Should-Read: Cosma Shalizi: Review of Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe

Should-Read: Cosma Shalizi Review of Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe http://bactra.org/reviews/fools-gold/: “This is an extremely smart and well-written look at the growth and explosion of credit derivatives, as told through the story of Tett’s sources at J. P. Morgan…

…It’s a really good book, which painlessly explains a lot of the details of how we got into the present mess, and I strongly recommend it. That said, Tett clearly sympathizes with her informants, and while she doesn’t exactly re-touch and air-brush their portraits for maximum flattery, they’re ones reasonable people would be happy with. A less becoming picture of the same facts begins like so: In the early to mid 1990s, the Morgan bank had a group of arrogant, inexperienced young financiers who looked at the damage then being done by unregulated financial derivatives, and decided the key institutions of the capitalist economy need some of that. Historically, a major role of banks has been to help provide corporate governance, which (as Uncle Norbert would remind you) relies on information. When firms go to banks for credit, they have to disclose lots of information about their finances, workings and plans which would normally stay locked inside the firm. (The firm does not want its rivals to know these things.) Banks have allocated capital, or not, on the basis of this information….

What the Morgan crew did was figure out a way of using derivatives to let a bank take a portfolio of loans and sell the risk of the loans in chunks to institutions outside the banks…. On the buyers’ side, the securities (“synthetic collateralized debt obligations”, in the jargon) were supposed to be safe because they were diversified across many borrowers; also they were structured so that all the buyers with low-grade securities would have to be wiped out before the payments to high-grade securities were cut….

In short, the group at Morgan decided to change the way a basic capitalist institution worked, on the basis of abstract ideological principles, without any concern for its real-world effects, or the hard-won experience embodied in the social order they had inherited. (No doubt it helped that they all considered each other super-smart.)…

It is at this point, after the victory of an elitist cadre of self-serving ideologues, that what Tett calls the “corruption” set in. The original Morgan group were rationalistic social engineers filled with hubris, but even they realized there were limits on the trick they devised. To pull it off, the bank had to estimate the risk not just of any one loan in the portfolio defaulting, but of groups of them doing so at once, which meant estimating the correlations among loan defaults. In the nature of things, this is much harder than just estimating the risk of a single loan, and in many cases, like defaults on sub-prime mortgages, the data just wasn’t there to support any sensible kind of estimation. (Cf..) The Morgan team realized this, and so did only a few mortgage deals. The rest of the industry was not so scrupulous…. Morgan suffered from its comparative restraint, and, had the bubble lasted just a bit longer, would probably have been forced to join in by its shareholders.)…

After turning Tett’s flattering portrayals into mug-shots, the truth is I find myself sympathizing with her protagonists. They are obviously nostalgic for being talented young people working on an innovative common project which they really believed in, and why not? That is a wonderful thing. (I can only imagine that being paid very well for being geniuses together enhances the experience.) Hearing about how their handiwork brought the global economy to its knees can’t feel good…