From The Archive
Maureen Tkacik
No. 18  December 2009

Journals of the Crisis Year


Hemp has been used for at least 5,000 years for cloth and food, as well as just about everything that is produced from petroleum products. Hemp is not marijuana and vice versa. Hemp is the male plant and it grows like a weed, hence the slang term. The original American flag was made of hemp fiber and our Constitution was printed on paper made of hemp. It was used as recently as World War II by the U.S. Government, and then promptly made illegal after the war was won. At a time when rhetoric is flying about becoming more self-sufficient in terms of energy, why is it illegal to grow this plant in this country? Ah, the female. The evil female plant—marijuana. It gets you high, it makes you laugh, it does not produce a hangover. Unlike alcohol, it does not result in bar fights or wife beating. So, why is this innocuous plant illegal? Is it a gateway drug? No, that would be alcohol, which is so heavily advertised in this country. My only conclusion as to why it is illegal, is that Corporate America, which owns Congress, would rather sell you Paxil, Zoloft, Xanax and other additive [sic] drugs, than allow you to grow a plant in your home without some of the profits going into their coffers.

The above paragraph is excerpted from one of the most widely read texts to emerge from the financial crisis: the October 2008 farewell letter of a hedge fund manager named Andrew Lahde. The letter opens, “Dear Investor,” and closes with the words “goodbye and good luck”; in the fifteen months prior to authoring it Lahde had amassed a 1000 percent profit for his clients and increased his own net worth nearly a hundredfold by anticipating the foreclosure crisis.

The letter depicts Lahde’s success as a victory over a class of people variously termed the “Aristocracy,” “the low hanging fruit,” the “idiots whose parents paid for prep school, Yale, and then the Harvard MBA,” who “were (often) truly not worthy of the education they received (or supposedly received)” but rose to the commanding heights anyway because they “had all the advantages (rich parents) that I did not.” Condemning politicians for repeatedly rejecting legislation that “would have reigned [sic] in the predatory lending practices” and bemoaning “a dearth of worthy philosophers in this country,” the letter challenged George Soros and other great minds to convene a meeting to devise a new form of government devoted to fostering a genuine meritocracy. “Capitalism worked for two hundred years, but times change, and systems become corrupt,” Lahde wrote. Before long he had earned his own Facebook fan page featuring a link to a site at which admirers could purchase black T-shirts that read “Andrew Lahde = Pure Awesome.”

Crisis profiteers like Andrew Lahde are often described as having “shorted” subprime mortgages, but what Lahde did involved far less risk than a classic short sale. He simply accumulated a large supply of credit default swaps, a once-obscure derivative that provided a form of “default insurance” on bonds backed by subprime mortgages. Credit default swaps were such unpopular investments in those days that $20 million bought a year’s protection on a billion dollars worth of the most odious bonds. Curiously, the lack of risk seemed to do little to ease Lahde’s mind as the crisis loomed—and as he prospered. He had lined up only a handful of small-time investors to back his experiment, and most brokers refused to sell credit default swaps to such a minor player. Long hours and chronic stress “destroyed” his health, he wrote, and after packing up his plunder he urged contemporaries who might aim to “amass nine, ten, or eleven figure net worths” to consider doing as he did: “Throw the Blackberry away and enjoy life.”

It has been more than a year since Lahde repaired to Salingeresque hermitage, a decision inspired by his “hero” Timothy Leary, according to Gregory Zuckerman’s book, The Greatest Trade Ever. In the interim, countless gigabytes of prose have been produced explicating the origins and the corrupt ideologies that enabled the multi-trillion dollar disaster. It is perhaps another failure of the market that all this activity has yet to produce a crisis chronicle so urgent or memorable as the investor letters composed by capitalists like Lahde, a literary genre that generally assigns words the status of wrapping paper around numerals and pie charts. To be sure, there were a few crucial distinctions with Lahde: For one thing, he seemed utterly indifferent to the chance to add more zeroes to his net worth. He had nothing more to prove. Besides, and even for a man so addled by his own exceptionalism, the size of the fortune he had amassed was simply too great to rationalize as the homage of a rational market. The conclusion he drew from his own success was that capitalism had become irretrievably corrupt.

More erudite free marketeers reached much the same conclusion in the aftermath of the Panic of ‘08, but none so distinguished as the conservative legal scholar, federal judge and cultural critic Richard Posner. While not a trained economist, Posner has long been an exponent of the University of Chicago school of economics, famous for insisting that markets are most efficient when they are left alone to self-regulate. In 2009 this acolyte of the invisible hand published a compact treatise declaring the crisis to be nothing less than A Failure of Capitalism. Like Lahde, Posner is pessimistic about the nation’s financial future, and he blames the coming full-scale “depression” upon a neglectful regulatory structure and an academy that had been “asleep at the switch.” The chief difference between the two seems to be their esteem for other capitalists. Where Lahde saw a financial industry peopled with mediocre trust fund kids who had traded their souls for Crackberries and Wellbutrin, Posner defends bankers “whose IQs exceed my own” as “brilliant.” He expends much text chastising the media as “ignorant” for indicting the bankers’ “failures of rationality or intellectual deficiencies” and finds the media naive for harping on “greed (whatever that means)”; he wonders rhetorically what anyone thought “businessmen were like.”

The character of capitalists is not a matter to which A Failure of Capitalism devotes many more words, but the rationally self-interested John Galt clones who seem to inform Judge Posner’s views are decidedly less believable characters than the rich-kid conformists Lahde indicts. And in a way, Lahde’s mixture of sympathy and contempt for his fellow financiers bodes better for the future of the American economy than does Posner’s soft bigotry of subprime moral standards. This is not an ancillary concern. If capitalism has failed, and socialism has failed, and the only remaining option is some improved version of the drab “mixed economy” that currently exists, then we are living in a perilous ideological vacuum.

To find our way out of the void, a stemwinding survey of the cultures and personalities that produced the catastrophe is required. And so despite Posner’s insistence that what we really need is “a concise, constructive, jargon and acronym-free, nontechnical, unsensational, light-on-anecdote, analytical examination of the major facts of the biggest U.S. economic disaster in my lifetime,” a survey of what the men who created the current crisis are actually like might be a useful first step.

Posner never identifies his intended audience—those readers who crave an account of the financial crisis stripped of any actual stories for fear of inflaming their allergies to sensation. But for less sensitive types, I have good news: the economic crisis was not only a sensational disaster story replete with edifying anecdotes, but it was also a story first pieced together in the name of profit by a small group of freelance capitalists who were in many cases just as astonished as the rest of us to discover the depths of systemic depravity that enabled their massive returns. And while Posner urges the Obama Administration to establish a “financial counterpart to the CIA” charged with collecting information so as to “assemble an intelligible mosaic from the scattered pieces, “he might have acknowledged that this sort of financial analysis has a name: “mosaic theory,” the very approach which Andrew Lahde credited for his success.” [*]

The trouble with mosaic theory is that it lacks a sophisticated theoretical pedigree, and thus had been largely abandoned before the financial system came to be dominated by institutions that were Too Big To Comprehend. So while it was generally understood by the middle of the decade that bonds backed by pools of mortgages were probably due for a fall thanks to speculative bubbles in certain real estate markets and the rise of subprime mortgages, almost no one understood the magnitude of the disaster that was coming.

This was not so much because of a dearth of data, but rather an almost willful refusal to see what decades of overcompensated executives forcing overleveraged companies to squeeze ever-fatter profits from an ever-more indebted consumer base had wrought. It is difficult enough, for example, to fathom that Dick Fuld survived comfortably in the Seventies as a Lehman Brothers bond trader on a salary of $6,000 a year, a sum the book Too Big To Fail offhandedly calculates as one-ten-thousandth of the annual pay he took home later as the firm’s CEO; but now try to wrap your head around the impact that such a man’s actions had on an economy that had fatefully entrusted him with a balance sheet more than 10,000 times the size of that later salary.

Before the present catastrophe, the average financial journalist would have resisted evaluating Fuld’s pay package on such absolutist grounds for fear of coming off as a socialist or a spoilsport; the media contrasted the compensation packages of CEOs as the CEOs did themselves: with those of other CEOs. Neither would a journalist have been likely to question the unbelievable bigness of Wall Street’s financial footprint, though for a more innocent reason: it was just too overwhelming. This symbiosis of the immoral and the incomprehensible is what enabled the current destruction, and the latter has yet to change: “too big to fail” is treated in the current crop of crisis chronicles more as a catchphrase than as the massive inscrutable menace it remains. The story, alas, is too big to tell.

Perhaps the one truly enlightening treatise on “too big to fail” appeared just before the big fail in the eccentric 2007 manifesto The Black Swan: The Impact of the Highly Improbable, in which the options trader and amateur philosopher Nassim Nicholas Taleb argued that high finance had become dangerously vulnerable to cataclysmic panics and crises. After surveying the many flaws in the way humans perceive reality, Taleb turned his sights on the fatal flaw in the mathematical models that dictate the operations of the financial system the idea that wealth flows in accordance with the statistical formulas Wall Street had adopted from the world of academic physics.

Physics, Taleb objected, has nothing to do with wealth, citing as evidence the absurd, gravity defying growth of certain individuals’ portfolios during the age of George W. Bush. Wealth accumulated so quickly in some pockets it created wild disparities even within the (wildly competitive) ranks of the superrich. While this random distribution of wealth blessed many on Wall Street, it simultaneously undermined the models of the Street’s own financial engineers, producing in turn an ever-accelerating flood of financial crises. Taleb explained his unique perspective as a function of growing up in a locale less historically blessed by randomness, Beirut, Lebanon, during that country’s civil war.

As it happens, another bit player in the financial crisis grew up not far from Taleb during the Lebanese civil war. But while Taleb spent the war reading philosophy in his basement, Daniel Sadek, the founder of Quick Loan Funding, played outside. He quit school after third grade, sustained two bullet wounds by the age of twelve, and spoke no English when he moved at eighteen to Orange County. After spending most of his twenties working at gas stations, he was selling cars when he decided to go into the subprime business in 2001, inspired by the number of luxury rides he’d begun selling to mortgage brokers. The firm he started, Quick Loan Funding, catered to the most subpar of subprime borrowers; in 2004, a Wall Street auditor reviewed a sample of Quick Loan’s applications and flagged 40 out of 40 as fraudulent. But Sadek’s outfit never made a loan Wall Street was not happy to securitize.

The Texas hedge fund manager Kyle Bass first noticed Quick Loan because its logo kept popping up when he screened mortgage securities for higher-than-average delinquency rates. Like Lahde, Bass was a relatively anonymous regional finance guy who quit his job in 2006 after learning about the then-obscure business of credit default swaps, which he wanted to use to bet against the housing bubble. At the time, delinquencies were rare because lenders like Quick Loan were falling over one another to offer refinancings.

Bass’ first and only glimpses of Sadek came via YouTube, which in April 2006 posted local news coverage of a stunt car wreck Sadek had engineered to build “buzz” for Redline, a movie he was producing about the bacchanalian Gumball circuit that starred his then-girlfriend and the comedian Eddie Griffin. The stunt required Griffin to purposely crash and destroy Sadek’s $575,000 Porsche Carrera. This was, Bass felt, “just a senseless destruction of capital,” but Sadek told reporters his aim was to give audiences bored by Hollywood’s outsourcing of destruction to computer-generated imagery the “real deal.” People “will know we’re destroying a real Porsche—not a model, but a real one,” he explained. It was to be quality waste.Bass, a fleshy former college athlete with a remarkably hideous painting of dollar signs hanging in his office, appeared to harbor few political or philosophical convictions—indeed, he had never so much as registered to vote. But by 2006 he was increasingly certain the economy was on the brink of a cataclysmic collapse, a rare bit of prescience made possible by a valuable insight he had gleaned from . . . his car. Bass was a longtime participant in the Gumball 3000 Rally, an annual spectacle in which wealthy men with rare and expensive cars drive at high speeds on public roads around the world, stopping to attend extravagant parties featuring bikini-clad models but zooming blithely past the wrecks their colleagues invariably cause. Many journalists and politicians owe their understanding of credit default swaps to Bass, whose apocalyptic letters to investors quickly earned a following on financial blogs, but only David Faber, author of And Then the Roof Caved In, learned what it felt like to reach 190 miles per hour on a public highway in Bass’s car.

To Sadek’s credit, all $4 billion in loans he originated during his short career in the mortgage business were taken out by real people living in real houses. But for each Quick Loan Wall Street pooled into a mortgage bond, there could be as many as ten “synthetic” mortgages trading in the esoteric derivatives market. Securities both synthetic and real were pooled into collateralized debt obligations or CDOs, then sliced into “tranches” paying out a range of interest rates, with riskier tranches paying higher yields in exchange for agreements to shoulder the first wave of defaults, and safer tranches paying barely more than Treasury bonds because they lost value only after the riskier tranches had been completely wiped out. Bass figured the incessant pooling and slicing to be a fertile environment for fraud, but he was stunned to learn what happened to lousy mortgage bonds and their synthetic clones upon entering the securitization process. The riskier tranche were being re-pooled and tranched again into “mezzanine” CDOs, and by some imaginative leap the credit rating agencies were grading the top 80 percent of those Triple-A. Who was buying these things?

Bass learned the answer at a wedding in Spain, when he found himself seated at the reception next to a man who sold precisely that subpar subset of subprime mortgage dreck for a top-tier investment bank. Calmly, the banker explained that “mezzanine” was essentially a marketing gimmick the banks had concocted to sell off the lowest classes of subprime mortgages back in 2003, when American pension funds and insurance companies had stopped buying them. By repooling those dregs, marking up their values and labeling the result “mezzanine,” the salesman explained, the banks had found a way to “EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!!” It was, Bass wrote his investors, nothing less than the “Greatest Bait and Switch of ALL TIME.”

It was also, of course, an epochal opportunity to bet against the house and win. But the era of easy money was quickly ending. Bass failed to secure backing from his old firm Bear Stearns, even though his presentation prompted a risk manager there to privately tell him, “God, I hope you’re wrong.” Sadek’s day job was disappearing by the time Redline premiered in March 2007, by which point Griffin had also totaled his rare $1.2 million Ferrari Enzo, this time in an apparent accident when he botched a tight turn and crashed into a concrete barrier. The $33 million movie was universally panned, but the spectacular crash sequences prompted more than one critic to note that the cars had more “personality” than the characters driving them. “I lost my dream car,” Sadek mused over his Ferrari. “But I went into my trailer and thought to myself, there’s people dying every day. A lot of worse things are happening in the world.”

Indeed there were. As it turned out, Wall Street hadn’t dumped all its foreclosure cases on Europe and Asia; hedge funds and “shadow banks” had stockpiled hundreds of billions of dollars in mortgage bonds as well using largely borrowed money in an almost criminally simple investment strategy known as the “carry trade.” By that summer all the hedge funds that had fueled the boom had wiped out their investors. The banks that lent them money would be next. A great symbol of the era, one mortgage investor’s yacht, Positive Carry, was for sale.

Kyle Bass, meanwhile, decided to tour some of the homes that comprised the collateral beneath the many layers of fraud and obfuscation to determine what else of value might remain. A road trip through central California proved the prognosis “MUCH WORSE than even I thought it would be,” he wrote investors, estimating that 90 percent of loans contained some form of fraud, thanks to a “wanton disassociation of risk inherent in the machine that churns out Subprime loans.” Daniel Sadek’s destruction of capital was significant not because it was an aberration; it was a perfect symbol of the age. By wrecking perfectly awesome cars, Sadek was simply the first guy in the business who had documented the senselessness of the era in a medium Bass could appreciate.

Bass imagined how an epidemic of foreclosures would feed upon itself, subjecting sunny exurbs and retirement communities to the blight of the grimy urban centers their cash-strapped inhabitants had fled. Even more disturbing was the baffling inaction of government at any level. “Is there a TRILLION DOLLAR INDUSTRY that you can name,” he challenged investors in January 2007, “that DIRECTLY touches the consumer and is COMPLETELY UNREGULATED???” And this was before he discovered the magnitude of the other completely unregulated industry in this story: the manufacture of derivatives, a market some thirty to sixty times greater than the trillion dollar mortgage industry on which it was based.

The one entity with enough authority to regulate subprime mortgage brokers was the Federal Reserve Board. Controlled by one politically appointed chairman and twelve regional presidents, the Fed is a perversely undemocratic agency, but it was by no means oblivious to subprime mortgage problems. In 1999, the Glass-Steagall Act was repealed, and the floodgates were opened for the nation’s investment banks to pour funds into the once-boring world of mortgage origination. By 2002 a longtime member of the Fed’s Consumer Advisory Committee named Agnes Bundy Scanlan, an executive at Fleet Bank in Boston, was publicly warning the Fed that the “seven, eight, nine, ten years of [Community Reinvestment Act enforcement] work that I’ve been doing has probably all been undone” by the predatory practices of the new generation of mortgage lenders. “We have lost everything we’ve gained.”

But the Fed did not operate as a “we.” The crisis narratives by both David Faber and David Wessel depict then-chairman of the Fed Alan Greenspan repeatedly dismissing statistics that detailed the rapid growth of the unregulated subprime mortgage business. Greenspan also routinely silenced dissent among members of the Board’s small voting body (he had once sneeringly called it the “Federal Open Mouth Committee”), insisting that investors were too “sophisticated” to gain anything from the clumsy oversight of the babbling bureaucrats who staffed his own organization. Many times this most ardent foe of government told how he bonded with J.P. Morgan’s team of loan officers during a meeting in the Eighties, a story that somehow proved the market policed itself better than any bureaucracy ever could. Why Greenspan failed to bond with the loan officer from Fleet is anybody’s guess.

Then again, perhaps Greenspan’s doubts about the “sophistication” of his own colleagues were warranted. Wessel explains the philosophical factions within the Fed in adolescent terms:

There were the cool guys, the jocks and the geeks. Bernanke, Don Kohn, Tim Geithner, and Kevin Warsh fell into the first category, the cool ones. The jocks were regional Fed bank presidents determined to show their manhood by talking tough about inflation and economic rectitude: economists Jeffrey Lacker in Richmond and Charles Plosser in Philadelphia, investor-turned-policy-maker Richard Fisher in Dallas. The geeks included monetary policy scholars who shared Bernanke’s view of the world: Rick Mishkin in Washington, Janet Yellen in San Francisco, Eric Rosengren in Boston. And then there were the wannabes: among them Randy Kroszner, the book-smart University of Chicago professor who managed to rub much of the Fed staff the wrong way, and newcomers James Bullard of St. Louis and Dennis Lockhart of Atlanta.

The Fed’s undemocratic and insular structure has been attacked relentlessly since the birth of Bailout Nation, but this characterization is perhaps even more damning. Where are the stoners and goth kids, the hoodlums and skateboarders, and the “street smart” entrepreneurs who procure fake IDs and give teen movies their plots? Well, there’s disgraced Bear Stearns CEO Jimmy Cayne, who may be down to his last $600 million but still enjoys access to “the best weed in New York,” as he boasts in The Sellout. And some of the kids know how to have fun even in the moment of ultimate crisis: on the eve of the Lehman Brothers bankruptcy, according to Too Big To Fail, the bankers assembled in the basement of the New York Fed spent that ultimate moment of crisis first impersonating Tim Geithner and SEC chairman Chris Cox and then competing against each other in an impromptu BrickBreaker tournament.

And if even a “cool kid” like Geithner felt he had “little available leverage” (in the words of an Inspector General report on the bailout) to negotiate a “haircut” with the Wall Street chiefs who had purchased hundreds of billions of dollars worth of “insurance” on their toxic mortgages, how could we expect the Fed to stand up to the Xtreme mortgage peddlers themselves, guys like Daniel Sadek and the “bodybuilders” former Lehman Brothers trader Lawrence McDonald describes after relating his own efforts to short the subprime mortgage market in A Colossal Failure of Common Sense.


Back at Lehman, McDonald relates, distressed debt traders like himself were the “sharks,” but an encounter with the “bodybuilders” on a “reconaissance mission” to Irvine, California, leaves him feeling a little less ferocious. Pulling into the Ferrari-filled parking lot at subprime giant New Century Financial, McDonald and a trader buddy panic that their rented Buick will give their spy mission away; they repair to a nearby steakhouse, where they soothe themselves with afternoon martinis served by glamorous waitresses. Here they encounter “the bodybuilders,” McDonald’s term for the brash young men who took home massive bonuses during the boom years by manning the front lines of the mortgage biz. Muscled and tanned, clad in tight suits and talking “with a brashness common among people who are paid huge amounts of money for tasks that require no real brilliance,” they are the physical embodiment of a market McDonald fears has been fatally “roided up” on derivatives. The louts actually recite company mottos—“New Century for a new century” and “new shade of blue chip”—and share debauched tales from the luxury booze cruise the company chartered for its top salesmen, wherein they sailed under the banner, “Best Damn Mortgage Company. Period.”

Delicately, McDonald raises his concern: a competing lender has been advertising a program to help its existing homeowners find jobs, suggesting number of borrowers had been caught off-guard when their “teaser fee” period was over and their monthly payments mushroomed. Responses from the bodybuilders range from “not our concern” to “someone else’s problem” to “otherwise it’s back to the ghetto, right?” And of the double commissions they are rumored to earn on the most predatory loans, they explain that it “takes a tough man to sell this stuff, and New Century is prepared to pay for the best.” Incidentally, New Century was also, according to allegations published in Business Week in 2008, one of numerous institutions to staff its mortgage-pooling divisions with attractive, flirtatious and often unqualified women; “mortgage sluts” hired, shall we say, to “incentivize” the bodybuilder types to bring home a steady supply of loans.[**]

But if the geeks at the Fed were oblivious to the indifference-to-consequences that would soon yank us all into a depressionary spiral, they at least shared the distinguished company of the PhD quants whose sophisticated models so efficiently converted one person’s fraud into someone else’s problem. The pioneering Nineties geek squad at J.P. Morgan that forms the cast of characters of Financial Times reporter Gillian Tett’s Fool’s Gold would probably get along great with the magnet-school crew of the Fed of 2008. Where Ben Bernanke’s brainstorming sessions were called “Blue Sky meetings,” the J.P. Morgan derivatives team leader Peter Hancock had “Come to Planet Pluto moments,” spontaneous creative outbursts intended to inspire his team to think outside the proverbial box. Although Hancock wasn’t a PhD—he had been promoted to head of derivatives mainly because he had captained a company sailing team that beat Goldman Sachs—he had studied physics at Oxford and is described as “exceedingly cerebral.”

What Hancock’s team invented was the credit default swap, a massive watershed in global financial history that dates to a corporate retreat at a Boca Raton resort in the summer of 1994, an employee field trip that would bankroll corporate risk disassociation parties long into the future. Tett attempts to recreate the magic moment when someone first concocted the CDS, but no one recalls much from the trip beyond an abundance of drinking games, prank room service orders and a poolside dunking contest in which a senior banker broke his nose, a tropical excursion the bankers recall with the fond nostalgia of aging celebrities reminiscing about the halcyon days of Woodstock and Studio 54.

“We had this sense of being special, of being detached from everyone else,” one says. “There was a sense of mission,” said the sustainer of the broken nose, a “sense that we had found this fantastic technology that we really believed in and we wanted to take to every part of the market we could.” Not content with her own seventy-odd uses of the word “innovation” and its variations over the course of 253 pages, Tett herself likens the team’s invention to “splitting the atom,” “cracking the DNA code,” “the banking equivalent of space travel” and the “financial equivalent of the Holy Grail.” Blythe Masters, a posh 25-year-old who would over the next few months take credit for inventing the credit default swap, would rave later that the concoction of sophisticated new “products” appealed to her not only because of her quantitative background, “but they are also so creative.” And finally: “I’ve known people who worked for the Manhattan Project, and for those of us on that trip there was that same kind of feeling at being present at the creation.”

For anyone who forgot what we were fighting for back in the Summer of ’94, a bit of historical context: “From time immemorial,” Tett explains, “the worlds of business and finance have been beset with the problem of default risk, the danger that a borrower will not repay a loan or bond.” This is frustrating to read if you think of this lingering “problem” as a bank’s fundamental reason for being. But Hancock’s real innovation was not so much getting rid of risk that it was rendering risk less risky.

Here’s how it worked: When J.P. Morgan made a loan, it would sell off the risk of the loan to another institution, which would get a portion of the interest payments in exchange for signing a contract agreeing to make good on the loan in the (highly improbable) event that J.P. Morgan’s borrower defaulted. This arrangement supposedly made for a “win-win” situation because banks were bound by law to keep a certain percentage of their total borrowing and lending activities in cash, while the institutions to which they were contracting out their risk were not. By end of the nineties, J.P. Morgan had convinced the government that any bank that had outsourced its risk in such a clever way ought to be allowed to risk more of its funds trading than the capital requirements allowed.

The bank also perfected the art of selling off risk at extremely low prices, by pooling together thousands of separate loans from different regions and industries, then dividing the pooled risk into layers of riskiness and selling off the layers for a range of interest rates. The riskiest risk paid higher interest rates and was in greater demand; the bland, virtually risk-free risk was offloaded to AIG at less than a tenth of a penny on the dollar. To keep a handle on all this newly tradeable risk, J.P. Morgan invented a model called “Value at Risk” or VaR, which the bank used at the close of every trading day to calculate, using historical data, the biggest possible loss it could expect to face.

It was a big success. Within years J.P. Morgan’s so-called “noninterest income”—income that came from activities other than lending—comprised four-fifths of the bank’s revenues, and the other big investment banks were following suit. VaR soon became the industry standard, as did the sale of socialized risk pools the team had invented. But J.P. Morgan itself soon fell behind. Peter Hancock had been sacked in a dotcom-era dustup, and his team couldn’t figure out how to compete in the fast-growing mortgage-backed sub-sector of the risk business. As Tett tells the story, this was because the bank’s geeks didn’t have enough historical data on mortgage defaults. There was a simple reason for this: housing prices in the United States had risen steadily since the Great Depression, and very few defaults had ever occurred. There simply didn’t appear to be enough risk for the geeks to make money mitigating.

Years later, Tett tells us, when competing banks began churning out mortgage-backed CDOs, J.P. Morgan’s derivatives team assumed their competitors had somehow found more reliable data. They could not know for sure because they were not regulated. They were not regulated in large part because of the lobbying efforts of J.P. Morgan. And because they were not regulated, the credit derivatives market soon grew to more than $66 trillion, a number almost no one would know until the next depression was on its way. Tett describes the “perversion” of the team’s innovations variously as a “bitter, bitter irony,” a “cruel irony” and a “terrible, horrible irony.”

Even in our Age of Imprecise Irony, this is something of a perversion of the term’s meaning. Of course, meaning itself didn’t enjoy much status in a banking industry convinced it could profitably lend money without ever shouldering the risk that it wouldn’t be paid back.

Taleb, for his part, accuses J.P. Morgan in The Black Swan of putting “the entire world at risk” not by inventing the CDS but by popularizing VaR, which elevated sophisticated, mathematically-minded geeks he termed “Dr. Johns” over his preferred Wall Street archetype, “skeptical Fat Tony.” (The difference between Fat Tony and Dr. John is revealed by their response to a question about the probability a coin will toss heads after tossing tails 99 times in a row: Dr. John answers “one in two” and Fat Tony answers “bullshit.”) Wall Street’s Dr. Johns had committed a grave error in their risk models, Taleb tells us, having to do with the “Gaussian” function statisticians use to calculate probability, in which data clusters around means and averages. A Gaussian bell curve is the shape taken by a graph plotting the heights of adult males in America, or the proximity of fallen leaves to their trees, or any other realm somehow bound by gravity.

Taleb’s contention was that while normal distribution patterns may govern most of the world’s activities, they were irrelevant to the workings of modern finance. Most of us lead predictable financial lives, earning and spending money as we might consume and excrete food, and the probability of encountering a fellow adult who runs twice as fast or who consumes four times our own caloric intake is incredibly low.

On the other hand, it would be virtually impossible for me to board a Manhattan subway at rush hour without encountering someone making ten times my salary. Although our ages, cholesterol levels, SAT scores and rankings on could and probably would cluster around a mean, if you compared my cash flow to that of the hedge fund guy and forecasted our net worths at retirement, the difference would be exponential, a barely noticeable tremor next to the San Francisco earthquake.

Fool’s Gold chronicles, if somewhat inadvertently, how Wall Street convinced itself—along with the regulators who agreed that J.P. Morgan’s innovations had effectively reduced risk by a factor of five—that it had conceived its own disruptive megatrend with all its new tools and models. Converting those innovations into the eight- and ten-figure bonuses that expanded the American centimillionaire population so dramatically was a slightly more elaborate matter, however. This required the wagering of ever-larger pools of capital on an ever-more arcane array of risky bets, plus the acceptance of both irrational expectations[***] and ubiquitous fraud. And of course, the abdication by public officials of any sense of responsibility that might otherwise prompt them to intervene.

Taleb’s gravest fear about the spread of analytical systems like VaR is that they bring a cognitive blindness he calls the “ludic fallacy,” the misinterpretation of real life for ludus, Latin for “school” or “game.” But Wall Street’s blindness was general by the end of the Bush years. The reason the Treasury, the Fed, the geeks and the mortgage brokers repeatedly invite comparisons to teen movies is because they seem to have operated under the assumption that the real world was an extension of high school.

Surely some degree of “ludic fallacy” is embedded in consciousness itself. But financial markets are supposed to be so vitally connected to all the tangible activities of humanity that Wall Street historically nurtured an unsentimental intimacy with real life, rewarding those who understood how trends and movements translated into day-to-day price fluctuations and who appreciated the real-world consequences of those fluctuations. This was where Fat Tony once thrived, and it is difficult to overstate the degree to which the Fat Tony types that dominated earlier Wall Street narratives like Liar’s Poker have been marginalized in our day. When Kyle Bass goes back to tour his old company, Bear Stearns, he finds the mortgage-pooling desk staffed by twentysomethings. “Capital is ubiquitous and free-flowing,” one of them tells him with spooky conviction, “and it will never stop.” At Lehman Brothers, McDonald’s distressed debt department was populated by Fat Tony types, but they controlled nowhere near the sums allotted to the mortgage desk for a simple reason: the overlords in risk management were “guided, advised, regulated, trapped, imprisoned, and threatened on pain of torture and death” by VaR, a “tyrant” and a “bonehead” and “goddamned machine” that endorsed the firm’s accumulation of tens of billions of dollars in subprime mortgage CDOs because it was programmed to prioritize historical volatility—and the mortgage CDO market was until 2006 a “calm, tranquil place.”

Fat Tony manifests himself to a degree in the form of J.P. Morgan Chase’s straight-talking CEO Jamie Dimon, who (supposedly) reined in his band of “innovators” by taking the trouble to educate himself about derivatives, and whose firm was the only major Wall Street player that did not need a massive bailout. But Dimon is described in most of these first drafts of financial history as a kind of mutant. As McDonald writes, “you could have tied Jamie Dimon to the bow of a patrolling nuclear submarine, so sensitive was his sonar.” Fat Tony is totally absent from the list of stereotypes cited by the narrator of The Ex-Mrs. Hedgefund, a fund manager’s wife who frets about her husband’s association with a “quintessential rowdy-jock-cum-date-rapist type” and delineates the various investment strategies of hedge funds in terms of the marital fidelity of their practitioners.

Not all hedge fund guys were like that. l’d studied the scene up close, and Kiki and I had decided there was a link between the style of the guy and the type of hedge fund he worked in. For example, at the quantitative style funds, where mathematical formulas and computer software helped determine investments, at the helm was a nice power-nerd type, who loved his wife and kids and didn’t care about “the scene.” Contrastingly, both the “global macro” type firms (who put their wedding rings in their pockets on Boondoggles) and the equity hedge funds (preppy white-shoe types, including scattered “Tiger cubs” from the once all—powerful Tiger Management) were way more life-in-the-fast-lane: jets, cars, wine, women, and song—the works.

In other words: there were jocks, and there were nerds. There were preppy jocks and power nerds and geeky prankster preps and date rapists, but in the end the distinctions between them were so superficial and meaningless as to be discernible only to the grown-up fratboys who perpetuated them. The flow of capital had come under the control of 180-pound children who still viewed life as a game they could win the way they’d won their way into the Ivy League. The Fat Tonys retired, and the world of finance had no adults left.

Washington wasn’t much different, the former jock Hank Paulson would learn as he pleaded with his ideological frat buddies in Congress to help him fend off the cataclysm that had resulted from their old project of dismantling the financial regulatory structure. Paulson, a former offensive lineman and Dartmouth alum, was accustomed to “two-facedness” among Congressional Republicans, but he was aghast when they privately agreed that he needed to act to save the system but refused to support him publicly with their votes. Before acting, others in the capital demanded some simple way to visualize and understand the panic in the credit markets, the sort of thing that comes from publicly available information, the collection and dissemination of which is the barest, most basic role of government oversight. Alas, almost no such oversight existed in the bond and derivatives markets, and thus there was no easy way to convey the magnitude of the panic even as it was happening, much less in the years before and even a year afterward. Perhaps Hank Paulson should have sponsored a viewing of the movie Redline.

What was easy to convey was that something about the past ten years had been unsustainable. But the truth—that an entire ideology had been unsustainable—is one that we have not yet grasped. And that is why so many journalists, economists, intellectuals and financiers now scramble to churn out books that for the most part read like the memoirs of people trying to make themselves feel less stupid. The current financial system was constructed to make us all feel stupid, and in the process of building it the architects allowed themselves to become stupid as well. That ignorance begat infantilization, which bred cowardice and systemic moral decay. The only sustainable way out is to reacquaint ourselves and our fellow citizens with the wisdom of asking stupid questions.

In defense of Hank Paulson and the shrinking Republican congressional caucus, we should remember that they weren’t alone in inventing the fable of an economy that could shutter all its factories and find a more innovative use for capital in the business of finding innovative uses for capital. The Party of Bob Rubin and Bill Clinton did such a good job preaching the gospel of accelerating profits that not one of the three bond-rating agencies thought to question the Triple-A grade inflation with which we laid the groundwork for catastrophe. With both parties converted to this new Gospel of Wealth, who was left to point out the frightening taste of the superrich for such gratuitously hazardous sports as the Gumball 3000, or the cavalier way its organizer shrugged off the hit-and-run death of a Macedonian couple who wandered onto a stretch of the Gumball route in Bratislava, and then returned in 2008 with a new route boasting a celebrity-studded party in . . . Pyongyang?

Besides, no proper broker nowadays feels anything other than indifference about the wider world, as McDonald writes of the bodybuilders:

They acted as if neither the fortunes of the company nor the borrowers had anything to do with them. They were like hired guns, oblivious to the fate of the victims or the company that had hired them. Professional salesmen who rode the waves, and when one wave petered out they would find the next one. They were utterly remote from the reality of what they were doing. They moved in a flock, migrating from one sales scam to another, probably about every five years. And they were good at it.

Perhaps full-scale economic devastation was the only way to restore the sense of “intimate and inextricable relation to the society” around us that Tom Wolfe famously hoped to instill in readers of his 1987 crash-lit classic Bonfire of the Vanities, one of the last memorable explorations of the morally hazardous culture of the Master of the Universe class.

Sadly, it was not to be. The cool kids in residence at Treasury and the Fed, following Tim Geithner’s curious motto, “Act fast, deal with the unintended consequences later” bailed out the jocks and geeks and bodybuilders and speed junkies, pledging a sum that by Barry Ritholtz’s estimate exceeds the combined inflation-adjusted costs of the Marshall Plan, the Louisiana Purchase, the Space program, the Savings & Loan Crisis, the Korean and Vietnam Wars, both Iraq Wars and the New Deal. Ritholtz doesn’t really fault their decisions, conceding later in a “naughty child index” that AIG was akin to “the kid who accidentally stumbles into a biotech warfare lab” and jams his pockets full of unlabeled vials before heading back to the playground. “History will judge” is the chorus reverberating through the rest. And maybe it will, if enough Andrew Lahdes and Fat Tonys can be lured out of retirement to impress upon this generation of entitled overachievers what vacuous, cowardly and parasitic twerps they all are.


Edmund Andrews, Busted: Life Inside The Great Mortgage Meltdown (W.W. Norton, $25.95)

David Faber, And Then the Roof Caved In: How Wall Street’s Greed and Stupidity Brought Capitalism to Its Knees (Wiley, $26.95)

Charles Gasparino, The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System (HarperBusiness, $27.99)

Jill Kargman, The Ex Mrs. Hedgefund (Dutton Adult, $25.95)

Duff McDonald, Last Man Standing: The Ascent Of Jamie Dimon and J.P. Morgan Chase (Simon & Schuster, $28.00)

Lawrence G. McDonald with Patrick Robinson, A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers (Crown Business, $27.00)

Richard Posner, A Failure of Capitalism: The Crisis of ‘08 and the Descent into Depression (Harvard University Press, $23.95)

Barry Ritholtz with Aaron Task, Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy (Wiley, $24.95)

Andrew Ross Sorkin, Too Big To Fail: The Inside Story of How Wall Street and Washington Fought To Save The Financial System—and Themselves (Viking, $32.95)

Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (Random House, $28.00)

Gillian Tett, Fool’s 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 (Free Press, $26.00)

David Wessel, In Fed We Trust: Ben Bernanke’s War on the Great Panic (Crown Business, $26.99)

Gregory Zuckerman, The Greatest Trade Ever: The Behind-The-Scenes Story of How John Paulson Defied Wall Street and Made Financial History (Broadway, $26.00)


[*] Mosaic theory was also cited in the first paragraph of “The World’s Largest Hedge Fund Is A Fraud.” the famous 19-page memo a freelance fraud investigator named Harry Markopoulos sent the Securities and Exchange Commission in 2005 suggesting that Bernard Madoff was operating a gargantuan Ponzi scheme. The memo was ignored, but in 2009 Markopoulos was called to testify before Congress about the failings of the SEC. Markopoulos painted a stark picture, one that veered far outside the frame of the Madoff scandal:

Government has coddled, accepted, and ignored white collar crime for too long. It is time the nation woke up and realized that it’s not the armed robbers or drug dealers who cause the most economic harm, it’s the white collar criminals living in the most expensive homes who have the most impressive resumes who harm us the most. They steal our pensions, bankrupt our companies, and destroy thousands of jobs, ruining countless lives.

[**] “Mortgage sluts” and Ferraris: again and again the teenage obsessions of sex and cars saturate the story of the financial crisis. The one regulator David Wessel commends for understanding in 2007 that the mortgage market would require a massive taxpayer bailout was yet another automobile enthusiast. Former deputy Treasury Secretary Neel Kashkari, when in high school, filled most of his senior yearbook page with a large photo of a Ferrari, superimposing a picture of himself and assorted heavy metal lyrics. Recognition of the disaster’s potential magnitude did not convert to concern, however; according to David Wessel’s book, In Fed We Trust, in early 2008 Kashkari jestingly likened it to the Iran hostage crisis that consumed the 1980 election year, advising colleagues that mortgages, like hostages, were a problem for the “next president.” (A slightly different account in Too Big To Fail has Kashkari reversing this stance, urging Paulson to start lobbying to use federal funds to bail out the mortgage market lest the history books accord Obama all the credit for “bringing home the hostages.” I’m not sure which story makes Kashkari look like a bigger douchebag.)

[***] For instance, the book Busted: Life Inside The Mortgage Meltdown excerpts a September 2008 “open letter” to Hank Paulson written by former Merrill Lynch CDO “guru” Christopher Ricciardi, who advised the Treasury Secretary to address the credit crisis by using taxpayer dollars to essentially guarantee all money managers willing to invest in mortgage bonds an “acceptable” annual return—“15% to 25% typically.”

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