How One Book Cured My Credit Crunch Ignorance

12/04/2016 13:39

Like most people I understand something of what happened in the great crash, credit crunch or whatever else you want to call the cataclysmic financial events of 2007-2010. I've read a few books, watched some movies and think I know the basics. I watched The Big Short and understood most of it even without the aid of Selena Gomez explaining the finer points.

I understood it was something about parcelling up debt, selling it around the world and the chickens coming home to roost when all the debt went bad. Sub-prime mortgages in US turned out not to be the best thing on which to base the global financial ecosystem. I got it at that level.

However I was aware that I didn't really understand why it really happened, and appreciate the scale of the crash. That's until I read Whoops! Why Everyone Owes Everyone and No One Can Pay by John Lanchester. I'm even going to try and explain some of it to you.
By the way, If you don't know Lanchester's writing, he's really very good. He wrote Capital, a great novel about London with the crash as a background to the events in one street in the city. In fact, this book was part of the research for that novel. His journalism for the New Yorker and The Guardian amongst others is also worth checking out. (His piece on the Snowden Files in The Guardian is a great read.

What he's achieved in Whoops! is to write a book that not only explains something very complicated but manages to entertain along the way. Some bits of it are surprisingly laugh-out-loud funny too.

To start with, it's a cracking tale and it's worth telling well. As Lanchester says:

"It's an absolutely amazing story, full of human interest and drama, one whose byways of mathematics, economics and psychology are both central to the story of the last decades and mysteriously unknown to the general public."

Lanchester is good at scale too. This is one of the things we all struggle with as we try to comprehend the some of the financial amounts at stake in this story.

"The sheer frictionlessness with which money moves around the world is frightening: it can induce a kind of vertigo. This can happen when you are reading the financial news and suddenly feel that you have no grip on what these numbers actually mean -- what those millions and billions and trillions actually represent, how to get hold of them in your mind. (Try the following thought experiment , suggested by the mathematician John Allen Paulos in his book Innumeracy. Without doing the calculation, guess how long a million seconds is. Now try to guess the same for a billion seconds. Ready? A million seconds is less than twelve days; a billion seconds is almost thirty years)"

Yep. Mind blown! That happens a lot in this book too.

So the story goes on. We start with Iceland and what the crash felt like there. Imagine going to the ATM and your hard earned money not being there because the bank had run out of money! As always it was a minority which created the problems that affected a whole nation.

Lanchester then interestingly takes the tale to Hong Kong "a lab test in free-market capitalism". We then follow the spread of this type of free-market capitalism and the ideology of Friedman and Hayek via Reagan and Thatcher across the western world. The fall of communism allowed this to spread pretty much everywhere and unchallenged. Suddenly capitalism was "unthreatened as the world's dominant political economic system". After Thatchers's Big Bang in the city, the UK was open for business and global capital flooded in. Further financial deregulation by Clinton and Bush in the US, opened the global floodgates even wider.

Lanchester explains how the banks, which were supposed to be the most secure and conservative businesses, became not just very big but also risky indeed. At one point, Royal Bank of Scotland , by asset size, was the biggest company in the world!

There follows for the main part of the book a clear explanation of some of the mechanics of banking but Lanchester's skills makes it understandable and very readable. From the importance of Derivatives to the more destructive financial mechanisms such as the Credit Default Swap (CDS).

The ideas of the 'swap' unleashed a very important concept which changed how the whole system worked. J.P. Morgan created an innovative type of swap which ultimately meant you could lend money at a good rate of interest at no risk.

"This had enormous potential in the world of banking. Since banking is based on making loans to customers, the risk of default by those customers is an extremely important part of the business. So a product which made it possible to reduce that risk -- to reduce it by selling it to somebody else- had the potential to create a gigantic new market. The new idea was a product which would resemble a kind of insurance, with the product insured being the risk of default on specific debt."

Then this is where you disappear down the rabbit hole a little

"The invention which allowed all this to happen was securitisation. The issue with credit default swaps was the underlying issue with all banking, everywhere and always: the risk that the person to whom you're lending money won't be able to pay you back....What securitisation did was bundle together a package of these loans and then rely on safety in numbers and the law of averages: even if some loans did default, the others wouldn't, and would keep the stream of revenue going, and this the risk of default would be spread and minimised."

As these products and mechanisms became more complex, banks lost a simple fundamental premise of all banking: the ability to assess every loan. It was just too complicated now.

"The whole idea that a banker looks a borrower in the eye and takes a view on whether he can trust him came to seem laughably nineteenth century"

Once all this was in place and despite of the alarm bells ringing, the money came flowing in. And then no one wanted to say stop.

And we all know what happened next. Everyone wanted more money. Let's invest in riskier and more lucrative lending. Sub Prime mortgages (for poorer or less creditworthy borrowers) paid a higher rate of interest than prime ones.

The loans got riskier and everyone from Ireland to America could be lent money, regardless of their financial situation, because as we now know, the risk was being carried by someone else. Risk is a key element in this story. Ultimately it becomes the biggest mistake that all the banks made.

"The bankers made inaccurate calculations about the mathematics of risk. That in essence was the mistake which destroyed some banks, forced others into public ownership, put taxpayers on the hook for hundred of billions of pounds and then brought the world financial system to a juddering panicky standstill. It led directly to the slowdown currently dominating every economy in the world."

Lanchester reserves much of his anger at vitriol for some of the real villains of the story, the credit ratings agencies. Also much time is spent on this key point about risk. This is when the absurdity of what happened becomes almost laughable -- if it wasn't so serious.

By the time the market had finished with its packaging and securitisation and CDOs and CDSs and VaR and formulas, the industry had convinced itself that nothing bad could happen to these loans, This is when Lanchesters' incredulity brings some dark humour to the story.

"Remember what we're talking about here is a drop in house prices which caused people with bad credit to have trouble paying their mortgages. That was turned into something that was literally the most unlikely thing to have happened on the history of the universe"

or to put in another way, and thanks to the credit rating agencies:

"We arrive in the bizarre position in which poor people struggling to pay back their mortgages had miraculously produced the worlds most secure financial instruments"

It's in the last few more philosophical sections of the book that Lanchester really flies. How did greed, corruption and the desire for such great wealth come to dominate our culture? That's a really important point and it reaches a crescendo in the last few incredible chapters of this very important book

"Free market capitalism's victory party lasted for two decades: now it's time to slow down, calm down and decide how to make the finance industry back into something which serves the rest of society rather than predating on it. And the level of our individual response is just as important. On that level, we have to start thinking about when we have sufficient -- sufficient money, sufficient stuff -- and whether we really need the things we think we do, beyond what we already have. In a world running out of resources the most important ethical and political and ecological idea can be summed up in one simple word: 'enough'"

Any book that starts with quotes from John Maynard Keynes and David St Hubbins from Spinal Tap is alright by me. The Spinal Tap quote?

"It's such a fine line between stupid and clever"

Read this book. It will make you a little cleverer. And may help us all to ensure we change things for good and never allow this all to happen again.

This article was originally published on Medium