In the first of three articles we take a look at what happened and how, despite the financial arrangements being characterised as almost immeasurably complicated, it is in fact pretty easy to understand what happened.

According to a great number of articles in the press, one of the most difficult things to understand was the methods used by the financial industry – the phrase “fiendishly complicated” is often used to describe the kinds of trading that went on.  Don’t believe it.  In fact, it’s reasonably easy to understand what they were doing once the jargon is cut out.  It’s the language that’s complicated, and as we’ll see in a later article, deciding what to do now that we’re in such a deep hole is also complicated.  The supposed complexity of the financial markets feels very much like an attempt to camouflage or ignore the simple fact of greed, and the willful ignorance it lead to that generated and perpetuated the crisis.

For example, here are a couple of quick definitions:

Sub-prime mortgages are mortgages that were given to people who, in reality, were very unlikely to be able to afford them.  In The End, Michael Lewis cites the example of a Mexican strawberry picker in Bakersfield, California, who, despite having an income of $14,000 and not being able to speak English was given a mortgage of $720,000.  Some may cry foul at picking the worst possible example, but even if he’d been given a mortgage of $100,000 (more than seven times his salary) it would have been reckless for the lending institution to lead him to believe that he could afford it.  In this case, some may consider that it was up to the strawberry picker to realise that he couldn’t afford it – but who is more likely to know whether a mortgage is sustainable, a bank (who has all the customer’s details) or a customer?  And where does the moral responsibility of banks lie when selling mortgages, if not in lending responsibly?

Mortgage-backed securities are lots of mortgages bundled together (mostly sub-prime) that are sold as an asset.  Basically, this means that someone buys all those mortgages in a single lump, and gets the income from them.  If anyone defaults on their mortgage, the owner of the mortgage can sell the house.  If you believe that house prices are going to rise forever, which was a belief that many of these financial deals were founded on, then this would give a guaranteed and rising income.  If, however, interest rates go up, people start defaulting on their mortgages, and house prices plummet, organisations who own these securities are stuck with something that is also plummeting in value, and no-one wants to buy.

Almost everything that happened is, in fact, that simple.

WHAT HAPPENED?

The End takes in a enormously readable broad sweep of the crisis, from its origins to the endgame.  Written by Michael Lewis, who also wrote an exposé of 1980s Wall Street, Liar’s Poker, he starts by pointing to the fact that this isn’t anything new:

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous—which is one of the reasons the money was so easy to walk away from. I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.

He goes on to show, through the example of a sceptical investor called Steve Eisman, how a lack of scrutiny was actively enforced in the financial markets:

The second company for which Eisman was given sole responsibility [in his early Wall Street days] was Lomas Financial, which had just emerged from bankruptcy. “I put a sell rating on the thing because it was a piece of shit,” Eisman says. “I didn’t know that you weren’t supposed to put a sell rating on companies. I thought there were three boxes—buy, hold, sell—and you could pick the one you thought you should.” He was pressured generally to be a bit more upbeat, but upbeat wasn’t Steve Eisman’s style. Upbeat and Eisman didn’t occupy the same planet. A hedge fund manager who counts Eisman as a friend set out to explain him to me but quit a minute into it. After describing how Eisman exposed various important people as either liars or idiots, the hedge fund manager started to laugh. “He’s sort of a prick in a way, but he’s smart and honest and fearless.”

“A lot of people don’t get Steve,” Whitney says. “But the people who get him love him.” Eisman stuck to his sell rating on Lomas Financial, even after the company announced that investors needn’t worry about its financial condition, as it had hedged its market risk. “The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “ ‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.

(Another quick definition: hedging is the same as hedging your bets.  You bet big on one result, e.g. a stock price going up, and less on the opposite outcome, e.g. that a stock price will go down (”shorting”).  This way you cut your losses if the deal doesn’t go as expected.  This is the strategy that “hedge funds” got their name from, although the term is applied to a companies with a wide variety of strategies – if they still exist.)

The End follows Steve Eisman’s path through the industry, where he was doing what everyone should have been doing – scrutinising the viability of these financial models.  The more he investigated, the more he realised that the whole system was rotten – and unlike many analysts who said they’d seen the crisis coming, but funnily enough hadn’t seen it clearly enough to put their money where their mouth was, he made a great deal of money by “shorting” companies who were dealing in that market. (”Shorting” is effectively making a bet that a company’s value will go down.  The more it goes down, the more money you make).

An interesting part of this article is when Eisman and his colleagues realised that they were in some ways actually fuelling the crisis.  Companies who Eisman was shorting were happily taking his bets that they would fail, and using it to prop up their faltering mortgage-backed securities.  Although Eisman is the hero of Lewis’ story, and is presented as someone who was incredibly angry about how these companies were playing fast and loose with other people’s money and homes (his “vindication” is that he made lots of money from them), did they stop when they realised that they were helping to fund it?  Well, no.  But at least they had the decency to feel a bit sheepish about it. Right?

The disconnection between people dealing in these financial instruments and people outside the financial sector was shown beautifully in a prescient post-Northern-Rock article from January 2008 by John Lanchester in the London Review of Books, Cityphilia, which is also worth reading for a very clear introduction to the kinds of financial deals that were being made.  Lanchester writes about a friend of his, Tony, who works (or perhaps “worked” might be more appropriate now) in the City, London’s financial district:

Not all City types are vile, obviously. My friend Tony isn’t vile. We have many interests in common and chat easily about all sorts of things. But I’m sometimes made aware of a significant gap between us. It’s a philosophical and practical gap, and it is to do with money. Tony will complain about the price of things – about parking permits, or the cost of the Playstation 3 he’s promised his son – but I’ve begun to wonder if this is a purely formal acknowledgment of the value of money to other people. Tony’s ‘basic’ is £120,000 a year; in a good year he earns a bonus of £500,000. In a very good year he is paid a million pounds. He is polite about this but the details slip out nonetheless. He bought a second home on Ibiza and I was commiserating with his complaints about the usual things (builders, local regulations) until the cost of the house was mentioned: £1.4 million.

A fundamental economic gap of that type does open up a distance between people, however many other things you have in common. He happened once to mention what he (as a head of department) pays new recruits, straight out of university: ‘45k a year, with a bonus of between ten and twelve grand guaranteed.’ I pointed out that in many cases that would mean these 22-year-olds would be earning more than the heads of department in the universities they’d just graduated from. He shrugged and laughed. ‘It is what it is,’ he said. Also, the bottom-performing 10 per cent of people in every department at his firm are sacked every year. He expressed surprise at my surprise. ‘That’s standard,’ he said. ‘I thought everyone did that.’ The moments when I realise Tony and I occupy very different spaces always turn on money and the assumptions built into our attitudes to it.

Lanchester goes on to consider quite how huge the scale of the problem might turn out to be, given the sums invested, although he mistakes opacity for complexity:

Derivatives, in their modern form, are the most powerful and the most complicated financial instruments ever devised. The third crucial thing about them is that they are everywhere. In 2003 the total size of the world economy was $49,000,000,000,000. The total size of the derivatives being traded was $85,000,000,000,000. In other words, derivatives today are worth far, far more than the total economic activity of the planet. More than $1,000,000,000,000 of derivatives are bought and sold every day. Every single thing that can be traded through derivatives, is. In the words of Warren Buffett, the greatest living stock market investor,

The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen). At Enron, for example, newsprint and broadband derivatives, due to be settled many years in the future, were put on the books. Or say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem – at a price, you will easily find an obliging counterparty.

Many companies which look as if their business is to do other things are in reality in the derivatives business – Enron being the best-known example. Buffett is a derivative-phobe, not least because he prefers to know what’s going on in the companies he invests in, and derivatives make that effectively impossible:

No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In Darwin’s words, ‘Ignorance more frequently begets confidence than does knowledge.’

The mention of Enron is a sobering reminder of how people can get away with what eventually turn out to be stupid ideas – ideas that people fall for because their greed makes them want to believe in them.  The film Enron, The Smartest Guys In The Room, is a fantastic dissection of the rise and fall of what at one point was considered “the most innovative company in the world” and is highly reccommended viewing.  Made in 2005, the film now seems eerily prescient:

Click here to view the embedded video.

For a bit of light relief, and a link into the idea of managing risk, here’s Andy Hamilton on BBC Radio 4’s comedy panel game The News Quiz, talking about why “innovative” and “banking” are two words that shouldn’t really be put together (for non-British readers, Ladbrokes is a large bookmaking and gambling company).

[See the full post to listen to this audio file]

A good way of looking at the laissez-faire attitude to these financial trades was that the risks were not managed properly – the people and organisations who traded in these instruments did not sufficiently understand the risk of these trades (if they did so at all).  The enforced lack of scrutiny in the markets characterised by Steve Eisman’s early days on Wall Street effectively means that they were blinding themselves to the risk.  Even ratings agencies, whose job it is to tell companies how risky an investment is, were giving AAA ratings, the highest possible, to mortgage-backed securities which consisted of sub-prime mortgages.  An interesting article in the Economist, which perhaps unsurprisingly has continued to be a cheerleader for unregulated markets, is the view of an anonymous risk analyst – someone who is employed by an organisation to advise on whether the risks inherent in a deal are too high.  In Confessions of a Risk Manager he or she describes, yet again, the bias against caution in these institutions.  An interesting aspect of this article is the way that it highlights the fact that the willful blindness to risk mentioned many times above is caused by greed:

In their eyes, we were not earning money for the bank. Worse, we had the power to say no and therefore prevent business from being done. Traders saw us as obstructive and a hindrance to their ability to earn higher bonuses. They did not take kindly to this. Sometimes the relationship between the risk department and the business lines ended in arguments. I often had calls from my own risk managers forewarning me that a senior trader was about to call me to complain about a declined transaction. Most of the time the business line would simply not take no for an answer, especially if the profits were big enough. We, of course, were suspicious, because bigger margins usually meant higher risk. Criticisms that we were being “non-commercial”, “unconstructive” and “obstinate” were not uncommon. It has to be said that the risk department did not always help its cause. Our risk managers, although they had strong analytical skills, were not necessarily good communicators and salesmen. Tactfully explaining why we said no was not our forte. Traders were often exasperated as much by how they were told as by what they were told.

At the root of it all, however, was—and still is—a deeply ingrained flaw in the decision-making process. In contrast to the law, where two sides make an equal-and-opposite argument that is fairly judged, in banks there is always a bias towards one side of the argument. The business line was more focused on getting a transaction approved than on identifying the risks in what it was proposing. The risk factors were a small part of the presentation and always “mitigated”. This made it hard to discourage transactions. If a risk manager said no, he was immediately on a collision course with the business line. The risk thinking therefore leaned towards giving the benefit of the doubt to the risk-takers.

(My emphasis)

And what were the business networks doing while this bubble was inflating (and even while it was bursting)?  Asking tough questions?  Yep, just like The Smartest Guys In The Room showed they asked tough questions of Enron:

Click here to view the embedded video.

So what was happening was this.  Banks were giving mortgages to people who shouldn’t have had had mortgages, because they could charge them high interest rates, and even if they defaulted house prices were rocketing so they’d still make money.  Those mortgages were sold on in batches to other companies as investments, and the income they generated was either from the mortgage payments or sales of defaulted houses.  These investments were rated as AAA investments by the ratings agencies, reinforcing the feeling that they were totally safe, which increased the amount that people would pay for them.  This enabled companies to ignore their risk managers, some of whom were having qualms about the sums being invested.  However, as interest rates were raised by central banks trying to control inflation, house prices started to stall, and people started defaulting on their mortgages.  As this happened the value of the investments – i.e. what investors were willing to pay each other for them – started to fall precipitously, and as they did so it started to become clear that they were worth a great deal less than people had paid for them.  This meant that fewer and fewer people wanted to buy them, until the market in them collapsed entirely and they became effectively worthless.  The banks suddenly owned lots of nothing.

And here’s how it affects the people who haven’t got millions of dollars in bonuses to tide them over.

In the next article in this series, we’ll look at how the financial industry reacted to this, and why, unlike something simpler like a steep rise in oil prices, the financial markets simply collapsed in the face of it – they knew not to trust each other.

Foreclosure photo by Joelogon.

In a recent issue of NY Arts Magazine, Éva Pelczer interviewed Margarita Gluzberg about her show The Money Plot at Paradise Row Gallery in London.

Read the full interview »

What he was using is called “misdirection” – a simple trick where the magician makes you more interested in something else (in this case his close proximity and the close attention he directed at me) while removing your watch.  (Having said that, and to his credit, you still have to be extremely dexterous to do something like that).

Another more threatening example was when my mobile phone got stolen.  I was sitting outside a cafe when some kids came up to me and one thrust a piece of paper with something scrawled on it into my face, mumbling something unintelligible – all my attention was on the fact that the first kid was too close for comfort, and I didn’t notice that the second one had simply picked my mobile up from the table until they were long gone.  Misdirection can seem like magic, but in a different context you can feel like you’ve been conned.

Advertising and marketing have adopted this trick of misdirection, except it’s more subtly done, and it aims to avoid the feeling that you’ve had the wool pulled over your eyes – on the contrary, it aims to please.  This move towards misdirection has been recent, as advertising has become steadily more sophisticated.  Have a look at this Persil advert from the 1960s:

Click here to view the embedded video.

It’s easy to see that advert and wonder how on earth people fell for it.  But this advert was only made during the early stages of advertising and marketing’s move from simple claims for a product – that Persil washes whiter, for example – to the use of psychological techniques, and particularly those based on the psychoanalytic theories of Sigmund Freud.  These techniques allow advertisers to transfer a much subtler non-verbal message than “I felt ashamed because Jimmy’s shirt wasn’t as white as Tom Williams’ shirt”.

This process was charted in “The Century Of The Self”, a documentary by Adam Curtis, which examines the strong influence of Freud’s theories on advertising and marketing in the 20th century:

Click here to view the embedded video.

Who among us would say that they’re not influenced by advertising?  If you’re not the target market for a Persil advert then it’s easy to scoff – but what happens when, for example, a Jean-Luc Godard fan sees an advert for a High Definition DVD boxed set of his films, or a Mac user sees an advert for the latest video iPod, or a gardener sees a new kind of hybrid rose in a catalogue?  She can resist the temptation, but there is no-one among us who wouldn’t be tempted by something.  Here’s Bill Hicks on marketing and advertising – the really interesting part starts at about 01:20 when he starts talking about the “anti-marketing dollar”:

Click here to view the embedded video.

As advertising has become more sophisticated, so have audiences in a psychological arms race.  Just as the Persil advert above seems ridiculously simplistic, over time people’s intellect adapts to advertising’s techniques as they start to consciously notice how these new techniques make them feel – and something that you notice you can resist.  Advertising’s Holy Grail is an advert that totally circumvents people’s rational thought and in the process side-steps their ability to resist by thinking about it, creating an unmediated desire for a product.  There is a tacit understanding of this in the stricter regulations governing advertising to children.

Misdirection in advertising is mostly used to remove the audience’s barriers to buying a product, to reassure them about buying something that they have rational reservations about.  This is particularly useful when public opinion turns against a group of products in a way that cannot be tackled head-on, and a good example of this is cars and car use.

Leaving aside the truth or falsity of global warming, which is another subject altogether, I think we would all accept that being “green” is now a prerequisite for companies and their commercials.  No company can afford to be seen to be unconcerned about environmental issues (unless they’re going for the anti-environmental dollar).  Because of the weight of public opinion that global warming is a real problem and that car use is a major contributor to this problem, in terms of advertising messages car manufacturers have the choice of accepting that opinion, or telling their potential buyers that they’re wrong.  The second strategy risks completely backfiring and alienating their potential customers – particularly in an age where the customer is always right, or “you’re worth it”.

In this situation, car companies basically have two options:

1. Completely and radically change the way they build cars, and the infrastructure that revolves around it, and advertise these profound changes.  This would be an enormously risky bet because if, for example, they started building large quantities of electric cars, not only would they have to bet on a completely new worldwide charging-point infrastructure being built, but they would have to completely change their manufacturing methods which would be vastly expensive.

2. Make as little change to their manufacturing processes and business model as possible, but make these changes the centre of attention in their marketing, just to the point where people can reassure themselves that it’s actually OK to buy a new car.

All the major car companies are currently taking the second course.  And no wonder, because without being able to share the risk with someone who has very deep pockets, the outcomes for the first are either glory or death for the company that tries it – not something that you want to take to a meeting with shareholders.

Here’s an example of how the second approach works when it comes to advertising.  This is Honda, telling you how environmentally friendly their new diesel engines are:

Click here to view the embedded video.

At the core of this advert, Honda’s message is “buy more cars” – no more or less than that.  But “buy more cars” is a culturally unacceptable message now, even if that’s something that people would really like to do, and this environmental barrier is one that needs to be overcome.  The bright colours, lovely cartoon animals, reassuring voice and soothing music all go to make up a very reassuring, if sickly sweet, context.  Honda’s cartoon animals – obviously exercising the will of “the environment” – kill off all the old, smoky diesel engines and then frolic with Honda’s new engine in a blissful environmental heaven.  If this was all the advert was, most people would be sickened by all the schmaltz – and so to undercut this, the song is about how it’s good to hate some things.  A very simple clash of opposites, but the irony that it generates allows enough of a knowing feeling to forget that in fact the core message, deeply buried, is “buy more cars”.  Or, more accurately, “that submerged desire that you have for a new car is ok – you go ahead and buy it”.  The fact that the song is about hate also prevents any feelings that Honda are being wilfully naive and ingenuous.  

There are many examples of this kind of misdirection in advertising, particularly combined with the message that it’s ok to desire and buy things like cars, removing barriers put up by rational thought.  Thought is anathema to this kind of advertising, which wants to take the shortest route to the viewer’s feelings – creating stronger desire, damping down negative feelings about a product and so on.

If you’re not in the least moved by an advert, you’re probably not the target market – perhaps you’d be more moved by a Jean-Luc Godard DVD boxed set, a new iPod or a new kind of hybrid rose.  And if you’re still unconvinced, here’s Derren Brown, who was that barrister-turned-”mentalist” in Bristol, getting one over on the advertising industry themselves:

Click here to view the embedded video.