The Ultimate Bear Market

House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan, Doubleday, 468 pages, $27.95

"We all fucked up," says Alan Schwartz in the final paragraph of House of Cards. "Government. Rating agencies. Wall Street. Commercial Banks. Regulators. Investors. Everybody."

Schwartz was the last chief executive officer of Bear Stearns, which, when it collapsed in March 2008, became the first of the financial-market dominos that ultimately toppled the U.S. and world economies. His generous sharing of culpability is a bit like the sly confession of the serial murderer who implicates his parents, his teachers, and the police for their failure to keep him from killing. Still, he has a point; there are multiple fingerprints at the scene of this crime.

House of Cards is not the complete picture of the bursting of Wall Street's credit bubble. Other books will give you a clearer understanding of swaps and derivatives (Charles Morris' The Trillion Dollar Meltdown), policy bungling (Dean Baker's Plunder and Blunder), and the nitty-gritty of life on the trading floor (Frank Partnoy's F.I.A.S.C.O.). But William Cohan fits an important piece into the mosaic: a portrait of the personalities turned loose on the country when we deregulated finance.

Bear Stearns was one of Wall Street's most highly leveraged promoters of mortgaged-backed securities. By investing a dollar of its own money for every $33 or more worth of stock it bought and sold and borrowing short-term for the rest, top managers and big investors became filthy rich as the market soared. Fortune magazine named Bear Stearns the most admired securities firm in 2002 and 2004 (Bear came in second in 2003). In January 2007, a share of the company's stock hit $172.69, four times its book value.

Bear Stearns' success tracked the transformation of the financial sector. Formerly the source of credit to industries that produce goods and services, finance became a source of credit to itself. And what did finance produce? More debt, for one thing. Between 1979 and 2007 the debt of American financial institutions rose from about one-third to double the debt of all other U.S. businesses.

Leverage giveth -- small upward movements in price translate into high returns on equity investments. But leverage also taketh away -- small drops in price wipe you out. When the sub-prime-based securities market started to tank, lenders demanded Bear put up more collateral immediately or pay off its loans. Rapacious short-sellers sniffed the company's blood and panicked investors sniffed their own. Together they hammered the stock into the cellar. Frightened bankers cut off Bear's credit, and the 85-year-old company collapsed.

Cohan, a journalist and ex-investment banker, writes a vivid page-turner on Bear's last frantic days as it gradually dawned on the company's cocky managers that they had driven the firm over a cliff. He paints Bear as the bad boy of the big Wall Street firms -- taking risks, cutting weak regulatory corners, and occasionally screwing customers to maximize its managers' fabulous bonuses. At the end, these masters of the universe sat in their plush offices stunned and helpless while Timothy Geithner, then head of the Federal Reserve Bank of New York, negotiated a buy-out by J.P. Morgan at $2 a share. (When Morgan's own high-priced lawyers bungled the sales contract, the final price went to $10.) A few months later, the ostensibly more upscale Goldman Sachs, Merrill Lynch, and Lehman Brothers were all caught in the leverage trap baited with massive short-term profits.

After finishing this book you cannot take seriously the claim that most, if any, Wall Street executives -- drawn from the same talent pool as the Bear Stearns gang -- were worth the money they were paid. The bosses at Bear were self-indulgent, small-minded, and much more interested in their golf game, vintage Ferraris, and bridge tournaments than in the company's survival. Cohan assures us that some of them made "brilliant" trades. Maybe. Yet, except for early partner Cy Lewis' purchase of cheap railroad bonds in the late 1930s on the assumption that the United States would win World War II, he doesn't give us much evidence.

Cohan's most troubling observation is that Bear's top managers actually saw the disaster coming and "did nothing." As the sound of an imminent cave-in of the mortgage markets grew louder, Schwartz and his predecessor Jimmy Cayne refused opportunities to protect the firm by raising more capital, in part because diluting the equity would have cut into their big bonuses. And while Bear hedge-fund manager Ralph Cioffi was predicting a drop in the prices of mortgage-backed securities and assuring his investors that he was selling out, he was actually buying more of those toxic assets to pump up his short-term bottom line.

As we now know, this kind of recklessness pervaded the finance industry from Wall Street to Washington. Bankers, brokers, and policy-makers seemed to learn nothing from the savings-and-loan and junk-bond crashes of the 1980s, the Enron and Long-Term Capital Management disasters of the 1990s, and the bursting of the dot-com bubble in the 2000s.

Former Treasury Secretary Robert Rubin, with a big foot in both New York and Washington, warned in his 2003 memoirs of ignoring risk and "reaching for yield." Yet at Treasury he had been a prime mover in lifting constraints on speculation, and later, as chair of Citigroup's executive committee, he presided over its catastrophic reaching for yield. In 2002, Federal Reserve Board chair Alan Greenspan told members of his Open Market Committee that there was "eye catching" evidence of housing-price inflation, while at the same time assuring Congress and the public that it was not so.

Perverse institutional behavior -- pursuing a policy despite the evidence that it is leading to calamity -- is a well-known psychological phenomenon. Business schools give courses on it. The late historian Barbara Tuchman termed virtually all of history a march of this kind of folly. John Maynard Keynes and Hyman Minsky explained how speculative fever overwhelms common sense and overshoots markets in a boom and undershoots them in a bust.

Greenspan and Rubin insist they were helpless to stop this madness of crowds. Rubin says, "Even if I'd taken a placard and walked up and down Pennsylvania Avenue saying the financial system would come to an end without strict regulation of derivatives, I would have had no traction."

Like Alan Schwartz, Rubin is copping a self-serving plea. But it's true that a thundering financial herd intoxicated with visions of quick riches is very hard to stop, especially now that Wall Street and Washington have become so closely tied together. Although both the Republican Greenspan in Washington and the Democratic Geithner in New York had authority to crack down on visible excesses, neither used it.

The history of financial markets suggests that animal spirits generating booms and busts -- and players dealing from the bottom of the deck -- will be with us always. The task is to keep the periodic collapse of Wall Street's house of cards from spreading to the rest of the economy. Effective reform may need to go well beyond marginal expansions of government's authority to monitor and regulate.

From this perspective, the bailout strategy of the Obama economic team to keep the great financial behemoths intact moves in the wrong direction. Rather, we need to shrink the industry, bringing it back to where its primary function is to provide credit for the real economy, generating sustainable growth and high employment, instead of creating complex financial instruments that can be sold at 10 A.M. on the expectation that with just a tap of your keyboard, you'll get rich by noon.

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