The Bible promised us seven years of fat times followed by seven years of lean. And that has remained a pretty reliable, if rough, guide to the cycles of economic activity ever since. What has also remained constant since Biblical times is the human need to assign blame for the end of each period of prosperity.
In the old days, when the crops failed, the villagers of New England knew whom to blame for their misfortune: witches. The peasants of Eastern Europe knew that the men with long beards and black hats who collected the nobility's taxes were at fault. And in the 1930s aftermath, the wise men in Washington, D.C., undertook an “investigation” to specifically blame short sellers for the 1929 crash.
This continues today: Shorts are still being called liars, thieves — even traitors. Retired money manager Peter Lynch likened short selling to “borrowing with criminal intent,” and it was Napoleon who said citizens shorting government securities were committing treason. Short sellers have been blamed for a multitude of financial catastrophes ranging from the collapse of the East India speculative frenzy in Amsterdam in 1610 to Black Tuesday in 1929.
Of course, the U.S. government learned in its investigations that short sellers didn't cause the market's collapse back then; shorts were healthy for a market. What legislators realized was that it was disclosure that was important (so Congress created the SEC out of the short selling investigations). But legislators are still blaming short sellers for just about everything. That's a losing proposition since a few years ago, the SEC decided to remove the so-called “uptick” rule, which restricted short selling on major exchanges. It turns out the uptick rule was pointless after all. After 60 years, the SEC essentially acknowledged that the anointed guilty party of the 1929 crash was, in fact, innocent. Such a major pardon has never received such a minimum of public understanding. Indeed, short sellers help provide liquidity and often keep optimists honest, throwing the glare of klieg lights on unwise investments and sometimes even uncovering actual fraud.
But the need to assign blame is perpetual — no matter what the facts are. Today, we are witnessing an ongoing process of blame assignment for our current economic woes; with Congress holding televised inquests, it's starting to feel like a modern-day Inquisition. Moral sensibilities have changed, of course, so blame is no longer immediately assigned to individuals based on personal identifiers like race or religion. But the need to assign moral culpability to a few actors for what are, after all, the failings of a score of different participants, still remains. The credit crisis is utterly repeatable and a commonplace macro event — it's called the credit cycle.
Today, in these politically correct times, the blame can only be assigned to those at the top of the power pyramid: That means rich, and usually white, executives — CEOs in particular — with the possible inclusion of Franklin Raines and Stan O'Neal. They are easy targets: It's more fun to single out Angelo Mozilo, complete with his perma-tan, bankrupt company and fraudulent mortgages than, say, Addie Polk, the 90-year-old Ohio woman who attempted suicide when sheriff deputies tried to foreclose on her house. Let's not forget Dick Fuld of Lehman or the Bear Stearns CEO castigated for playing golf while the balance sheet of his empire burned. These are the men being made to walk the financial industry's “perp walk.” It is this handful of deposed kings taking the blame on the front page for the choices and decisions made by literally hundreds of thousands of free-acting humans who participated in the housing bubble.
The funny thing is, those kings — who gorged themselves on leverage — want to shrug off responsibility, too. They point their fingers at the nefarious short sellers: It is they who brought the companies down. Part of the folklore, of course, is “naked shorting,” which supposedly drives down stock prices and causes market crashes. The SEC's regulatory actions prior to the bubble's collapse make it clear that they do not accept this causality. In other words, where are all these perpetrators of naked shorts?
The collapse this year brought with it a renewal of public belief in the mythology of naked shorting, leading regulators to create a short-term ban on the shorting of financial institutions' shares and expanding their authority to prohibit naked short selling. None of this, of course, had any positive effect on stock prices: Financial stocks actually declined during the outright ban on short selling, and to date no evidence has even surfaced that naked short selling actually happens, let alone drives stock prices down. The SEC ban on short selling began on September 19, 2008 and ended October 9, 2008. During that time, the Bloomberg U.S. Restricted Short Sell Index, which measures the performance of equities on the SEC's short sales list, dropped from a value of 100 to 74.20, a decline of more than 25 percent in less than a month. It has since declined to 63 in the roughly two months since then: Its decline was greater during the ban than after it was over.
And so the question on Main Street — and in the editorial pages of newspapers — becomes: “How could those idiots on Wall Street build this monster? Didn't they realize what was going to happen?” As an employee in the financial services industry, I am often asked this question. But was it really these rich executives' fault? To blame their behavior, we first need to interpret it. Examining and understanding the mind of the CEO is no different from inspecting the mind of a politician or an entertainer: Their first and only job is to please their audience — stockholders and employers.
And the audience demands growth — not only growth in sales, loans made, or cars produced, but in net income. Nothing irritates this audience more than a CEO whose company fails to match the growth rates of its peers. For investors, all companies must sport “above average” growth rates. Therefore, any financial services company that failed to offer Alt-A loans, no-documentation loans or pick-a-payment loans would soon find itself lagging behind its peers, prompting irate phone calls to the Investor Relations department from the holders of its stock — hedge fund managers, mutual fund managers, analysts at brokerage firms, registered reps, even retail investors would complain. The chorus is big and loud: Any CEO who failed to heed this drumbeat for growth at any cost would have soon found himself out of a job.
Such is the nature of crowds, and of organizations. Resisting consensus becomes exponentially more difficult as the size of an organization increases. And so the typical worker or risk manager within an organization finds himself unable to point out the obvious: The emperor has no clothes, and the course of business he is embarked upon can only end badly. But whatever objections employees might meekly offer up get ignored.
In this sense, the financial services industry is no different from a policeman who hides behind a “blue wall of silence” or a group of schoolchildren sitting mute when asked to identify the misbehaving individual. Service industries are ultimately structured as fraternal orders: You are incentivized to go with the flow, to do as you are told and to not ask any questions. “If you want to get along, go along,” Lyndon Johnson once observed about the path to success in Congress; life at Goldman Sachs is no different.
Blame All Of Us
So, who created this mess? The answer to this question has many parts. Since the early 1990s, both the leaders of Fannie Mae and the regulatory agencies that govern American financial institutions pressured private financial corporations to make riskier loans to consumers eager to reach the American dream of home ownership. This pressure essentially forced lenders to make loans to undeserving people, and to treat the ensuing credit losses as a cost of doing business. It also helped create the market for high-risk mortgage bonds. The rating agencies also figured prominently, assigning obviously incorrect ratings to the bonds and giving comfort to naïve buyers.
While these factors helped legitimize sub-prime lending, they did not make it inevitable. What made the drumbeat so loud? In a simple phrase: the cost of funds. Ultimately, in my view, the majority of the blame resides with the Federal Reserve. In the aftermath of the tech bubble bursting, they dropped interest rates so low that real interest rates were zero or negative, meaning, of course, that borrowing money was free. Giving people access to goods or services without cost is a guaranteed way to ensure over-consumption, and this was the undeniable consequence of the Fed's actions: Individuals and institutions borrowed more money than they needed or could possibly afford. And lenders of money — the “Italian dentists,”who effectively competed with the Fed in finding willing and creditworthy borrowers for their money — were forced to match the Fed's largesse, buying bonds at yields far too low to compensate them for the risks they were taking. (“Italian dentist” combines the two favorite Wall Street stereotypes for suckers: Europeans and retail investors. Europeans and Asians are net savers — and silly for loaning the U.S. money.)
The signs of the coming apocalypse were obvious to many. In the summer of 2006, while working at a different hedge fund, I attempted to convince my risk manager to allow me to purchase credit default swaps on low-quality mortgage bonds, the very same bearish bet that hedge fund managers like Henry Paulson placed — and won triple-digit returns. I carefully argued my case, presented my evidence and gave my risk manager a copy of the presentation I had prepared. He listened intently and carefully to my arguments, and then told me that he would consider the matter and inform me of his decision sometime later. He couldn't see the beauty of my quasi-short sale of mortgages.
Here's another red flag I saw: Members of our staff would meet with representatives of major investment banks involved in the mortgage securitization business to ask them, “What on earth are you doing making these loans? They are guaranteed to explode.” We saw three years of double-digit home price growth without any corresponding increase in personal income. And so the 28-year-old sell-side mortgage analyst in the $2,500 suit would not explicitly agree with our analysis. (It was often clear to me at least that he did agree, but could not say so, instead demuring in an oblique way.) And so I would change the topic, hoping to garner some useful information about the impending train wreck.
We would ask: Just who on Earth is buying these bonds? And the analyst would smirk, finger the buttons on the sleeve of his blazer, and shrug his shoulders. “Italian dentists,” would come the analyst's response. In other words, the only people buying these bonds were idiots.
And that was the point at the end of the day. The reason Angelo Mozilo made these loans was because Wall Street was willing to buy them. And the reason Wall Street was willing to buy them was because someone — either on Main Street or in Milano, or even in the office towers in New York and Boston — was willing to buy them. And to blame men for selling what others want to buy is an exercise in moral sanctimony which does not answer the key question: Why were these customers willing to buy bonds that were so obviously doomed to failure?
And so we return to our original formulation: While the buyers of these bonds were complicit in the creation of a credit bubble, the moral economy of the post-bubble environment demands a scapegoat, and blaming Italian dentists lacks the needed gravitas.
And so the Gretchen Morgensens and Paul Krugmans — not to mention the Barney Franks and Henry Waxmans — of the world seek to lay the blame with the comparatively few individuals who easily provoke ire and anger in the public. But to accept their formulation is to fail to understand that markets require not only willing and informed buyers and sellers, but government and regulatory institutions as able as possible to resist the siren song of interest group politics, which is why judges and Fed governors are appointed, not elected, and often for life. The failure of some of these individuals to protect longer-term interests is the ultimate cause of this debacle.
As for me, my risk manager never responded to my request, no doubt because he feared that allowing an equity focused manager to purchase options on mortgage debt was a “risky” move.
— Nate Wendler is the pen name of the author, an analyst at a large Manhattan hedge fund.