A crisis too complex for easy fixes

PARIS: Just over 100 years ago, J.P. Morgan gathered his fellow financiers at his Manhattan mansion amid growing financial panic and declared, "This is where the trouble stops."

Last weekend, a similar conclave gathered farther downtown at the Federal Reserve Bank of New York, with the Fed''s chairman and the U.S. Treasury secretary giving the bosses of Wall Street giants like Citigroup, Goldman Sachs and, yes, J.P. Morgan, a similar ultimatum.

Unlike the successful dénouement to the Panic of 1907, however, the trouble did not stop. Indeed, the crisis of 2008 worsened, with one financial firm filing for bankruptcy protection, another ending up in a shotgun wedding with a major bank and a third essentially getting nationalized by Washington.

In the end, it looks as if only the full faith and credit of the U.S. government, now committed to taking over the lion''s share of bad housing debt, may be enough to stem the fear.

Why didn''t the magic wrought by J.P. Morgan (the banker, not the bank) work this time around? It may be because, unlike the financiers 100 years ago, the people in the room did not fully understand what the institutions they run actually owned and were trading back and forth - at immense profit.

Neither did they fully grasp the speed at which their world had changed since the last financial crisis a decade ago, when the collapse of Long-Term Capital Management, a giant hedge fund, seemingly brought Wall Street to the brink.

"I consider myself a serious student of Wall Street history, but history is not going to be a lot of help here," said Byron Wien, a 40-year market veteran who is now chief investment strategist for Pequot Capital.

"The degree of complexity is so great, the products are new and untested and the operations are now global," he added. "This is Long-Term Capital on steroids."

In some ways, Wall Street suffers from a generation gap. At 62, Richard Fuld, the head of Lehman Brothers, had ridden out everything from the oil shocks of the 1970s to the Russian debt default and Asian economic flu in 1998. But in recent years, his firm and other Wall Street giants derived an ever-increasing share of profits from products that barely existed a decade ago, like credit-default swaps. Essentially insurance on debt, the market for credit-default swaps has ballooned from $900 billion in 2001 to a nearly unimaginable $45.5 trillion now.

In fact, the insurance giant AIG, which was effectively taken over by the U.S. government Tuesday, was one of the very largest players in this gargantuan market - far bigger than Lehman, which filed for bankruptcy protection early Monday. That was a top reason why AIG got an $85 billion government lifeline, while Lehman was left to fend for itself.

Jamie Cawley, a veteran player in the credit-default swaps market, says he doubts whether the older chiefs of the firms who profited from these products, or the young traders who specialized in them, fully understood the implications of what they were doing.

"Had they understood the implications, we wouldn''t be where we are today," said Cawley, founder and chief executive of IDX Capital. The overriding feeling on Wall Street, he said, was: "Let''s make money while the sun shines and worry about the details later."

While Fuld and other chief executives bear the ultimate responsibility for their firms'' fates, it would take a doctorate in mathematics to unravel the most complex of the derivatives that helped bring down Lehman or Bear Stearns earlier this year.

The compensation of Fuld and other Wall Street chief executives followed a similar trajectory higher during the earlier boom years.

"If you''re approving things you don''t understand, that''s not doing your job," said Jonathan Koppell, director of the Millstein Center for Corporate Governance and Performance at the Yale School of Management. "What are these guys compensated for, if they''re checking off things they don''t understand?"

"A huge number of directors probably didn''t understand what their companies were up to, and it''s quite likely at least some of the leaders of these companies didn''t fully understand what their employees were doing," he added.

To make matters worse, the financial models undergirding many of the most sophisticated new products were largely based on recent trading patterns - an unusually tranquil time, at least by historical standards.

With the inflation spike of the 1970s largely conquered by the central banks, the last 25 years have seen steadily dropping interest rates, the successful integration of emerging markets, and low inflation, according to Thomas Mayer, chief European economist for Deutsche Bank.

Despite occasional periods of volatility - the crash of 1987, the failure of Long-Term Capital, the bursting of the technology bubble and economic fallout from Sept. 11 - the markets managed to bounce back each time.

"People were lulled into complacency," said Wien of Pequot Capital.

To be sure, it was not only the veterans who were caught off guard by the risks lying in wait. The young lions were, too.

Earlier this year, a 31-year old derivatives trader named Jérôme Kerviel nearly brought down Société Générale, the 150-year-old French financial giant, by making unauthorized bets on the stock market that cost his bank almost ,5 billion, or $7.7 billion at the exchange rate at that time.

His supervisors later said they had had no idea what he was up to.

It is not just Wall Street that has changed, either.

The global economic landscape is also fundamentally different from that of a decade ago, not to mention that when men like Fuld and his contemporaries came of age. Maurice Greenberg was 80 when he stepped down from AIG in 2005. James Cayne, the former boss of Bear Stearns, is 74.

In earlier eras, says Wien, a stricken firm like Lehman or AIG would have turned to deep-pocketed investors in the United States, or failing that, Europe.

This time around, banks are turning to the Middle East and especially Asia for capital. Lehman itself entered a death spiral when the state-controlled Korea Development Bank walked away from talks to buy a stake in the 158-year-old investment bank.

"The balance of economic power has shifted out of the U.S and Europe to the Middle East and Asia," Wien said.

At the same time, dramatic gains in computing power allowed the creation of financial products with many more variables - and gave individual traders like Kerviel much more power to move them at lightning speed.

"Twenty years ago, it was hard to accurately price a corporate bond, let alone calculate credit spreads," said David Munves, a managing director in the capital markets research group of Moody''s, who spent 10 years at Lehman. Even in the mid-1990s, he recalls, bond traders would use oversized calculators at their desks to figure out yields down to 1/16 and 1/32.

Now, he said, traders can call up databases that feature 400 fields for a single bond, with once-straightforward features like duration and yield sliced a multitude of different ways. "As you build more complex products, you get further away from real world events, like actually having to sell these bonds," he said.

The result, said Mayer of Deutsche Bank, is that products were developed for markets that everyone assumed would be like they were then, only more so, with capital freely flowing, rational minds prevailing and fear largely in check.

"A generation grew up that has been very well trained in this new finance theory, very well educated to apply it on a broad scale with the necessary computing power, and off we went," Mayer said.

Recent events, he said, have shown that the basic assumptions that have held sway for a generation or two no longer hold. "This will leave us with a different paradigm," he added. "If I could give it to you, I''d win the Nobel Prize."

Link: http://www.iht.com/articles/2008/09/19/business/crisis.php
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