In the past few months, we've been riveted and disgusted by the exploits of scamsters like Bernard Madoff and Allen Stanford (characters who, if they didn't exist, would have to be invented by Tom Wolfe). It's both easy and convenient to hold them up as the ultimate symbols of the just-ended boom. But we shouldn't. While there was some crime in the mortgage industry, law-abiding, respectable, upstanding citizens caused the overwhelming majority of financial losses suffered thus far. Skeezy money managers and mobbed-up boiler rooms didn't create the economic catastrophe. It was visited on us by firms in the Dow Jones Industrial Average and S&P 500—companies that trace their origins back to the 1800s, run by graduates of Yale and Harvard. The people who blew up the system weren't anarchists. They were members of the club: central bankers and private-equity honchos, hedge-fund geniuses and Ph.D. economists, CEOs and investment bankers. And the (overwhelmingly legal) con they perpetuated on themselves, their colleagues, their shareholders and creditors, and, ultimately, on us taxpayers makes Madoff's sins look like child's play.
That's one of the central arguments of my book, Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation, which has just been published as an e-book. (You can buy a digital version, for the Kindle or Sony Reader, or an audio version. Readers interested in seeing a PDF of the first chapter or even a paper version should send an e-mail to: email@example.com)
My book explains how during the late, great credit bubble, an Era of Cheap Money devolved into an Era of Dumb Money, and then into an Era of Dumber Money. The culture of Wall Street and the rise of the shadow banking system spawned reckless, largely unregulated lending, borrowing, and trading, a financial culture that preferred short-term fees to long-term gains, and that confused liquidity (access to other people's money) with cash on hand. Looking back, the investors who believed the stories told by Madoff and Stanford—that they could deliver steady, positive, market-beating returns in any type of climate, despite the manifest failure of virtually every other money manager to do so—were obviously foolish. But our best financial minds also spun tales and theories with great assurance, making seemingly irrational and unprecedented activity seem completely sensible. And we bought them.
The Dumb Money creed rested on four pillars: perpetually low interest rates, perpetually rising asset prices (especially for housing), borrowers of all types remaining perpetually current, and perpetually strong markets for debt. The high priests of this cult were the nation's central bankers. In the Era of Cheap Money (the fall of 2001 through June 2004), Fed Chairman Alan Greenspan convinced us that we could have low interest rates despite inflationary pressures and global growth. His successor, Ben Bernanke, in 2002 began trying to convince us that we might have as much to fear from deflation as from inflation.
Bernanke also provided intellectual fortification for the argument that one of our greatest vices—a tendency to debt-financed consumption—was actually something of a virtue. He helped popularize the concept of a savings glut, arguing that America's twin budget and trade deficits could be traced not to a dearth of American savings but to a glut of foreign savings. Because foreigners weren't consuming enough, we had to do it for them. Other worthies chimed in that saving money the old-fashioned way was a waste of time because the market was doing the heavy lifting for us. Economists claimed that the government measures of income used to calculate savings—which includes wages and salaries, interest on bonds, and stock dividends but which excluded capital gains on stocks, profits from selling a house, or withdrawals from 401(k) plans—were hopelessly behind the times. "The structure of the household portfolio has changed over time," said David Malpass, chief economist at Bear Stearns, one of the leading exponents of what might be dubbed the theory of Magical Market Savings. In 2004, Malpass found that, thanks to the booming stock and housing markets, the net worth of U.S. households—their assets minus their liabilities—stood at a record $48.54 trillion, up 9.6 percent from 2003 despite sluggish income growth. Why put money aside for a rainy day when your house and the market were doing it for you?
The Magical Market Savings theory only made sense as a national strategy if asset prices moved in just one direction. Here, too, the elites provided justification. In February 2005, David Lereah, chief economist of the National Association of Realtors, published Are You Missing the Real Estate Boom?: The Boom Will Not Bust and Why Property Values Will Continue To Climb Through the End of the Decade—and How To Profit From Them. Real estate, he argued, was now in the midst of a permanent boom, fueled by demographics and changes in the marketing and financing of homes. In 2005, Robert Toll, CEO of McMansion giant Toll Bros., argued, cogently, that America stood on the precipice of a brave new world in which yuppies would devote half their incomes to mortgage payments.
Wall Street bought into the same mentality, adding a new twist. Wall Street CEOs had an unshakable faith in the ability of hot new technologies—securitization and derivatives—to control and spread risk. If any risk could be managed, then any risk could be assumed—no-money-down mortgages, payment-in-kind corporate bonds, covenant-lite loans, $50 billion private-equity buyouts of cyclical companies. Whatever. Technology—zippy computer models and credit agencies—could gauge the riskiness and value of the new types of securities and derivatives. Since the firms could quantify precisely how much they could lose if things went wrong, there was little need to maintain large reserves. VAR—value at risk, the amount of money firms had at risk on any given day—became a staple of quarterly and annual reports. Lehman Bros. assured investors in 2006 that the firm, which had hundreds of billions of dollars in mostly short-term debt outstanding, could lose no more than $42 million in an off day. Whoops!
In 2007 and 2008, each of the pillars of Dumb Money began to crumble. The rules of physics still applied to finance. Interest rates, it turned out, could rise. Asset prices could, indeed, fall. Borrowers, having seen no income growth in a decade, fell behind on their debts. All of which helped cause the markets for securitizing debt and derivatives to break down.
There's a lot more to the story, of course: the rapid rise and slow-motion humbling of the hedge fund community, the smartest of the smart money; the absurd deals pulled off by private-equity titans, who, egos swollen with cheap money, fancied themselves experts on all sorts of industries, ranging from newspapers to cars; the feckless regulators; the botched rescue plans; Wall Street's continuing, inexplicable arrogance in the face of massive failure; and the refusal of those who started the fire to take any responsibility for the inferno.
Last October, when Alan Greenspan appeared before Congress, he offered something of a mea culpa. Greenspan had been the chief proselytizer for the holy trinity of the Dumb Money creed: low interest rates, deregulated markets, and the ability of financial innovation to insulate markets from calamities. But Greenspan was experiencing a dark night of the soul. "I found a flaw," in the theories, he said. "I was shocked because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well." A flaw? The persistence of low interest rates, which, he assured us, made all the sense in the world, sparked a speculative orgy in securities and derivatives. These instruments, he had assured us, would help people manage risk; instead, they created systemic risk. And deregulated, free and open markets had gone so haywire they required massive government intervention. In short, pretty much everything Greenspan said about how this system was supposed to work turned out to be wrong. And yet he's still around, offering cures to treat the disease he failed to diagnose. Maybe the Era of Dumb Money isn't over just yet.