Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe

Citation

Jain, A.K. (2010), "Fool's Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe", Critical Perspectives on International Business, Vol. 6 No. 1, pp. 72-75. https://doi.org/10.1108/17422041011017630

By the fall of 2007, it had became clear to everyone except the diehard apologists for markets that a major correction was in store for global asset prices that had seen quite a spectacular climb over the past two decades. Skeptics that had always viewed the growth in these asset markets, be they stocks, real estate or commodities, as bubbles that would collapse sooner or later were happy that they were finally being proven right. The rout was global – every country was going to get hit and there was no asset class that would offer a safe heaven to investors. Policy makers in every industrialized country as well as international institutions were scrambling to ensure that the decline did not become another great depression. What was to follow in the fall of 2008 was indeed spectacular – venerable financial institutions would fall, others would have to be bailed out and one would be forced to accept the humiliation of being bought at $2 per share less than eighteen months after its shares had traded at 86 times that amount. The banking industry in the United Kingdom saw its capitalization (as a percent of domestic GDP) fall to about one‐fifth its previous value after having peaked at more than 25 percent of the GDP for a decade before the crisis.

There is no shortage of analyses and finger pointing for the events that shook the global economy in 2007 and 2008. Given the extent of the shock, neither should there be any limit on such dissections. After all, we have still not exhausted our analysis of the previous big shock for the global economy – the depression of 1930 s. The actor in charge of the financial system at the epicenter of the storm, the United States, had made its reputation on the basis of the analysis of that disaster. All aspects of the present crisis – financial, economic, systemic, political as well as behavioral – must come under thorough scrutiny. This book, Fool's Gold, is a study of the people who were at the epicenter of the storm – bankers who developed the derivatives that brought the international financial system to its knees. It is a story of how some who seemed to be well meaning and intelligent financial wizards played their part in building a complex and intricate world of derivatives, risks, and financial obligations that came down under its own weight because no one seemed to have had the foresight to challenge the rules by which the game was being played.

Fool's Gold is an anthropologists' look at the culture of banking and innovations in which the instruments which became the lightening rods for the crisis – the credit default swaps and the mortgage backed securities – were developed and foisted on the market where very few people understood what the real risks of such derivatives were. Blissfully, this book is not about finance theory that drives those developments, although the author understands the financial underpinnings of events as well as most experts on finance do. It is her background in cultural anthropology that provides the insights into the behavior of bankers' teams that will provide valuable information for anyone trying to understand how supposedly very intelligent people – those in the private banks and those in the regulatory agencies – can engage in behaviors that are catastrophic for large segments of populations when the houses built with a deck of cards finally unravels.

The main theme of the book is build around the events that took place within one bank that played a key role in the development of what were to become the toxic derivative products. In examining how decisions were made, the book provides ample evidence for demolishing the “rational human beings” assumption that forms the basis for much of the economic analysis in the textbooks. There is evidence in this volume to support the work of behavioral economists who have begun to identify many flaws, imperfections and deviations from the supposed “rational” behavior in which investors and decision makers are supposed to engage.

There are a number of stories running through out this book. Some deal with how banks work, others with how they, as well as the regulators, do not work.

First, there are the stories of individuals who played key roles in the development of ideas that culminated in the creation of derivatives that became the triggers for the current crisis – mortgage backed securities and credit default swaps. There is nothing unusual about the ambition that drove these people – they were devoted to their ideas and nothing was going to stop them from achieving their goals.

What is perhaps surprising is the loyalty that some commanded and others provided. This loyalty seems to coexist with desires for personal ambitions. One would expect that the two would be in conflict – yet personal loyalties prevail in some situations. There are ample stories and incidences in this book when, at least at an individual level, bankers do not fit the stereotypes that the street demonstrations against banks would want to project.

Behavioral scientists have identified “overconfidence” as one of the traits that many investors exhibit. Overconfidence refers to unjustified beliefs in one's own analysis and conclusions and leads investors to ignore evidence that may contradict the conclusions they may have drawn. As many stories in this book reveal, it is not just the investors who suffer from overconfidence. Bankers who lead and form innovative teams within banks have plenty of overconfidence and they throw in arrogance for good measures. Their attitude could be summarized as, “We have created these innovations – how dare you – a mere regulator – criticize our work and try to control us?”

This arrogance and overconfidence is reinforced by the political power of the financial services industry. The financial clout of the industry is combined with the sophistication that the industry has developed and is used very effectively to influence the legislative process in the United States. It was this clout that created the environment that led to the overconfidence in the abilities of markets to regulate themselves and to the gradual relaxation of regulations on banks through the 1990 s. As becomes quite clear through the stories in the book, regulators were quite content to let the banks do whatever they wanted – be it the creation of Structured Investment Vehicles, repacking of sub‐prime mortgages with triple A tranches, or just estimate risks without any data.

Perhaps most disturbing of all is the evidence that confirms the existence of what amounts to regulatory hubris. Fearing that regulators would begin to develop regulations for complex derivatives, commercial bankers decided to prepare their own report on self‐regulation through the Group of 30. The report, though well received when it was released in 1993, struck a senior Bank of England official as “somewhat complacent” in regard to the risks posed by the derivative world (p. 41.). The Bank's response was not to fill that gap with its own guidelines or rules that the commercial banks would have to follow but merely to urge the industry to maintain discipline by upholding a set of common standards. The industry, needless to say, was relieved with this reaction and went on to do exactly nothing.

AIG, which was to receive almost 200 billion dollars worth of government support in the fall of 2008, had been one of the largest suppliers of credit default swaps to the market. Since it was an insurance company, however, regulators of financial markets had never bothered to ensure that the company came under the regulatory umbrella of the authorities that had oversight responsibilities for other issuers of such derivatives – the commercial and the investment banks. The company was under the regulatory watch of Office of Thrift Supervision – an agency with very limited capabilities to understand and control complex derivatives (p. 72). In the end, it was the company's exposure to such swaps that brought it to the brink of bankruptcy.

Regulators were sometimes just as clueless about systemic risks as the inventors of the products. They failed to balance their conflict of interest – as guardians to banks as well as guardians of the public against unscrupulous behavior of banks because in the end they put full trust in the banks and allowed them a free hand in their dealings with investors.

One of the most fascinating stories in this book, for this author, is about how decisions are made with or without ensuring that relevant and valid data are available. Assessment of risks of derivatives depends critically on data regarding default structures. What can happen when things begin to go wrong? How big will the losses be if events do not unfold according to the plans and the hopes? How are risks of various assets correlated? The essence of estimating risk is the ability to say what may happen in the future, especially if things go wrong. It is however impossible to provide probabilities of possible outcome on new innovations – innovations that are completely different from what we may have known before. No one should have been expected to provide probabilities of Apollo 13 getting into trouble. But mortgages? Mortgages have been around for centuries. Of course, we have not kept data for that long – but the mortgages themselves are not a new phenomenon. Banks selling insurance against failures of mortgages, have to know what may be the chances of defaults and what were the correlations of mortgages' returns with returns on other assets.

In the end the problem of lack of data was shelved because competitors were using bad or incomplete data. Stupendously bad assumption, that past fully reflects the future, seemed acceptable when others were making that assumption and capturing large market shares. This is not the first time banks had relied upon the absence of data to make colossal mistakes. Before the previous banking crisis that had brought the international banking system to its knees, the third world debt crisis of 1982, commercial banks had been engaged in lending large volumes of money to developing countries. When the crisis broke in the fall of 1982, many banks were surprised by the exposure of some of the countries. The explanation given by the banks – and largely accepted by their regulators – was that the countries had not provided the information on their exposure and the banks had no knowledge of countries' exposures.

Contrary to the claims and the popular myth, most of the innovators do not appear to be “evil” characters who plot to control or to bring this world down; they were just as caught up with themselves and their ideas as most driven people tend to be.

Fool's Gold is a very readable account of the people involved in one of the most important financial crisis of our generation. The author makes an attempt to get to know many individuals who are part of the innovative process and yet is able to expose the underbelly of this part of the banking world that pushes the envelop.