The full dress rehearsal

My column in yesterday’s Fin looked at the dotcom bubble and bust as a precursor of the current much larger disaster.

The pace of events in financial markets has been so rapid that any projection of events in the short term seems likely to be obsolete soon after it is printed. So, rather than try to predict the immediate future, it may be useful to look back at the relatively recent past. The stockmarket boom and bust of the late 1990s, focusing on Internet-based ‘dotcom’ enterprises has important similarities with the current crisis.

The NINJA (‘no income, no job, assets’) subprime mortgages that form the starting point of the chain of securitisation and financial engineering that has produced the current disaster are identical, in all important respects, to the hot startup companies of the late 1990s, valued at billions of dollars despite having no profits, minimal revenues and, in some cases, not even any products.

In both cases, the claim was made that old-fashioned concerns about income and cash flows were no longer relevant. In the 1990s, the Internet was supposed to wipe out the difficulties involved in turning a (supposedly) good idea into a massively profitable business. In the early 2000s, financial engineering turned mortgages with no serious prospect of repayment into AAA-rated assets.

There is nothing new about such new-era speculative bubbles. As Robert Shiller has pointed out, every speculative boom in history has come with its own new era theory, promising that this time, everything is different.

What is remarkable is to observe two such bubbles in immediate succession. Normally, the bursting of a bubble is followed by a period of caution and conservatism, lasting until those burned the first time around have died or retired, to be replaced by a new generation eager to find new ways of getting rich quickly.

The obvious explanation is that no one who really mattered paid a price for the dotcom bubble. Many individual investors lost their life savings, but the financial sector as a whole barely missed a beat.

The Wall Street investment banks that had pumped and dumped Internet stocks had a bad year in 2001, but were soon back, bigger than ever, selling products like collateralized debt obligations (CDOs) to naïve or greedy investors. From 2002 to 2006, these firms reported record profits time and again.

The ratings agencies that had failed to detect Enron’s misuse of off-balance sheet special purpose entities (SPEs) promised to reform. But within a few years they were giving AAA ratings to CDOs and other assets held in ‘structured investment vehicles’ that were little more than rebadged SPEs.

Commercial banks and S&Ls, largely left on the sidelines during the dotcom boom made up for lost time with innovative products like “Pick-a-pay� mortgages in which cash-constrained borrowers chose how much to repay. The assumption was that however fast their debts might grow, the value of their houses would grow even faster.

And, of course, the CEOs and senior managers of these enterprises abandoned any remaining restraint on their pay and perks. Bonuses went from millions to tens of millions, and with share options, hundreds of millions. By 2007, billionaire status seemed guaranteed for the top brass, and anyone with an ounce of ambition expected to be a multimillionaire.

Most strikingly of all, the limited restraints introduced in response to the bubble, such as the Sarbanes-Oxley Act, were derided as unnecessary over-reactions, holding up innovation. Financial firms in particular, found it easy to evade the controls that were supposed to prevent another Enron.

This was supported by a policy of easy money, implemented by Alan Greenspan and continued by his successor, Ben Bernanke. The existence of the ‘Greenspan put’ (the idea that if asset prices ever fell really sharply, the Fed would rescue investors) has been confirmed in spectacular fashion by the trillion-dollar bailout now being proposed.

At this point the risk of full-scale collapse is such that a rescue seems inevitable. But unless all those who are rescued are made to bear large losses, the whole cycle is likely to be repeated on an even larger scale within a few years.

Memories are short, but regulations endure. Only if regulation is greatly tightened will the lessons of the current crisis endure beyond the current cohort of financial system players. The stringent regulations introduced after the Depression kept the financial system stable for decades. The cost was a restrictive regime in which financial innovation was severely constrained. But now that uncontrolled financial innovation has led the system to the brink of disaster, this is a trade-off that must be reconsidered.

14 thoughts on “The full dress rehearsal

  1. Yep, regulation, that will do it, lets fight this years war, with the last wars tactics. (not seen any actual suggestions as yet, but everyone seems to like the word)

    How about the Pols cleaning up their act and actually doing the job they are elected to do, which is a governance about kicking the lobbyists, the NGOs? the Unions, the Bosses everyone except visiting officials from foreign countries and voters themselves out of the corridors of power, and even banning private meetings.

    There is no link between dot com and sub prime, the banks ect where before, during and even today running the same risk models, that just keep failing based on the same failed risk aversion culture, not so much casino capitalism as theme park capitalism. Im sure as soon as the dust settles the same plan will re-emerge.

    Dotcom can best be described as a “pioneer” bubble, a whole new market, a whole new technology, the thing that was missing was broadband, a lot of the ideas where pretty good and we see a lot of them today.

    Credit Crunch, is a technocratic bubble, made by the failure of the pols, and a big black swan in the form of Asian wealth flowing into a corrupt market.

    Ive never invested in shares, even thought i support the democratic Capitalist free market system, I dont even have a private pension of note, (I dont want to give the financial s 10% of my money, esp when they are working with dodgy maths) The reason for this is simple, I tend to go along with Bladder theory, which states, Corporations pay dividends in order so management can pish the money away.

    So Governance issue one, get rid of dividends, issue two, no off book accounting, this should get the shareholders attention, and they might even start taking a keener interest in what the bosses are up too. And I might even get my cheque book out.

  2. “Ive never invested in shares, even thought i support the democratic Capitalist free market system, I dont even have a private pension of note,…”

    And yet you feel qualified to share with us your desire to re-enact Pol Pot’s Year Zero.

  3. “Pol Pot’s Year Zero”

    I had no idea that millions were dying due to the banking crisis. I am aware of the poor souls dying because of our blind rush for bio fuels, but not banking.

    If you are talking about getting away from dumb risk models dreamed up by dumb economists who cant connect with the real world of risk then I am with you, lets get back to hiring folks with experience and chuck the computer models out of the window.

    Here is a tip, why not try to make a serious contribution, rather than sniping.

  4. I was referri9ng to your plan to shut down the universities and ship the faculty off to work camps.

    If you object to the Pol Pot comparison this policy was also advocated by Hitler, Stalin and Mao.

    When you stop advocating that your host be fired and jailed, you can start claiming others are sniping.

  5. Ian, I’ve read the first post 3 times now, and I still haven’t found a reference to work camps. Are you sure you’re responding to the correct thread?

  6. In another thread, Sean repeatedly advocated shutting down all university economics and maths schools and sending the staff off to forced manual labor.

    He insisted that he wasn’t joking. I’m merely taking him at his word.

    Oh and anyone who uses computer models to predict the future which he apparently believes to be a branch of the black arts.

  7. Ian Gould Says: September 28th, 2008 at 4:34 pm

    In another thread, Sean repeatedly advocated shutting down all university economics and maths schools and sending the staff off to forced manual labor.

    He insisted that he wasn’t joking. I’m merely taking him at his word.

    On another thread Ian Gould suggested that the recent studies claiming appalling rates of Aboriginal sexual abuse were fabricated to justify right-wing political intervention:

    No Jack it proves that the supposed underground epidemic of undiagnosed sexual abuse which justified spending one billion dollars of public money never existed.

    Later Ian Gould suggested he was only joking. I am disinclined to take him at his word, given the way he stretches the truth when smearing other commenters.

  8. Oh, and the idea of sending MBA schools, and their graduates working in the financial swindling sector, off to work camps to actually do something useful for modest rates of pay (instead of putting spanners in the works for obscene pay-offs) strikes me as “the punishment fitting the crime”.

    As I said five years ago, whats required in the financial system is a root and branch purge, followed by a punitive regime of intrusive regulation.

    The action of deregulated Global Financial markets is counter-productive. They fail, causing:

    * financial instability: distributing their costs – local financial stability (hedging)purchased at global financial instability (contagion)
    * income inequality: concentrating their benefits to facile calculators & manipulators
    * industrial inefficiency: misallocating capital over (short-term) time & (high-profile) space

    There clearly needs to be a tax/regulatory impediment to financial “casino capitalising� or some sort of purge of the finance class.

    Far from ushering us back to Year Zero and Pol Pot a purge (preferably along the lines of Keynes “euthanasia of the rentier”) would put us back to the era when bankers and financiers were conservative, respectable pillars of the establishment who decent folk could look up to. Rather than the shameless hucksters, swindlers, con-men, card-sharps, blood-sucking leeches, parasites that were celebrated during the post-modern era.

    The various federal interventions currently on-going indicate that the era of post-modern liberalism (both in its Left-cultural and Right-financial forms) is over, dead if not buried yet. I, for one, am going to enjoy a good dance on its grave.

  9. Poor, poor Jack.

    I think the attempt to constuact an argument that the financial crisis (liek every other social, economic and environmental problem) can be solved by restricting immigration has finally undone him.

    “post-modern liberal” it just rolls off the tongue like “asocial”, “unassimilatable elements” or “rootless cosmopolitan”.

  10. Sean

    I think you might be a little confused, payment of dividends gives management less money to piss away, not more.

    You’ll find the 1.0% fed funds rate that followed the dotcom bust plus the Fed’s tardiness in raising it to normal levels was a big contributor to the current crisis.

    Black swan is the most over-used term in finance today.

  11. GOULD

    “I was referri9ng to your plan to shut down the universities and ship the faculty off to work camps.” I think it was get another job!!

    “He insisted that he wasn’t joking. I’m merely taking him at his word. ”


  12. 10, “I think you might be a little confused, payment of dividends gives management less money to piss away, not more.”

    Yes you are right, but the effect is to give them more control of the money left, which is the problem.

    What I think the net effect of this would be is to force greater interest of the shareholder, and thus greater oversight.

  13. also “Black swan is the most over-used term in finance today.”

    No its not, in philosophy, math and economics is probably the major problem and issue.

    the known unknowns and the unknowns unknowns, as Donny rumsfeld would say. and the left fell about laughing, well I can tell you the way we approach the unknown or the future is a massive dividing line.

    And the financial models developed in the last 30 years its been claimed (now falsified) that they have dealt with it, this is where the term “masters of the universe” comes from.

  14. Well Sean I would suggest that anyone who thinks this crisis was unforeseeable wasn’t paying attention. There are ample warnings of the dangers of easy money across a broad range of economic philosophies from the Austrians to Keynes.

    Referring to the crisis as a black swan event is a cop-out used to ease the minds of the those who thought this time it really was different.

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