Finance

Wall Street Lays Another Egg

Not so long ago, the dollar stood for a sum of gold, and bankers knew
the people they lent to. The author charts the emergence of an
abstract, even absurd world—call it Planet Finance—where mathematical
models ignored both history and human nature, and value had no
meaning.
by Niall Ferguson December 2008
Illustration by Tim Bower

The bigger they come: Uncle Sam and Wall Street take the hardest fall
since the Depression. Illustration by Tim Bower.

This year we have lived through something more than a financial
crisis. We have witnessed the death of a planet. Call it Planet
Finance. Two years ago, in 2006, the measured economic output of the
entire world was worth around $48.6 trillion. The total market
capitalization of the world's stock markets was $50.6 trillion, 4
percent larger. The total value of domestic and international bonds
was $67.9 trillion, 40 percent larger. Planet Finance was beginning to
dwarf Planet Earth.

Planet Finance seemed to spin faster, too. Every day $3.1 trillion
changed hands on foreign-exchange markets. Every month $5.8 trillion
changed hands on global stock markets. And all the time new financial
life-forms were evolving. The total annual issuance of mortgage-backed
securities, including fancy new "collateralized debt obligations"
(C.D.O.'s), rose to more than $1 trillion. The volume of
"derivatives"—contracts such as options and swaps—grew even faster, so
that by the end of 2006 their notional value was just over $400
trillion. Before the 1980s, such things were virtually unknown. In the
space of a few years their populations exploded. On Planet Finance,
the securities outnumbered the people; the transactions outnumbered
the relationships.
Illustration by Brad Holland

Read Niall Ferguson's prescient article on today's financial woes,
Empire Falls (November 2006).

New institutions also proliferated. In 1990 there were just 610 hedge
funds, with $38.9 billion under management. At the end of 2006 there
were 9,462, with $1.5 trillion under management. Private-equity
partnerships also went forth and multiplied. Banks, meanwhile, set up
a host of "conduits" and "structured investment vehicles" (sivs—surely
the most apt acronym in financial history) to keep potentially risky
assets off their balance sheets. It was as if an entire shadow banking
system had come into being.

Then, beginning in the summer of 2007, Planet Finance began to
self-destruct in what the International Monetary Fund soon
acknowledged to be "the largest financial shock since the Great
Depression." Did the crisis of 2007–8 happen because American
companies had gotten worse at designing new products? Had the pace of
technological innovation or productivity growth suddenly slackened?
No. The proximate cause of the economic uncertainty of 2008 was
financial: to be precise, a crunch in the credit markets triggered by
mounting defaults on a hitherto obscure species of housing loan known
euphemistically as "subprime mortgages."

Central banks in the United States and Europe sought to alleviate the
pressure on the banks with interest-rate cuts and offers of funds
through special "term auction facilities." Yet the market rates at
which banks could borrow money, whether by issuing commercial paper,
selling bonds, or borrowing from one another, failed to follow the
lead of the official federal-funds rate. The banks had to turn not
only to Western central banks for short-term assistance to rebuild
their reserves but also to Asian and Middle Eastern sovereign-wealth
funds for equity injections. When these sources proved insufficient,
investors—and speculative short-sellers—began to lose faith.

Beginning with Bear Stearns, Wall Street's investment banks entered a
death spiral that ended with their being either taken over by a
commercial bank (as Bear was, followed by Merrill Lynch) or driven
into bankruptcy (as Lehman Brothers was). In September the two
survivors—Goldman Sachs and Morgan Stanley—formally ceased to be
investment banks, signaling the death of a business model that dated
back to the Depression. Other institutions deemed "too big to fail" by
the U.S. Treasury were effectively taken over by the government,
including the mortgage lenders and guarantors Fannie Mae and Freddie
Mac and the insurance giant American International Group (A.I.G.).

By September 18 the U.S. financial system was gripped by such panic
that the Treasury had to abandon this ad hoc policy. Treasury
Secretary Henry Paulson hastily devised a plan whereby the government
would be authorized to buy "troubled" securities with up to $700
billion of taxpayers' money—a figure apparently plucked from the air.
When a modified version of the measure was rejected by Congress 11
days later, there was panic. When it was passed four days after that,
there was more panic. Now it wasn't just bank stocks that were
tanking. The entire stock market seemed to be in free fall as fears
mounted that the credit crunch was going to trigger a recession.
Moreover, the crisis was now clearly global in scale. European banks
were in much the same trouble as their American counterparts, while
emerging-market stock markets were crashing. A week of frenetic
improvisation by national governments culminated on the weekend of
October 11–12, when the United States reluctantly followed the British
government's lead, buying equity stakes in banks rather than just
their dodgy assets and offering unprecedented guarantees of banks'
debt and deposits.

Since these events coincided with the final phase of a U.S.
presidential-election campaign, it was not surprising that some rather
simplistic lessons were soon being touted by candidates and
commentators. The crisis, some said, was the result of excessive
deregulation of financial markets. Others sought to lay the blame on
unscrupulous speculators: short-sellers, who borrowed the stocks of
vulnerable banks and sold them in the expectation of further price
declines. Still other suspects in the frame were negligent regulators
and corrupt congressmen.

This hunt for scapegoats is futile. To understand the downfall of
Planet Finance, you need to take several steps back and locate this
crisis in the long run of financial history. Only then will you see
that we have all played a part in this latest sorry example of what
the Victorian journalist Charles Mackay described in his 1841 book,
Extraordinary Popular Delusions and the Madness of Crowds.
Nothing New

As long as there have been banks, bond markets, and stock markets,
there have been financial crises. Banks went bust in the days of the
Medici. There were bond-market panics in the Venice of Shylock's day.
And the world's first stock-market crash happened in 1720, when the
Mississippi Company—the Enron of its day—blew up. According to
economists Carmen Reinhart and Kenneth Rogoff, the financial history
of the past 800 years is a litany of debt defaults, banking crises,
currency crises, and inflationary spikes. Moreover, financial crises
seldom happen without inflicting pain on the wider economy. Another
recent paper, co-authored by Rogoff's Harvard colleague Robert Barro,
has identified 148 crises since 1870 in which a country experienced a
cumulative decline in gross domestic product (G.D.P.) of at least 10
percent, implying a probability of financial disaster of around 3.6
percent per year.

If stock-market movements followed the normal-distribution, or bell,
curve, like human heights, an annual drop of 10 percent or more would
happen only once every 500 years, whereas in the case of the Dow Jones
Industrial Average it has happened in 20 of the last 100 years. And
stock-market plunges of 20 percent or more would be unheard of—rather
like people a foot and a half tall—whereas in fact there have been
eight such crashes in the past century.

The most famous financial crisis—the Wall Street Crash—is
conventionally said to have begun on "Black Thursday," October 24,
1929, when the Dow declined by 2 percent, though in fact the market
had been slipping since early September and had suffered a sharp, 6
percent drop on October 23. On "Black Monday," October 28, it plunged
by 13 percent, and the next day by a further 12 percent. In the course
of the next three years the U.S. stock market declined by a staggering
89 percent, reaching its nadir in July 1932. The index did not regain
its 1929 peak until November 1954.

That helps put our current troubles into perspective. From its peak of
14,164, on October 9, 2007, to a dismal level of 8,579, exactly a year
later, the Dow declined by 39 percent. By contrast, on a single day
just over two decades ago—October 19, 1987—the index fell by 23
percent, one of only four days in history when the index has fallen by
more than 10 percent in a single trading session.

This crisis, however, is about much more than just the stock market.
It needs to be understood as a fundamental breakdown of the entire
financial system, extending from the monetary-and-banking system
through the bond market, the stock market, the insurance market, and
the real-estate market. It affects not only established financial
institutions such as investment banks but also relatively novel ones
such as hedge funds. It is global in scope and unfathomable in scale.

Had it not been for the frantic efforts of the Federal Reserve and the
Treasury, to say nothing of their counterparts in almost equally
afflicted Europe, there would by now have been a repeat of that "great
contraction" of credit and economic activity that was the prime mover
of the Depression. Back then, the Fed and the Treasury did next to
nothing to prevent bank failures from translating into a drastic
contraction of credit and hence of business activity and employment.
If the more openhanded monetary and fiscal authorities of today are
ultimately successful in preventing a comparable slump of output,
future historians may end up calling this "the Great Repression." This
is the Depression they are hoping to bottle up—a Depression in denial.

To understand why we have come so close to a rerun of the 1930s, we
need to begin at the beginning, with banks and the money they make.
From the Middle Ages until the mid-20th century, most banks made their
money by maximizing the difference between the costs of their
liabilities (payments to depositors) and the earnings on their assets
(interest and commissions on loans). Some banks also made money by
financing trade, discounting the commercial bills issued by merchants.
Others issued and traded bonds and stocks, or dealt in commodities
(especially precious metals). But the core business of banking was
simple. It consisted, as the third Lord Rothschild pithily put it,
"essentially of facilitating the movement of money from Point A, where
it is, to Point B, where it is needed."

The system evolved gradually. First came the invention of cashless
intra-bank and inter-bank transactions, which allowed debts to be
settled between account holders without having money physically change
hands. Then came the idea of fractional-reserve banking, whereby banks
kept only a small proportion of their existing deposits on hand to
satisfy the needs of depositors (who seldom wanted all their money
simultaneously), allowing the rest to be lent out profitably. That was
followed by the rise of special public banks with monopolies on the
issuing of banknotes and other powers and privileges: the first
central banks.

With these innovations, money ceased to be understood as precious
metal minted into coins. Now it was the sum total of specific
liabilities (deposits and reserves) incurred by banks. Credit was the
other side of banks' balance sheets: the total of their assets; in
other words, the loans they made. Some of this money might still
consist of precious metal, though a rising proportion of that would be
held in the central bank's vault. Most would be made up of banknotes
and coins recognized as "legal tender," along with money that was
visible only in current- and deposit-account statements.

Until the late 20th century, the system of bank money retained an
anchor in the pre-modern conception of money in the form of the gold
standard: fixed ratios between units of account and quantities of
precious metal. As early as 1924, the English economist John Maynard
Keynes dismissed the gold standard as a "barbarous relic," but the
last vestige of the system did not disappear until August 15, 1971—the
day President Richard Nixon closed the so-called gold window, through
which foreign central banks could still exchange dollars for gold.
With that, the centuries-old link between money and precious metal was
broken.

Though we tend to think of money today as being made of paper, in
reality most of it now consists of bank deposits. If we measure the
ratio of actual money to output in developed economies, it becomes
clear that the trend since the 1970s has been for that ratio to rise
from around 70 percent, before the closing of the gold window, to more
than 100 percent by 2005. The corollary has been a parallel growth of
credit on the other side of bank balance sheets. A significant
component of that credit growth has been a surge of lending to
consumers. Back in 1952, the ratio of household debt to disposable
income was less than 40 percent in the United States. At its peak in
2007, it reached 133 percent, up from 90 percent a decade before.
Today Americans carry a total of $2.56 trillion in consumer debt, up
by more than a fifth since 2000.

Even more spectacular, however, has been the rising indebtedness of
banks themselves. In 1980, bank indebtedness was equivalent to 21
percent of U.S. gross domestic product. In 2007 the figure was 116
percent. Another measure of this was the declining capital adequacy of
banks. On the eve of "the Great Repression," average bank capital in
Europe was equivalent to less than 10 percent of assets; at the
beginning of the 20th century, it was around 25 percent. It was not
unusual for investment banks' balance sheets to be as much as 20 or 30
times larger than their capital, thanks in large part to a 2004 rule
change by the Securities and Exchange Commission that exempted the
five largest of those banks from the regulation that had capped their
debt-to-capital ratio at 12 to 1. The Age of Leverage had truly
arrived for Planet Finance.

Credit and money, in other words, have for decades been growing more
rapidly than underlying economic activity. Is it any wonder, then,
that money has ceased to hold its value the way it did in the era of
the gold standard? The motto "In God we trust" was added to the dollar
bill in 1957. Since then its purchasing power, relative to the
consumer price index, has declined by a staggering 87 percent. Average
annual inflation during that period has been more than 4 percent. A
man who decided to put his savings into gold in 1970 could have bought
just over 27.8 ounces of the precious metal for $1,000. At the time of
writing, with gold trading at $900 an ounce, he could have sold it for
around $25,000.

Those few goldbugs who always doubted the soundness of fiat
money—paper currency without a metal anchor—have in large measure been
vindicated. But why were the rest of us so blinded by money illusion?
Blowing Bubbles

In the immediate aftermath of the death of gold as the anchor of the
monetary system, the problem of inflation affected mainly retail
prices and wages. Today, only around one out of seven countries has an
inflation rate above 10 percent, and only one, Zimbabwe, is afflicted
with hyperinflation. But back in 1979 at least 7 countries had an
annual inflation rate above 50 percent, and more than 60
countries—including Britain and the United States—had inflation in
double digits.

Inflation has come down since then, partly because many of the items
we buy—from clothes to computers—have gotten cheaper as a result of
technological innovation and the relocation of production to low-wage
economies in Asia. It has also been reduced because of a worldwide
transformation in monetary policy, which began with the
monetarist-inspired increases in short-term rates implemented by the
Federal Reserve in 1979. Just as important, some of the structural
drivers of inflation, such as powerful trade unions, have also been
weakened.

By the 1980s, in any case, more and more people had grasped how to
protect their wealth from inflation: by investing it in assets they
expected to appreciate in line with, or ahead of, the cost of living.
These assets could take multiple forms, from modern art to vintage
wine, but the most popular proved to be stocks and real estate. Once
it became clear that this formula worked, the Age of Leverage could
begin. For it clearly made sense to borrow to the hilt to maximize
your holdings of stocks and real estate if these promised to generate
higher rates of return than the interest payments on your borrowings.
Between 1990 and 2004, most American households did not see an
appreciable improvement in their incomes. Adjusted for inflation, the
median household income rose by about 6 percent. But people could
raise their living standards by borrowing and investing in stocks and
housing.

Nearly all of us did it. And the bankers were there to help. Not only
could they borrow more cheaply from one another than we could borrow
from them; increasingly they devised all kinds of new mortgages that
looked more attractive to us (and promised to be more lucrative to
them) than boring old 30-year fixed-rate deals. Moreover, the banks
were just as ready to play the asset markets as we were. Proprietary
trading soon became the most profitable arm of investment banking:
buying and selling assets on the bank's own account.
Illustration by Barry Blitt

Losing our shirt? The problem is that our banks are also losing
theirs. Illustration by Barry Blitt.

There was, however, a catch. The Age of Leverage was also an age of
bubbles, beginning with the dot-com bubble of the irrationally
exuberant 1990s and ending with the real-estate mania of the
exuberantly irrational 2000s. Why was this?

The future is in large measure uncertain, so our assessments of future
asset prices are bound to vary. If we were all calculating machines,
we would simultaneously process all the available information and come
to the same conclusion. But we are human beings, and as such are prone
to myopia and mood swings. When asset prices surge upward in sync, it
is as if investors are gripped by a kind of collective euphoria.
Conversely, when their "animal spirits" flip from greed to fear, the
bubble that their earlier euphoria inflated can burst with amazing
suddenness. Zoological imagery is an integral part of the culture of
Planet Finance. Optimistic buyers are "bulls," pessimistic sellers are
"bears." The real point, however, is that stock markets are mirrors of
the human psyche. Like Homo sapiens, they can become depressed. They
can even suffer complete breakdowns.

This is no new insight. In the 400 years since the first shares were
bought and sold on the Amsterdam Beurs, there has been a long
succession of financial bubbles. Time and again, asset prices have
soared to unsustainable heights only to crash downward again. So
familiar is this pattern—described by the economic historian Charles
Kindleberger—that it is possible to distill it into five stages:

(1) Displacement: Some change in economic circumstances creates new
and profitable opportunities. (2) Euphoria, or overtrading: A feedback
process sets in whereby expectation of rising profits leads to rapid
growth in asset prices. (3) Mania, or bubble: The prospect of easy
capital gains attracts first-time investors and swindlers eager to
mulct them of their money. (4) Distress: The insiders discern that
profits cannot possibly justify the now exorbitant price of the assets
and begin to take profits by selling. (5) Revulsion, or discredit: As
asset prices fall, the outsiders stampede for the exits, causing the
bubble to burst.

The key point is that without easy credit creation a true bubble
cannot occur. That is why so many bubbles have their origins in the
sins of omission and commission of central banks.

The bubbles of our time had their origins in the aftermath of the 1987
stock-market crash, when then novice Federal Reserve chairman Alan
Greenspan boldly affirmed the Fed's "readiness to serve as a source of
liquidity to support the economic and financial system." This sent a
signal to the markets, particularly the New York banks: if things got
really bad, he stood ready to bail them out. Thus was born the
"Greenspan put"—the implicit option the Fed gave traders to be able to
sell their stocks at today's prices even in the event of a meltdown
tomorrow.

Having contained a panic once, Greenspan thereafter had a dilemma
lurking in the back of his mind: whether or not to act pre-emptively
the next time—to prevent a panic altogether. This dilemma came to the
fore as a classic stock-market bubble took shape in the mid-90s. The
displacement in this case was the explosion of innovation by the
technology and software industry as personal computers met the
Internet. But, as in all of history's bubbles, an accommodative
monetary policy also played a role. From a peak of 6 percent in
February 1995, the federal-funds target rate had been reduced to 5.25
percent by January 1996. It was then cut in steps, in the fall of
1998, down to 4.75 percent, and it remained at that level until June
1999, by which time the Dow had passed the 10,000 mark.

Why did the Fed allow euphoria to run loose in the 1990s? Partly
because Greenspan and his colleagues underestimated the momentum of
the technology bubble; as early as December 1995, with the Dow just
past the 5,000 mark, members of the Fed's Open Market Committee
speculated that the market might be approaching its peak. Partly,
also, because Greenspan came to the conclusion that it was not the
Fed's responsibility to worry about asset-price inflation, only
consumer-price inflation, and this, he believed, was being reduced by
a major improvement in productivity due precisely to the tech boom.

Greenspan could not postpone a stock-exchange crash indefinitely.
After Silicon Valley's dot-com bubble peaked, in March 2000, the U.S.
stock market fell by almost half over the next two and a half years.
It was not until May 2007 that investors in the Standard & Poor's 500
had recouped their losses. But the Fed's response to the sell-off—and
the massive shot of liquidity it injected into the financial markets
after the 9/11 terrorist attacks—prevented the "correction" from
precipitating a depression. Not only were the 1930s averted; so too,
it seemed, was a repeat of the Japanese experience after 1989, when a
conscious effort by the central bank to prick an asset bubble had
ended up triggering an 80 percent stock-market sell-off, a real-estate
collapse, and a decade of economic stagnation.

What was not immediately obvious was that Greenspan's easy-money
policy was already generating another bubble—this time in the
financial market that a majority of Americans have been encouraged for
generations to play: the real-estate market.
The American Dream

Real estate is the English-speaking world's favorite economic game. No
other facet of financial life has such a hold on the popular
imagination. The real-estate market is unique. Every adult, no matter
how economically illiterate, has a view on its future prospects.
Through the evergreen board game Monopoly, even children are taught
how to climb the property ladder.

Once upon a time, people saved a portion of their earnings for the
proverbial rainy day, stowing the cash in a mattress or a bank safe.
The Age of Leverage, as we have seen, brought a growing reliance on
borrowing to buy assets in the expectation of their future
appreciation in value. For a majority of families, this meant a
leveraged investment in a house. That strategy had one very obvious
flaw. It represented a one-way, totally unhedged bet on a single
asset.

To be sure, investing in housing paid off handsomely for more than
half a century, up until 2006. Suppose you had put $100,000 into the
U.S. property market back in the first quarter of 1987. According to
the Case-Shiller national home-price index, you would have nearly
tripled your money by the first quarter of 2007, to $299,000. On the
other hand, if you had put the same money into the S&P 500, and had
continued to re-invest the dividend income in that index, you would
have ended up with $772,000 to play with—more than double what you
would have made on bricks and mortar.

There is, obviously, an important difference between a house and a
stock-market index. You cannot live in a stock-market index. For the
sake of a fair comparison, allowance must therefore be made for the
rent you save by owning your house (or the rent you can collect if you
own a second property). A simple way to proceed is just to leave out
both dividends and rents. In that case the difference is somewhat
reduced. In the two decades after 1987, the S&P 500, excluding
dividends, rose by a factor of just over six, meaning that an
investment of $100,000 would be worth some $600,000. But that still
comfortably beat housing.

There are three other considerations to bear in mind when trying to
compare housing with other forms of assets. The first is depreciation.
Stocks do not wear out and require new roofs; houses do. The second is
liquidity. As assets, houses are a great deal more expensive to
convert into cash than stocks. The third is volatility. Housing
markets since World War II have been far less volatile than stock
markets. Yet that is not to say that house prices have never deviated
from a steady upward path. In Britain between 1989 and 1995, for
example, the average house price fell by 18 percent, or, in
inflation-adjusted terms, by more than a third—37 percent. In London,
the real decline was closer to 47 percent. In Japan between 1990 and
2000, property prices fell by more than 60 percent.

The recent decline of property prices in the United States should
therefore have come as less of a shock than it did. Between July 2006
and June 2008, the Case-Shiller index of home prices in 20 big
American cities declined on average by 19 percent. In some of these
cities—Phoenix, San Diego, Los Angeles, and Miami—the total decline
was as much as a third. Seen in international perspective, those are
not unprecedented figures. Seen in the context of the post-2000
bubble, prices have yet to return to their starting point. On average,
house prices are still 50 percent higher than they were at the
beginning of this process.

So why were we oblivious to the likely bursting of the real-estate
bubble? The answer is that for generations we have been brainwashed
into thinking that borrowing to buy a house is the only rational
financial strategy to pursue. Think of Frank Capra's classic 1946
movie, It's a Wonderful Life, which tells the story of the
family-owned Bailey Building & Loan, a small-town mortgage firm that
George Bailey (played by James Stewart) struggles to keep afloat in
the teeth of the Depression. "You know, George," his father tells him,
"I feel that in a small way we are doing something important. It's
satisfying a fundamental urge. It's deep in the race for a man to want
his own roof and walls and fireplace, and we're helping him get those
things in our shabby little office." George gets the message, as he
passionately explains to the villainous slumlord Potter after Bailey
Sr.'s death: "[My father] never once thought of himself.… But he did
help a few people get out of your slums, Mr. Potter. And what's wrong
with that? … Doesn't it make them better citizens? Doesn't it make
them better customers?"

There, in a nutshell, is one of the key concepts of the 20th century:
the notion that property ownership enhances citizenship, and that
therefore a property-owning democracy is more socially and politically
stable than a democracy divided into an elite of landlords and a
majority of property-less tenants. So deeply rooted is this idea in
our political culture that it comes as a surprise to learn that it was
invented just 70 years ago.
Fannie, Ginnie, and Freddie

Prior to the 1930s, only a minority of Americans owned their homes.
During the Depression, however, the Roosevelt administration created a
whole complex of institutions to change that. A Federal Home Loan Bank
Board was set up in 1932 to encourage and oversee local mortgage
lenders known as savings-and-loans (S&Ls)—mutual associations that
took in deposits and lent to homebuyers. Under the New Deal, the Home
Owners' Loan Corporation stepped in to refinance mortgages on longer
terms, up to 15 years. To reassure depositors, who had been
traumatized by the thousands of bank failures of the previous three
years, Roosevelt introduced federal deposit insurance. And by
providing federally backed insurance for mortgage lenders, the Federal
Housing Administration (F.H.A.) sought to encourage large (up to 80
percent of the purchase price), long (20- to 25-year), fully
amortized, low-interest loans.

By standardizing the long-term mortgage and creating a national system
of official inspection and valuation, the F.H.A. laid the foundation
for a secondary market in mortgages. This market came to life in 1938,
when a new Federal National Mortgage Association—nicknamed Fannie
Mae—was authorized to issue bonds and use the proceeds to buy
mortgages from the local S&Ls, which were restricted by regulation
both in terms of geography (they could not lend to borrowers more than
50 miles from their offices) and in terms of the rates they could
offer (the so-called Regulation Q, which imposed a low ceiling on
interest paid on deposits). Because these changes tended to reduce the
average monthly payment on a mortgage, the F.H.A. made home ownership
viable for many more Americans than ever before. Indeed, it is not too
much to say that the modern United States, with its seductively samey
suburbs, was born with Fannie Mae. Between 1940 and 1960, the
home-ownership rate soared from 43 to 62 percent.

These were not the only ways in which the federal government sought to
encourage Americans to own their own homes. Mortgage-interest payments
were always tax-deductible, from the inception of the federal income
tax in 1913. As Ronald Reagan said when the rationality of this tax
break was challenged, mortgage-interest relief was "part of the
American dream."

In 1968, to broaden the secondary-mortgage market still further,
Fannie Mae was split in two—the Government National Mortgage
Association (Ginnie Mae), which was to cater to poor borrowers, and a
rechartered Fannie Mae, now a privately owned government-sponsored
enterprise (G.S.E.). Two years later, to provide competition for
Fannie Mae, the Federal Home Loan Mortgage Corporation (Freddie Mac)
was set up. In addition, Fannie Mae was permitted to buy conventional
as well as government-guaranteed mortgages. Later, with the Community
Reinvestment Act of 1977, American banks found themselves under
pressure for the first time to lend to poor, minority communities.

These changes presaged a more radical modification to the New Deal
system. In the late 1970s, the savings-and-loan industry was hit first
by double-digit inflation and then by sharply rising interest rates.
This double punch was potentially lethal. The S&Ls were simultaneously
losing money on long-term, fixed-rate mortgages, due to inflation, and
hemorrhaging deposits to higher-interest money-market funds. The
response in Washington from both the Carter and Reagan administrations
was to try to salvage the S&Ls with tax breaks and deregulation. When
the new legislation was passed, President Reagan declared, "All in
all, I think we hit the jackpot." Some people certainly did.

On the one hand, S&Ls could now invest in whatever they liked, not
just local long-term mortgages. Commercial property, stocks, junk
bonds—anything was allowed. They could even issue credit cards. On the
other, they could now pay whatever interest rate they liked to
depositors. Yet all their deposits were still effectively insured,
with the maximum covered amount raised from $40,000 to $100,000,
thanks to a government regulation two years earlier. And if ordinary
deposits did not suffice, the S&Ls could raise money in the form of
brokered deposits from middlemen. What happened next perfectly
illustrated the great financial precept first enunciated by William
Crawford, the commissioner of the California Department of Savings and
Loan: "The best way to rob a bank is to own one." Some S&Ls bet their
depositors' money on highly dubious real-estate developments. Many
simply stole the money, as if deregulation meant that the law no
longer applied to them at all.

When the ensuing bubble burst, nearly 300 S&Ls collapsed, while
another 747 were closed or reorganized under the auspices of the
Resolution Trust Corporation, established by Congress in 1989 to clear
up the mess. The final cost of the crisis was $153 billion (around 3
percent of the 1989 G.D.P.), of which taxpayers had to pay $124
billion.

But even as the S&Ls were going belly-up, they offered another, very
different group of American financial institutions a fast track to
megabucks. To the bond traders at Salomon Brothers, the New York
investment bank, the breakdown of the New Deal mortgage system was not
a crisis but a wonderful opportunity. As profit-hungry as their
language was profane, the self-styled "Big Swinging Dicks" at Salomon
saw a way of exploiting the gyrating interest rates of the early
1980s.

The idea was to re-invent mortgages by bundling thousands of them
together as the backing for new and alluring securities that could be
sold as alternatives to traditional government and corporate bonds—in
short, to convert mortgages into bonds. Once lumped together, the
interest payments due on the mortgages could be subdivided into strips
with different maturities and credit risks. The first issue of this
new kind of mortgage-backed security (known as a "collateralized
mortgage obligation") occurred in June 1983. The dawn of
securitization was a necessary prelude to the Age of Leverage.

Once again, however, it was the federal government that stood ready to
pick up the tab in a crisis. For the majority of mortgages continued
to enjoy an implicit guarantee from the government-sponsored trio of
Fannie, Freddie, and Ginnie, meaning that bonds which used those
mortgages as collateral could be represented as virtual government
bonds and considered "investment grade." Between 1980 and 2007, the
volume of such G.S.E.-backed mortgage-backed securities grew from less
than $200 billion to more than $4 trillion. In 1980 only 10 percent of
the home-mortgage market was securitized; by 2007, 56 percent of it
was.

These changes swept away the last vestiges of the business model
depicted in It's a Wonderful Life. Once there had been meaningful
social ties between mortgage lenders and borrowers. James Stewart's
character knew both the depositors and the debtors. By contrast, in a
securitized market the interest you paid on your mortgage ultimately
went to someone who had no idea you existed. The full implications of
this transition for ordinary homeowners would become apparent only 25
years later.
The Lessons of Detroit

In July 2007, I paid a visit to Detroit, because I had the feeling
that what was happening there was the shape of things to come in the
United States as a whole. In the space of 10 years, house prices in
Detroit, which probably possesses the worst housing stock of any
American city other than New Orleans, had risen by more than a
third—not much compared with the nationwide bubble, but still hard to
explain, given the city's chronically depressed economic state. As I
discovered, the explanation lay in fundamental changes in the rules of
the housing game.

I arrived at the end of a borrowing spree. For several years agents
and brokers selling subprime mortgages had been flooding Detroit with
radio, television, and direct-mail advertisements, offering what
sounded like attractive deals. In 2006, for example, subprime lenders
pumped more than a billion dollars into 22 Detroit Zip Codes.

These were not the old 30-year fixed-rate mortgages invented in the
New Deal. On the contrary, a high proportion were adjustable-rate
mortgages—in other words, the interest rate could vary according to
changes in short-term lending rates. Many were also interest-only
mortgages, without amortization (repayment of principal), even when
the principal represented 100 percent of the assessed value of the
mortgaged property. And most had introductory "teaser" periods,
whereby the initial interest payments—usually for the first two
years—were kept artificially low, with the cost of the loan
backloaded. All of these devices were intended to allow an immediate
reduction in the debt-servicing costs of the borrower.

In Detroit only a minority of these loans were going to first-time
buyers. They were nearly all refinancing deals, which allowed
borrowers to treat their homes as cash machines, converting their
existing equity into cash and using the proceeds to pay off
credit-card debts, carry out renovations, or buy new consumer
durables. However, the combination of declining long-term interest
rates and ever more alluring mortgage deals did attract new buyers
into the housing market. By 2005, 69 percent of all U.S. householders
were homeowners; 10 years earlier it had been 64 percent. About half
of that increase could be attributed to the subprime-lending boom.

Significantly, a disproportionate number of subprime borrowers
belonged to ethnic minorities. Indeed, I found myself wondering, as I
drove around Detroit, if "subprime" was in fact a new financial
euphemism for "black." This was no idle supposition. According to a
joint study by, among others, the Massachusetts Affordable Housing
Alliance, 55 percent of black and Latino borrowers in Boston who had
obtained loans for single-family homes in 2005 had been given subprime
mortgages; the figure for white borrowers was just 13 percent. More
than three-quarters of black and Latino borrowers from Washington
Mutual were classed as subprime, whereas only 17 percent of white
borrowers were. According to a report in The Wall Street Journal,
minority ownership increased by 3.1 million between 2002 and 2007.

Here, surely, was the zenith of the property-owning democracy. It was
an achievement that the Bush administration was proud of. "We want
everybody in America to own their own home," President George W. Bush
had said in October 2002. Having challenged lenders to create 5.5
million new minority homeowners by the end of the decade, Bush signed
the American Dream Downpayment Act in 2003, a measure designed to
subsidize first-time house purchases in low-income groups. Between
2000 and 2006, the share of undocumented subprime contracts rose from
17 to 44 percent. Fannie Mae and Freddie Mac also came under pressure
from the Department of Housing and Urban Development to support the
subprime market. As Bush put it in December 2003, "It is in our
national interest that more people own their own home." Few people
dissented.

As a business model, subprime lending worked beautifully—as long, that
is, as interest rates stayed low, people kept their jobs, and
real-estate prices continued to rise. Such conditions could not be
relied upon to last, however, least of all in a city like Detroit. But
that did not worry the subprime lenders. They simply followed the
trail blazed by mainstream mortgage lenders in the 1980s. Having
pocketed fat commissions on the signing of the original loan
contracts, they hastily resold their loans in bulk to Wall Street
banks. The banks, in turn, bundled the loans into high-yielding
mortgage-backed securities and sold them to investors around the
world, all eager for a few hundredths of a percentage point more of
return on their capital. Repackaged as C.D.O.'s, these subprime
securities could be transformed from risky loans to flaky borrowers
into triple-A-rated investment-grade securities. All that was required
was certification from one of the rating agencies that at least the
top tier of these securities was unlikely to go into default.

The risk was spread across the globe, from American state pension
funds to public-hospital networks in Australia, to town councils near
the Arctic Circle. In Norway, for example, eight municipalities,
including Rana and Hemnes, invested some $120 million of their
taxpayers' money in C.D.O.'s secured on American subprime mortgages.

In Detroit the rise of subprime mortgages had in fact coincided with a
new slump in the inexorably declining automobile industry. That
anticipated a wider American slowdown, an almost inevitable
consequence of a tightening of monetary policy as the Federal Reserve
belatedly raised short-term interest rates from 1 percent to 5.25
percent. As soon as the teaser rates expired and mortgages were reset
at new and much higher interest rates, hundreds of Detroit households
swiftly fell behind in their mortgage payments. The effect was to
burst the real-estate bubble, causing house prices to start falling
significantly for the first time since the early 1990s. And the
further house prices fell, the more homeowners found themselves with
"negative equity"—in other words, owing more money than their homes
were worth.

The rest—the chain reaction as defaults in Detroit and elsewhere
unleashed huge losses on C.D.O.'s in financial institutions all around
the world—you know.
Drunk on Derivatives

Do you, however, know about the second-order effects of this crisis in
the markets for derivatives? Do you in fact know what a derivative is?
Once excoriated by Warren Buffett as "financial weapons of mass
destruction," derivatives are what make this crisis both unique and
unfathomable in its ramifications. To understand what they are, you
need, literally, to go back to the future.

For a farmer planting a crop, nothing is more crucial than the future
price it will fetch after it has been harvested and taken to market. A
futures contract allows him to protect himself by committing a
merchant to buy his crop when it comes to market at a price agreed
upon when the seeds are being planted. If the market price on the day
of delivery is lower than expected, the farmer is protected.

The earliest forms of protection for farmers were known as forward
contracts, which were simply bilateral agreements between seller and
buyer. A true futures contract, however, is a standardized instrument
issued by a futures exchange and hence tradable. With the development
of a standard "to arrive" futures contract, along with a set of rules
to enforce settlement and, finally, an effective clearinghouse, the
first true futures market was born.

Because they are derived from the value of underlying assets, all
futures contracts are forms of derivatives. Closely related, though
distinct from futures, are the contracts known as options. In essence,
the buyer of a "call" option has the right, but not the obligation, to
buy an agreed-upon quantity of a particular commodity or financial
asset from the seller ("writer") of the option at a certain time (the
expiration date) for a certain price (known as the "strike price").
Clearly, the buyer of a call option expects the price of the
underlying instrument to rise in the future. When the price passes the
agreed-upon strike price, the option is "in the money"—and so is the
smart guy who bought it. A "put" option is just the opposite: the
buyer has the right but not the obligation to sell an agreed-upon
quantity of something to the seller of the option at an agreed-upon
price.

A third kind of derivative is the interest-rate "swap," which is
effectively a bet between two parties on the future path of interest
rates. A pure interest-rate swap allows two parties already receiving
interest payments literally to swap them, allowing someone receiving a
variable rate of interest to exchange it for a fixed rate, in case
interest rates decline. A credit-default swap (C.D.S.), meanwhile,
offers protection against a company's defaulting on its bonds.
Illustration by Brad Holland

Bringing down the bull: The pain of America's financial crisis is felt
all over the world. Illustration by Brad Holland.

There was a time when derivatives were standardized instruments traded
on exchanges such as the Chicago Board of Trade. Now, however, the
vast proportion are custom-made and sold "over the counter" (O.T.C.),
often by banks, which charge attractive commissions for their
services, but also by insurance companies (notably A.I.G.). According
to the Bank for International Settlements, the total notional amounts
outstanding of O.T.C. derivative contracts—arranged on an ad hoc basis
between two parties—reached a staggering $596 trillion in December
2007, with a gross market value of just over $14.5 trillion.

But how exactly do you price a derivative? What precisely is an option
worth? The answers to those questions required a revolution in
financial theory. From an academic point of view, what this revolution
achieved was highly impressive. But the events of the 1990s, as the
rise of quantitative finance replaced preppies with quants
(quantitative analysts) all along Wall Street, revealed a new truth:
those whom the gods want to destroy they first teach math.

Working closely with Fischer Black, of the consulting firm Arthur D.
Little, M.I.T.'s Myron Scholes invented a groundbreaking new theory of
pricing options, to which his colleague Robert Merton also
contributed. (Scholes and Merton would share the 1997 Nobel Prize in
economics.) They reasoned that a call option's value depended on six
variables: the current market price of the stock (S), the agreed
future price at which the stock could be bought (L), the time until
the expiration date of the option (t), the risk-free rate of return in
the economy as a whole (r), the probability that the option will be
exercised (N), and—the crucial variable—the expected volatility of the
stock, i.e., the likely fluctuations of its price between the time of
purchase and the expiration date (s). With wonderful mathematical
wizardry, the quants reduced the price of a call option to this
formula (the Black-Scholes formula):

in which:

Feeling a bit baffled? Can't follow the algebra? That was just fine by
the quants. To make money from this magic formula, they needed markets
to be full of people who didn't have a clue about how to price options
but relied instead on their (seldom accurate) gut instincts. They also
needed a great deal of computing power, a force which had been
transforming the financial markets since the early 1980s. Their final
requirement was a partner with some market savvy in order to make the
leap from the faculty club to the trading floor. Black, who would soon
be struck down by cancer, could not be that partner. But John
Meriwether could. The former head of the bond-arbitrage group at
Salomon Brothers, Meriwether had made his first fortune in the wake of
the S&L meltdown of the late 1980s. The hedge fund he created with
Scholes and Merton in 1994 was called Long-Term Capital Management.

In its brief, four-year life, Long-Term was the brightest star in the
hedge-fund firmament, generating mind-blowing returns for its elite
club of investors and even more money for its founders. Needless to
say, the firm did more than just trade options, though selling puts on
the stock market became such a big part of its business that it was
nicknamed "the central bank of volatility" by banks buying insurance
against a big stock-market sell-off. In fact, the partners were
simultaneously pursuing multiple trading strategies, about 100 of
them, with a total of 7,600 positions. This conformed to a second key
rule of the new mathematical finance: the virtue of diversification, a
principle that had been formalized by Harry M. Markowitz, of the Rand
Corporation. Diversification was all about having a multitude of
uncorrelated positions. One might go wrong, or even two. But thousands
just could not go wrong simultaneously.

The mathematics were reassuring. According to the firm's "Value at
Risk" models, it would take a 10-s (in other words,
10-standard-deviation) event to cause the firm to lose all its capital
in a single year. But the probability of such an event, according to
the quants, was 1 in 10,24—or effectively zero. Indeed, the models
said the most Long-Term was likely to lose in a single day was $45
million. For that reason, the partners felt no compunction about
leveraging their trades. At the end of August 1997, the fund's capital
was $6.7 billion, but the debt-financed assets on its balance sheet
amounted to $126 billion, a ratio of assets to capital of 19 to 1.

There is no need to rehearse here the story of Long-Term's downfall,
which was precipitated by a Russian debt default. Suffice it to say
that on Friday, August 21, 1998, the firm lost $550 million—15 percent
of its entire capital, and vastly more than its mathematical models
had said was possible. The key point is to appreciate why the quants
were so wrong.

The problem lay with the assumptions that underlie so much of
mathematical finance. In order to construct their models, the quants
had to postulate a planet where the inhabitants were omniscient and
perfectly rational; where they instantly absorbed all new information
and used it to maximize profits; where they never stopped trading;
where markets were continuous, frictionless, and completely liquid.
Financial markets on this planet followed a "random walk," meaning
that each day's prices were quite unrelated to the previous day's, but
reflected no more and no less than all the relevant information
currently available. The returns on this planet's stock market were
normally distributed along the bell curve, with most years clustered
closely around the mean, and two-thirds of them within one standard
deviation of the mean. On such a planet, a "six standard deviation"
sell-off would be about as common as a person shorter than one foot in
our world. It would happen only once in four million years of trading.

But Long-Term was not located on Planet Finance. It was based in
Greenwich, Connecticut, on Planet Earth, a place inhabited by
emotional human beings, always capable of flipping suddenly and en
masse from greed to fear. In the case of Long-Term, the herding
problem was acute, because many other firms had begun trying to copy
Long-Term's strategies in the hope of replicating its stellar
performance. When things began to go wrong, there was a truly bovine
stampede for the exits. The result was a massive, synchronized
downturn in virtually all asset markets. Diversification was no
defense in such a crisis. As one leading London hedge-fund manager
later put it to Meriwether, "John, you were the correlation."

There was, however, another reason why Long-Term failed. The quants'
Value at Risk models had implied that the loss the firm suffered in
August 1998 was so unlikely that it ought never to have happened in
the entire life of the universe. But that was because the models were
working with just five years of data. If they had gone back even 11
years, they would have captured the 1987 stock-market crash. If they
had gone back 80 years they would have captured the last great Russian
default, after the 1917 revolution. Meriwether himself, born in 1947,
ruefully observed, "If I had lived through the Depression, I would
have been in a better position to understand events." To put it
bluntly, the Nobel Prize winners knew plenty of mathematics but not
enough history.

One might assume that, after the catastrophic failure of L.T.C.M.,
quantitative hedge funds would have vanished from the financial scene,
and derivatives such as options would be sold a good deal more
circumspectly. Yet the very reverse happened. Far from declining, in
the past 10 years hedge funds of every type have exploded in number
and in the volume of assets they manage, with quantitative hedge funds
such as Renaissance, Citadel, and D. E. Shaw emerging as leading
players. The growth of derivatives has also been spectacular—and it
has continued despite the onset of the credit crunch. Between December
2005 and December 2007, the notional amounts outstanding for all
derivatives increased from $298 trillion to $596 trillion.
Credit-default swaps quadrupled, from $14 trillion to $58 trillion.

An intimation of the problems likely to arise came in September, when
the government takeover of Fannie and Freddie cast doubt on the status
of derivative contracts protecting the holders of more than $1.4
trillion of their bonds against default. The consequences of the
failure of Lehman Brothers were substantially greater, because the
firm was the counter-party in so many derivative contracts.

The big question is whether those active in the market waited too long
to set up some kind of clearing mechanism. If, as seems inevitable,
there is an upsurge in corporate defaults as the U.S. slides into
recession, the whole system could completely seize up.
The China Syndrome

Just 10 years ago, during the Asian crisis of 1997–98, it was
conventional wisdom that financial crises were more likely to happen
on the periphery of the world economy—in the so-called emerging
markets of East Asia and Latin America. Yet the biggest threats to the
global financial system in this new century have come not from the
periphery but from the core. The explanation for this strange role
reversal may in fact lie in the way emerging markets changed their
behavior after 1998.

For many decades it was assumed that poor countries could become rich
only by borrowing capital from wealthy countries. Recurrent debt
crises and currency crises associated with sudden withdrawals of
Western money led to a rethinking, inspired largely by the Chinese
example.

When the Chinese wanted to attract foreign capital, they insisted that
it take the form of direct investment. That meant that instead of
borrowing from Western banks to finance its industrial development, as
many emerging markets did, China got foreigners to build factories in
Chinese enterprise zones—large, lumpy assets that could not easily be
withdrawn in a crisis.

The crucial point, though, is that the bulk of Chinese investment has
been financed from China's own savings. Cautious after years of
instability and unused to the panoply of credit facilities we have in
the West, Chinese households save a high proportion of their rising
incomes, in marked contrast to Americans, who in recent years have
saved almost none at all. Chinese corporations save an even larger
proportion of their soaring profits. The remarkable thing is that a
growing share of that savings surplus has ended up being lent to the
United States. In effect, the People's Republic of China has become
banker to the United States of America.

The Chinese have not been acting out of altruism. Until very recently,
the best way for China to employ its vast population was by exporting
manufactured goods to the spendthrift U.S. consumer. To ensure that
those exports were irresistibly cheap, China had to fight the tendency
for its currency to strengthen against the dollar by buying literally
billions of dollars on world markets. In 2006, Chinese holdings of
dollars reached 700 billion. Other Asian and Middle Eastern economies
adopted much the same strategy.

The benefits for the United States were manifold. Asian imports kept
down U.S. inflation. Asian labor kept down U.S. wage costs. Above all,
Asian savings kept down U.S. interest rates. But there was a catch.
The more Asia was willing to lend to the United States, the more
Americans were willing to borrow. The Asian savings glut was thus the
underlying cause of the surge in bank lending, bond issuance, and new
derivative contracts that Planet Finance witnessed after 2000. It was
the underlying cause of the hedge-fund population explosion. It was
the underlying reason why private-equity partnerships were able to
borrow money left, right, and center to finance leveraged buyouts. And
it was the underlying reason why the U.S. mortgage market was so awash
with cash by 2006 that you could get a 100 percent mortgage with no
income, no job, and no assets.

Whether or not China is now sufficiently "decoupled" from the United
States that it can insulate itself from our credit crunch remains to
be seen. At the time of writing, however, it looks very doubtful.
Back to Reality

The modern financial system is the product of centuries of economic
evolution. Banks transformed money from metal coins into accounts,
allowing ever larger aggregations of borrowing and lending. From the
Renaissance on, government bonds introduced the securitization of
streams of interest payments. From the 17th century on, equity in
corporations could be bought and sold in public stock markets. From
the 18th century on, central banks slowly learned how to moderate or
exacerbate the business cycle. From the 19th century on, insurance was
supplemented by futures, the first derivatives. And from the 20th
century on, households were encouraged by government to skew their
portfolios in favor of real estate.
Illustration by Brad Holland

Read Niall Ferguson's prescient article on today's financial woes,
Empire Falls (November 2006).

Economies that combined all these institutional innovations performed
better over the long run than those that did not, because financial
intermediation generally permits a more efficient allocation of
resources than, say, feudalism or central planning. For this reason,
it is not wholly surprising that the Western financial model tended to
spread around the world, first in the guise of imperialism, then in
the guise of globalization.

Yet money's ascent has not been, and can never be, a smooth one. On
the contrary, financial history is a roller-coaster ride of ups and
downs, bubbles and busts, manias and panics, shocks and crashes. The
excesses of the Age of Leverage—the deluge of paper money, the
asset-price inflation, the explosion of consumer and bank debt, and
the hypertrophic growth of derivatives—were bound sooner or later to
produce a really big crisis.

It remains unclear whether this crisis will have economic and social
effects as disastrous as those of the Great Depression, or whether the
monetary and fiscal authorities will succeed in achieving a Great
Repression, averting a 1930s-style "great contraction" of credit and
output by transferring the as yet unquantifiable losses from banks to
taxpayers.

Either way, Planet Finance has now returned to Planet Earth with a
bang. The key figures of the Age of Leverage—the lax central bankers,
the reckless investment bankers, the hubristic quants—are now feeling
the full force of this planet's gravity.

But what about the rest of us, the rank-and-file members of the
deluded crowd? Well, we shall now have to question some of our most
deeply rooted assumptions—not only about the benefits of paper money
but also about the rationale of the property-owning democracy itself.

On Planet Finance it may have made sense to borrow billions of dollars
to finance a massive speculation on the future prices of American
houses, and then to erect on the back of this trade a vast inverted
pyramid of incomprehensible securities and derivatives.

But back here on Planet Earth it suddenly seems like an extraordinary
popular delusion.

Niall Ferguson is Laurence A. Tisch Professor of History at Harvard
University and a Senior Fellow of the Hoover Institution at Stanford,
and the author of The War of the World: Twentieth-Century Conflict and
the Descent of the West.