged
Vl11 ALCHEMISTS OF LOSS
bankers to throw caution to the winds, since in the immortal words of
Citibank chief Chuck Prince in 2007, "As long as the music is playing,
you've got to get up and dance."
Bankers should not speak and far less act like this. Bankers should
be sober men in a reliable and even boring business, cautious custodians
of other peoples' money. We have heard this before, most memorably
from WaIter Bagehot, a polymath who wrote on physics and philoso
phy and literature, edited The Economist and produced in Lombard Street
(1873) the first classic book on banking. His advice on the role of cen
tral banks in financial panics and crises has never been bettered: "to
avert panic, central banks should lend early and freely, to solvent firms,
against good collateral, and at high rates." These three essential condi
tions have been signally and perilously flouted in our current crisis.
Central banks have lent to the insolvent, against toxic collateral and at
the lowest of rates. We will pay dearly for the temporary and uncon
vincing relief the Fed's actions have delivered.
Bagehot argued, in a remark that neatly encapsulates the core argu
ment of this book, that "The business of banking ought to be simple;
if it is hard, it is wrong." The Alchemists who are the targets of this
book made the business of banking and credit and debt management
into something not only hard, but well-nigh impenetrable. Their algo
rithms and quants and Gaussian models and Efficient Market hypotheses
turned finance into an arm of higher mathematics and bamboozled
investors and bankers in the process. Their mumbo-jumbo perfectly
embodied George Bernard Shaw's remark that "any profession is a
conspiracy against the laity." It also failed its first real market test, with
the Long Term Capital Management fiasco of1998, a warning that was
ignored, thanks to a brisk exercise of the Greenspan put.
The authors predicate a (somewhat) mythical golden age of fi
nance, characterized by "the importance of trust, integrity and saving,
the need to invest for the long term," and proceed to contrast it with
Modern Finance. This is defined as "a focus on marketing and sales,
form over substance, and never mind the client; an obsession on the
short-term and the next bonus; a preference for speculation and trading
over long-term investment; stratospheric remuneration for practition
ers, paid for through exploitation of clients and taxpayers."
Modern finance and its mathematician-alchemists are the targets of
this book, but the authors identity a single arch-villain it is the eminent