Rainbow's End

The Perfect Financial Storm
New books dissected over email.
Dec. 4 2001 4:39 PM

Rainbow's End

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Dear Ted,

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My favorite new word is retronym. It describes a term that was once perfectly clear to everyone who used or heard it but then had to be modified to retain its original meaning due to changes in culture or technology or historical events. We are all aware of the way that a word can be adapted to describe something new—voice mail and e-mail, for example. And sometimes we just stick with the old ones out of habit. They outlive their accuracy but are still correctly understood; most people still speak of "dialing" a phone. Then there are these poor retronym words. They just go along, minding their own business and doing a perfectly adequate job of communicating until through no fault of their own, they have to take on further descriptive baggage just to hold their place in the lexicon of meaning. These terms include "snail mail," "biological mother," and "acoustic guitar."

I think "stock market crash" might be on its way to retronymhood. I told several people that I was reading a book about the stock market crash, and most of them said, "Which one?" The rest said, "The old one or the next one?"

Author Maury Klein intended Rainbow's End as a readable history of what happened 70 years ago, but today's investors will be more interested in looking for symptoms and precursors to compare 1929 with what is going on right now. Klein does begin by describing the crash with an almost biblical inevitability, the following of seven years of plenty with seven years of blight, or what we in the money business call cyclicality. Klein puts it this way: "[The crash] brought to a stunning halt a decade that had witnessed the greatest economic prosperity and most profound cultural changes yet known and ushered in a decade blighted by the longest and deepest depression Americans had ever endured."

Klein wisely concludes that the crash did not cause the Depression, but that the same factors caused them both. That does not mean that even now we fully understand what those factors were. It is always tempting in retrospect to say that one event triggered another because they happened near each other. There is a strong human impulse to see order and achieve a sense of control. Klein looks for some sort of pattern in the events of the 1920s, from hemlines and flagpole-sitting to Aimee Semple McPherson and The Jazz Singer; from the spread of cars and radios to Florida land speculation and a president who said that the business of America was business. And then Klein concludes, persuasively but not very helpfully, that it all boiled down to psychology.

Psychologically and in other ways, there are a lot of parallels between the roaring '20s and the roaring '90s. Some are meaningless background noise, like setting new baseball records or continuing the perpetual debate about repealing the capital gains tax. Others are familiar to anyone who lived through high-school history—the use of teetery financial structures like holding companies and margin trading. These were considerably restricted by post-crash reforms, and a good thing, too.

Other post-crash reforms have been discarded or superceded, however. This Friday my friendly little hometown bank is disappearing into some generic national chain, so I have been thinking about the Glass-Steagall Act, a Franklin Roosevelt initiative enacted in 1933 to separate the businesses of banking, insurance, and securities. Combining those businesses in the '20s had led to conflicts of interest and abuse, with banks giving unsafe loans to bail out companies because they also held their securities and investing in companies to protect their loans. Separating these functions was the idea of Sen. Glass, a former treasury secretary and the guy behind the Federal Reserve Act. Steagall added the idea of federal deposit insurance.

Glass decided he had gone too far and began trying to cut back on the prohibitions just two years later. But it was not until 1999, after a 20-year debate and a certain amount of erosion, that the restrictions were finally repealed. Steagall's contribution, thankfully, remains in place, providing a level of oversight and a list of liquidity and disclosure requirements for banks that did not exist in the 1920s.

Still, I thought of the unimaginably pervasive Citigroup when I read Klein's description of J.P. Morgan and the way that old-fashioned "adherence to the banker's code weakened amid the complexities and temptations of New Era finance." And when I read his description of the Goldman Sachs Trading Corporation, I thought of the involvement in the go-go IPOs of the 1990s by none other than Goldman Sachs, home of rosy-scenario buy-buy analysts. It makes me wonder whether the current system provides enough protection from conflicts of interest. The time for the old Glass-Steagall Act may be over, but some new version might be called for if we want to prevent future moral hazards.

The AFL-CIO recently filed a shareholder proposal at Goldman Sachs, to be voted on by all of the shareholders on the company's next proxy. It asks Goldman Sachs to ban analyst ownership of covered securities, involvement of analysts in underwriting sales teams, and linking analyst compensation to the financial performance of Goldman's investment banking business. The proponents cite CFO Magazine, which reported that analysts who work for full-service financial services firms provide 6 percent higher earnings forecasts and 25 percent more "buy" recommendations than analysts at firms that do not provide corporate finance services. If Goldman Sachs refuses and investors do not have a clear way to distinguish between advice from analysts who have some financial tie to the companies they cover and those who do not, it may be time for some new legislation. I got a chill when I read one quote from a 1920s broker that could have been said on Wall Street this morning: "Win or lose, we get our commissions."

Speaking of where we get our advice about how to invest, I was glad to see my favorite story about Joseph Kennedy included in the book because it is charming and because it makes the right point. When the guy who shined his shoes started giving him stock tips, Kennedy knew it was time to sell out of the market. For me, stock tips are like new slang—by the time they get to me, they are by definition not cool enough to use any more.

I agree with you entirely on the book's strengths and weaknesses. Noyes was one of my favorite characters, and I could just see him in a typically busy Gluyas Williams drawing, lost in a huge chair in some fusty men's club. I enjoyed Klein's little vignettes—his descriptions of Durant and of "Sunshine Charley" Mitchell were wonderfully vivid. I was glad to get a fuller picture of Hoover and got a huge kick out of Coolidge's description of the "malady of self-delusion" that infects people in high offices. I'd love to have that as a sampler on the wall of every CEO in America. But the reason Klein never nails the "why" of it is that it is just unknowable. I think the closest he comes is when he says that it was the financial version of a perfect storm, "the random coming together of a confluence of unfortunate forces." Some of those forces we can name. Some we can prevent. But many of them are beyond our ability to do either.

Tomorrow I'm going to talk a bit about some of the more disturbing parallels between the era Klein describes and today's indicators and about some things Klein left out that might help us attack future perfect financial storms, if we are unable to prevent them.

Batten down the hatches!

Nell

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