BOOK REVIEW: Andrew Redleaf & Richard Vigilante's Panic
It's one of life's truisms that after any big event myriad individuals raise their hands to say that they astutely predicted what just passed. The 2008 financial crisis was no exception in this regard, though in the case of multi-billion dollar hedge fund manager Andrew Redleaf, he in fact alerted clients in December of 2006 to the coming credit troubles.
As he put it in a client newsletter nearly four years ago, "Sometime in the next twelve to eighteen months there is going to be a panic in the credit markets." Thankfully for the multitude still searching for a better understanding of what happened and why, Redleaf and Richard Vigilante have written Panic, an important, and very readable account of what transpired not long ago.
Redleaf and Vigilante cover many themes in their book, but perhaps their underlying thesis can be broken down to how they describe the ‘80s and ‘90s versus the decade just passed. As they see it, the "great boom" of the ‘80s and ‘90s "was driven by entrepreneurs: outsiders, upstarts, and innovators", whereas the "great mortgage meltdown" of the 21st century "was an establishment game", "created and driven by the largest, most well-established, most heavily regulated and government-subsidized players in mainstream financial markets."
So true in so many ways, and note how the authors don't buy into the absurd notion that the media elite, politicians, and even some on the right embrace about the crisis having been fathered by too much in the way of deregulation. Unwilling to forward what on its face is ridiculous, Redleaf and Vigilante happily slay a lot of conventional wisdom on their way to explaining how we got here.
And for those who presume that the authors' regulatory point-of-view signals some kind of right-wing polemic, they needn't worry. Though both are "staunch Republicans who believe Ronald Reagan was the greatest president in our lifetimes", Panic is in no way partisan.
To Redleaf and Vigilante the crisis was authored by both parties, or, in their articulate prose, "Crony capitalists on the right and socialists on the left united as always behind their most fundamental belief, that wealth is to be captured by power and pull rather than created in the minds of men." Regarding their thoughts on the Republican Bush administration, they make the powerful point that "No Democratic administration, with the exception of Roosevelt's first term, has been as abusive of financial markets as the Bush administration." Amen.
Considering the widely held view that one factor in the meltdown had to do with a Wall Street establishment that was "heedless of risk", the authors argue the opposite; as in investors "were so obsessed with risk that they became terrified to live by their own judgment." Instead, they make the suggestion that as opposed to heavily liquid, modern markets being the best kinds of markets, maybe they're "closer to being the worst" for academia and Wall Street worshipping at the altar of efficient markets.
Indeed, it is the notion of efficient markets and modern portfolio theory (MPT) that take a thorough beating throughout the book. Redleaf and Vigilante feel that MPT concentrates too much on the mechanics of markets, while ignoring the underlying entrepreneurialism ("minds of men") that truly drives ours and any vibrant economy.
To the authors, MPT is essentially a cop out, or safe haven for money managers "trying to support capitalist lifestyles with only bureaucratic talents." This desire for sameness among modern managers supports a world "in which process is everything, original insight is suspect, and the best possible outcome is to earn the same mediocre returns as everyone else."
This seeming herd mentality ultimately had a body count. Captive to the notion that markets are always right, and that the money that actually moves markets is always the smart money, a great many investors bought into the view that with seemingly all the smart money flowing into increasingly suspect mortgage securities, those securities must have been more credible than rational analysis would suggest.
At this point everyone knows that a great many managers thought to be smart were caught unaware by the eventual crisis, whereas a small number of deniers, including Redleaf and Vigilante's firm Whitebox Advisors, emerged flush, or largely unscathed. What's interesting here is that the authors make the compelling claim that we shouldn't be surprised by the turn of events.
Indeed, as they point out in impressive detail, the conventional wisdom concerning "smart money" is very definitely faulty. Specifically they note that on average, "mutual fund managers consistently fail to outperform the market and usually underperform after fees and transaction costs are taken into account."
Considering investment flows, that the average mutual fund customer chases performance is well documented, and the problem there that the authors alert the reader to is that "Over three years on average, the top 20 percent of stocks, measured by how much new investment they got from mutual funds, underperformed stocks that got the least new investment by about 8 percentage points per year." Far from a market of smart money, lemming-like investors consistently chase the very managers whose market outperformance to some degree foretells underperformance going forward.
All of this leads to one of the book's best attributes whereby the authors simplify for the reader the previously obscure products and buzzwords that were part and parcel of the crisis including the nature of mortgage "tranches" for investors depending on their risk preference, what credit default swaps and no-recourse loans are, Fannie Mae and Freddie Mac's role in the mortgage industry, the difference between subprime and Alt-A loans, etc. Whatever the reader's opinion of the supposed ideology underlying what is a very useful book, Redleaf's and Vigilante's simplified explanations of what might seem complicated make it a very worthwhile purchase.
Concerning the crisis itself, Redleaf and Vigilante helpfully walk readers through a rapidly degrading mortgage market, one that was increasingly infiltrated by "fly by night" mortgage originators eager to shove money out the door without regard to the underlying fundamentals of the borrowers. Redleaf himself became very bearish as the originators themselves took a blasé approach to mortgages issued to prospective homeowners putting little to nothing down. He knew then that this rush to property wasn't going to end nicely.
And far from a subprime crisis as so many assume (they note that defaults among poor credit risks alone could never have caused so much damage), this was in many ways to them a crisis of fealty to efficient markets as institutional managers, bolstered by dumb money chasing performance created by financial wizardry, trusted market history in terms of mortgage defaults over simple rationality, and their own ability to analyze securities. Put simply, those with little skin in the game aren't good mortgage bets.
To the authors, capitalism was betrayed by Washington and Wall Street as the "conjurers" who crafted mortgage securities achieved "their most cherished dream", which "was to isolate money management from flawed human judgment, including their own." Washington's role in this was as the classic enabler, winking at and encouraging non-economic behavior through subsidy on the way to collapse. And then, seeking to fix the mess that it helped to create, Washington's botched intervention made what was already a problem, something much worse.
As with all the books, there were surely disagreements and questions. For one, the great George Gilder's masterful work, Wealth and Poverty, achieves prominent mention within, and it should be said that this reviewer rarely has it much beyond arm's reach.
But there lies one of the problems with Panic in that as Wealth and Poverty makes very plain, crazed rushes to housing are hardly new. As Gilder wrote about the late ‘70s housing market back in 1981, one that occurred amid skyrocketing interest rates alongside a falling dollar, "What happened was that citizens speculated on their homes...Not only did their houses tend to rise in value about 20 percent faster than the price index, but with their small equity exposure they could gain higher percentage returns than all but the most phenomenally lucky shareholders." To put it plainly, housing has always boomed in seemingly irrational ways whenever the currency in which it's priced is weak, but the U.S. Treasury's encouragement of a weak dollar this decade, and the latter's signal role in the property boom never merited mention.
They also decry how structured finance transformed a quiet mortgage market into something much worse. Maybe, but to complain about financial advances is somewhat of an empty protest. Regardless of the mistakes that occurred, if securitized mortgages hadn't been introduced here by profit interested banks, someone, somewhere was going to invent them.
Early on they note that ignorance, not a lack of liquidity is the father of all panic, and there they finger the structure of mortgage securities for making investors oblivious to what was within. A fair point, but not asked enough was whether the true driver of the panicked ignorance wasn't in fact the government's intervention in the mortgage markets back in 2007 whereby it became apparent that lenders would be asked to "voluntarily" to rewrite mortgages; that or individuals struggling to make payments would be allowed through government force to rework what they owed.
It seems with the above that the true ignorance that drove the aforementioned panic wasn't obscure securities loaded with a lot of "John Doe" borrowers, but instead ignorance as to what the government would do next to cushion the mistakes of foolish borrowers. For two writers possessing a perhaps congenital skepticism about government, this non-mention of the government's early role in fostering panicked ignorance stood out.
In addition to calling the 2008 crisis, Redleaf predicted the 1987 crash, suggesting ahead of October during that year that the proliferation of equity futures would cause a great deal of carnage. To the authors, "the reign of risk is at the root of repeated crises in modern financial markets."
A nice platitude for sure, but the better explanation would be that bull markets never die of old age, rather they decline due to policy failure. Indeed, the 1929 crash occurred on the day that investors became aware that President Hoover intended to sign the Smoot-Hawley Tariff in 1930 (investors never price the present), while Redleaf's 1987 reasoning ignored that during the week preceding the 22.5% decline, Rep. Richard Gephardt was aggressively moving through Congress a tariff bill, the Senate was considering a bill meant to make LBO's very tax inefficient (the authors single out the ‘80s LBO boom as an economic positive), not to mention that Treasury Secretary James Baker went on national television the Sunday before Black Monday and talked down the dollar.
To reduce any market decline or rise to a phenomenon of trading enhancements or worship of risk is to oversimplify things, while ignoring Washington's significant potential to foment crisis at a moment's notice. Indeed, it's not as though S&P futures disappeared after 1987, but markets were largely sanguine for another 13 years.
Further on Redleaf and Vigilante argue that "the one thing the investor must do is accurately identify the risks particularly relevant to any investment and go about eliminating them as thoroughly and inexpensively as possible." Sound advice for sure, but since one of the seeming foundations of their argument was that risk obsession helped author the crisis, their advice later on confused at least this reader.
As for the federal government's response to the market carnage, very surprisingly they argue that the Fed cutting rates and pumping money into the system was a good thing. Regarding the latter, the notion that excess money fixes anything seems to pervert the Ricardian view that the only perfect money is that which is stable in value. As for the Fed cutting rates, it may sound good on paper, but didn't the Fed's efforts to make credit artificially cheap unwittingly make it expensive (the authors make plain that the businesses lacking a tight relationship with the government faced tight money) for the vast majority of businesses thanks to low rates driving away the intrepid creditor?
No doubt the authors know the negative impact of price controls anywhere else in the economy, why wouldn't this apply to the Fed's actions? Indeed, as they go on to point out, illiquidity generally can't take solvent businesses under, and that properly explains why one wouldn't want central banks distorting the cost of credit on the way to its disappearance. Rent controls, anyone?
Regarding the response to the collapse of Bear Stearns, Redleaf and Vigilante suggest that its bailout was handled properly. Really? Not only did Bear's bailout excuse a lot of non-economic behavior while delaying the economy-cleansing process whereby poorly run financial firms would be put out of their misery, it also sowed the seeds of the Lehman Brothers fiasco considering that investors assumed a bailout of the latter was on the way right up to the now deceased firm's bankruptcy. Ignorance, caused by government, once again sowing panic.
Not stated enough is that the failures of the banks in question were a sign that capitalism was working, that the economy was on the mend for bankruptcy driving poorly managed assets into the hands of better managers, and the economy being rid of that which didn't work. Most would disagree, including apparently the authors, but it was the bailouts themselves that turned what should have been merely painful into something quite horrific.
Indeed, the authors describe a period of market calm after the defaults and mortgage-firm bankruptcies began in 2006-7, and this seemingly speaks to how very inefficient markets were, and presumably are. Maybe, but it says here that the defaults and bankruptcies were once again a positive sign of the markets rendering their negative judgment on that which was bad, and that had the government simply relaxed and done nothing as this writer argued in the spring of 2007, there never would have been a crisis.
One of their stated solutions to the crisis is that the federal government should have "attacked" the high cost of corporate credit due to money being scarce. This might sound good, but it also defies basic economics. High prices of anything always and everywhere foretell lower future prices for the profit-interested being compensated for parting with what is limited capital. To use force in order to make cheap what the markets deem expensive is to ensure the wasteful accession of limited capital, all the while driving away potential sources of new funds.
So while Panic remains an essential and very enlightening read, some of the conclusions left this reviewer somewhat flat for them embracing government solutions to government problems that almost by definition weren't going to work. And didn't.
Indeed, while what happened in 2008 is to this day deemed by nearly everyone a "financial crisis", it bears mentioning that that the crisis wasn't financial at all. Instead, and as is the case with all other negative market/economic events, this was very much a government crisis caused by intervention that fostered ignorance about what the government would do; ignorance driving panic.
The bailouts only made things worse by virtue of them damaging an economy that necessarily needed to be relieved of non-economic ideas. It's popular to say that Wall Street is part of the problem, but this is like saying immigration is hazardous. In truth, we don't have an immigration problem as much as we have a problem of governments offering up too many services to natives and illegals alike. Much the same, Wall Street and its financial alchemy isn't so much of problem as much as bailouts of its mistakes are.
And for those who continue to forward the false notion that Wall Street's errors cause global economic pain, thus necessitating bailouts, they need only consider how Japan and Germany were literally destroyed by World War II, yet their economies roared back in its aftermath. That both were quickly back on their feet mocks the absurd notion that any financial mistake could have any lasting economic impact.
Beyond that, it bears mentioning that arguably the biggest theme of the prosperous ‘80s and ‘90s was that free markets won out over government control. Intervention that began in 2007 and continues to this day signaled to investors that somewhat dormant governments were re-asserting themselves within the global economy, and there was born the biggest crisis of all.
All of these quibbles are in no way meant to detract from an excellent book. At the same time, this reader still awaits the book that lacks any pretense of being subtle, and which instead makes plain that while Wall Street oversaw gargantuan errors, those mistakes alone could never have caused the Panic of 2008.