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Top Five Causes of the Financial Crisis

1.  Alternative Realities:  The Black-Scholes Revolution

Hatched by two MIT finance wizards, the Black-Scholes model of pricing options securities took hold in the financial industry in the 1980s.  It was known as “Portfolio Insurance” because it purported to free traders of all market risk, at least theoretically.  While the mathematical intricacies of this theory are virtually incomprehensible, Michael Lewis, author of Liar’s Poker, sums up the bottom line:

The model is based on the assumption that a trader can suck all the risk out of the market by taking a short position and increasing that position as the market falls, thus protecting against losses, no matter how steep. Nearly every employee stock-ownership plan uses Black-Scholes as its guiding principle. A pension-fund manager sitting on billions of U.S. equities and fearful of a crash needn’t call a Wall Street broker and buy a put option—an option to sell at a set price, limiting potential losses—on the S&P 500. Managers can create put options for themselves, cheaply, by shorting the S&P as it falls, and thus, in theory, be free of all market risk.

Sound too good to be true?  Well, it is. The model’s alternative reality assumes there’s no such thing as a crash:

When a market is crashing and no one is willing to buy, it’s impossible to sell short. If too many investors are trying to unload stocks as a market falls, they create the very disaster they are seeking to avoid. Their desire to sell drives the market lower, triggering an even greater desire to sell and, ultimately, sending the market into a bottomless free fall.

The stock market crash of 1987, a financial Black Swan, essentially proved Black-Scholes to be flawed and dangerous.  Strike one.  Incredibly, however, the theory maintained its appeal.  Its underlying thrust–the belief that somehow a complex mathematical formula can virtually neuter all market risk–endured as those within the industry searched for new and innovative ways to achieve risk-free profit positions.  Indeed, so compelling was Black-Scholes that its founders and main advocates were hired on to the hedge fund Long Term Capital Management in 1994 to create some mathematical magic for the fund.  While the fund was initially enormously successful with annualized returns of over 40% (after fees) in its first years, in 1998 it lost $4.6 billion in less than four months following the Russian financial crisis and became a prominent example of the risk potential in the hedge fund industry.  Strike two.

Still, traders believed that the Black Mondays and the LTCMs of the world were the exceptions that only proved their imaginary rule.  Also ignored were the dot.com crash and accounting scandals of 2001.  Indeed,

{Black-Scholes’] influence has mushroomed in the most fantastic ways. At the end of 2006, according to the Bank for International Settlements, there were $415 trillion in derivatives—that is, $415 trillion in securities for which there is no completely satisfactory pricing model. Added to this are trillions more in exchange-traded options, employee stock options, mortgage bonds, and God knows what else—most of which, presumably, are still priced using some version of Black-Scholes. Investors need to believe that there’s a rational price for what they buy, even if it requires a leap of faith.

While the previous crashes may have affected broker-dealers more that the public, the sub-prime mortgage meltdown was different in that the underlying assets were peoples’ homes, the roofs over our heads.  The current meltdown is essentially the violent collision of two worlds–the reality of peoples’ homes and lives, and the unreality of Black-Scholes.  Strike three.

2.  Blind Faith and/or Greed

So why did the fantastical Black-Scholes model continue to have appeal despite many warning signs that it was toxic?  Two basic reasons, neither of which is very debatable:

Greed–the model had the potential to make enormous sums of money for traders, managers, execs and others in the short-term.  And it’s not all Wall Street greed.  Ordinary Americans, while doubtless unaware of Black-Scholes or its implications, continued to pump money into the system, continued to buy beyond their means.  The primary motivation of many was to make a quick buck, even if it meant creating bubble that would clobber everyone in the long term.

Blind Faith–the unsupportable notion that real estate prices would continue to rise, despite ALL evidence to the contrary.  In other words, people believed that a crash would not occur.  Ever.  I remember people talking about the real estate bubble popping way back in 2003 and 2004.  But it didn’t, and didn’t, and didn’t some more.  Eventually, people started to believe that it wouldn’t, even when every historical indicator proved that it would.

3.  The Greenspan Put

From the late 80s to the middle of 2000, the myopic Alan Greenspan instituted a policy of lowering interest rates every time there was a hint of a financial crisis.  It was reactionary, and robotic.  Economic restraint was something Greenspan could not comprehend.  As stated by Wikipedia:

The Fed’s pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. Investors increasingly believed that when things go bad, the Fed would step in and inject liquidity until the problem got better. Invariably, the Fed did so each time, and the perception became firmly embedded in asset pricing in the form of higher valuation, narrower credit spreads, and excess risk taking.

Bernanke followed suit, and so began the bail-out mentality in the financial industry that has culminated in recent months.

Greenspan lowered the fed rate to a ridiculously low level after 9/11.  That, by itself, was a time bomb.

The low interest rates made loans cheap, and housing seem cheaper, creating more demand, increasing prices, and so on.  After a while, pervasive blind faith set in.  (see above).

4.  Financial “Modernization”

Enacted under FDR, the Glass-Steagall Act prohibited the intermingling of commercial banks with investment banks.   Under Alan Greenspan, the Act’s prohibitions were eroded and, in 1999 it was totally repealed by dint of the “Financial Services Modernization Act.”  Many in Congress argued that the repeal of Glass-Steagall would create conflicts of interest, lack of transparency and megabanks that would become “too big to fail.”  In light of the emergence of the utterly opaque sub-prime finance industry and of CitiGroup’s (among others) ultimate demise and bail-out, they were right.  Indeed, the most significant aspect of this so-called “Modernization” was that it was forced and engineered by none other than CitiGroup. “Modernization” was, in truth, an unprecedented usurpation of government by the finance industry.

A second piece of “modernization” legislation, the so-called Gramm-Lugar Commodity Futures Modernization Act, was passed in December 2000 while Clinton was busy taking the “W” keys off all White House keyboards, without any debate or formal hearings.  This act paved the way for the speculative onslaught in primary commodities including oil and food staples, and also enabled Enron to be, well, Enron.  On the Enron piece, the conventional wisdom is that Enron engineered the entire thing so as to create a deregulated atmosphere for its latest brilliant idea, “Enron On-Line.”

But, as Mother Jones reports, Enron’s piece of the pie was nothing “compared to the devastation that unregulated swaps would unleash”:

Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It’s like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm’s bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.

“Tens of trillions of dollars of transactions were done in the dark,” says University of San Diego law professor Frank Partnoy, an expert on financial markets and derivatives. “No one had a picture of where the risks were flowing.” Betting on the risk of any given transaction became more important—and more lucrative—than the transactions themselves, Partnoy notes: “So there was more betting on the riskiest subprime mortgages than there were actual mortgages.” Banks and hedge funds, notes Michael Greenberger, who directed the cftc’s division of trading and markets in the late 1990s, “were betting the subprimes would pay off and they would not need the capital to support their bets.”

These unregulated swaps have been at “the heart of the subprime meltdown,” says Greenberger. “I happen to think Gramm did not know what he was doing. I don’t think a member in Congress had read the 262-page bill or had thought of the cataclysm it would cause.”

Thought it’s hard to pin this financial mess on one single person, you could do worse than blaming it on Phil Gramm, the chief “sponsor” of both the foregoing pieces of legislation.

5.  Groupthink And Conformity

Psychologist Irving Janis defines Groupthink as “the mode of thinking that persons engage in when concurrence-seeking becomes so dominant in a cohesive in-group that it tends to override realistic appraisal of alternative courses of action.”

As the New York Times reports with respect to the CitiGroup collapse:

[M}any Citigroup insiders say the bank’s risk managers never investigated deeply enough. Because of longstanding ties that clouded their judgment, the very people charged with overseeing deal makers eager to increase short-term earnings — and executives’ multimillion-dollar bonuses — failed to rein them in, these insiders say.

There has been for at least 7 years a pervasive Groupthink in this country on Wall Street and Main Street, but mostly Wall Street. The pressures to conform, the temptations of those multi-million dollar bonuses, were just too much.  Because the innovative strategies and blind optimism seemed to be working in that huge profits continued to come pouring in, any employee that would actually question what was going on, suggest some restraint, risked ostracization.  Over time, Wall Street was distilled into a roving band of Yes Men.  This included the ratings agencies which somehow managed, time and time again, to create AAA-rated debt out of subprime crap.  Literally.  And, of course, accountants and lawyers gladly jumped up upon the Yes Train.  It’s the most widespread, heinous case of Groupthink ever recorded.

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