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Reading About the Financial Crisis: a Twenty-One-Book Review

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Reading About the Financial Crisis: a Twenty-One-Book Review Reading About the Financial Crisis: A Twenty-One-Book Review The MIT Faculty has made this article openly available. Please share how this access benefits you. Your story matters. Citation Lo, Andrew W. "Reading about the Financial Crisis: A Twenty-One- Book Review." Journal of Economic Literature, 50(1): 151-78 (2012). As Published http://dx.doi.org/ 10.1257/jel.50.1.151 Publisher American Economic Association Version Final published version Citable link http://hdl.handle.net/1721.1/75360 Terms of Use Article is made available in accordance with the publisher's policy and may be subject to US copyright law. Please refer to the publisher's site for terms of use. Journal of Economic Literature 2012, 50:1, 151–178 http:www.aeaweb.org/articles.php?doi=10.1257/jel.50.1.151 Reading About the Financial Crisis: A Twenty-One-Book Review Andrew W. Lo* The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of twenty-one books on the crisis, eleven written by academics, and ten written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed. (JEL E32, E44, E52, G01, G21, G28) 1. Introduction which completely satisfies our need for redemption and closure. Although the movie n Akira Kurosawa’s classic 1950 film won many awards, including an Academy IRashomon, an alleged rape and a mur- Award for Best Foreign Language Film in der are described in contradictory ways by 1952, it was hardly a commercial success in four individuals who participated in various the United States, with total U.S. earnings of aspects of the crime. Despite the relatively $96,568 as of April 2010.1 This is no surprise; clear set of facts presented by the differ- who wants to sit through 88 minutes of vivid ent narrators—a woman’s loss of honor and story-telling only to be left wondering who- her husband’s death—there is nothing clear dunit and why? about the interpretation of those facts. At Six decades later, Kurosawa’s message the end of the film, we’re left with several of multiple truths couldn’t be more rel- mutually inconsistent narratives, none of evant as we sift through the wreckage of the worst financial crisis since the Great Depression. Even the Financial Crisis * MIT Sloan School of Management and AlphaSimplex Group, LLC. I thank Zvi Bodie, Jayna Cummings, Janet Inquiry Commission—a prestigious biparti- Currie, Jacob Goldfield, Joe Haubrich, Debbie Lucas, Bob san committee of ten experts with subpoena Merton, Kevin Murphy, and Harriet Zuckerman for help- power who deliberated for eighteen months, ful discussions and comments. Research support from the MIT Laboratory for Financial Engineering is gratefully acknowledged. The views and opinions expressed in this article are those of the author only, and do not necessarily represent the views and opinions of MIT, AlphaSimplex, 1 See http://www.the-numbers.com/movies/1950/0RASH. any of their affiliates or employees, or any of the individuals php. For comparison, the first Pokemon movie, released in acknowledged above. 1999, has grossed $85,744,662 in the United States so far. 151 152 Journal of Economic Literature, Vol. L (March 2012) interviewed over 700 witnesses, and held much higher yields than straight corporate nineteen days of public hearings—presented bonds with identical ratings, apparently for three different conclusions in its final report. good reason.4 Disciples of efficient markets Apparently, it’s complicated. were less likely to have been misled than To illustrate just how complicated it can those investors who flocked to these instru- get, consider the following “facts” that have ments because they thought they had identi- become part of the folk wisdom of the crisis: fied an undervalued security. As for the second point, in a recent study 1. The devotion to the Efficient Markets of the executive compensation contracts Hypothesis led investors astray, causing at 95 banks, Fahlenbrach and Stulz (2011) them to ignore the possibility that secu- conclude that CEOs’ aggregate stock and ritized debt2 was mispriced and that the option holdings were more than eight times real-estate bubble could burst. the value of their annual compensation, and 2. Wall Street compensation contracts were the amount of their personal wealth at risk too focused on short-term trading prof- prior to the financial crisis makes it improb- its rather than longer-term incentives. able that a rational CEO knew in advance of Also, there was excessive risk-taking an impending financial crash, or knowingly because these CEOs were betting with engaged in excessively risky behavior (exces- other people’s money, not their own. sive from the shareholders’ perspective, that 3. Investment banks greatly increased is). For example, Bank of America CEO Ken their leverage in the years leading up Lewis was holding $190 million worth of com- to the crisis, thanks to a rule change pany stock and options at the end of 2006, by the U.S. Securities and Exchange which declined in value to $48 million by the Commission (SEC). end of 2008,5 and Bear Stearns CEO Jimmy Cayne sold his ownership interest in his com- While each of these claims seems perfectly pany—estimated at over $1 billion in 2007— plausible, especially in light of the events of for $61 million in 2008.6 However, in the 2007–09, the empirical evidence isn’t as clear. case of Bear Stearns and Lehman Brothers, The first statement is at odds with the fact Bebchuk, Cohen, and Spamann (2010) have that, prior to 2007, collateralized debt obliga- argued that their CEOs cashed out hundreds tions (CDOs),3 the mortgage-related bonds at of millions of dollars of company stock from the center of the financial crisis, were offering 2000 to 2008, hence the remaining amount 2 “Securitized debt” is one of the financial innovations at 4 For example, in an April 2006 publication by the the heart of the crisis, and refers to the creation of bonds Financial Times, reporter Christine Senior (2006) filed of different seniority (known as “tranches”) that are fixed- a story on the enormous growth of the CDO market in income claims backed by collateral in the form of large Europe over the previous years, and quoted Nomura’s portfolios of loans (mortgages, auto and student loans, estimate of $175 billion of CDOs issued in 2005. When credit card receivables, etc.). asked to comment on this remarkable growth, Cian 3 A CDO is a type of bond issued by legal entities that O’Carroll, European head of structured products at Fortis are essentially portfolios of other bonds such as mort- Investments replied, “You buy a AA-rated corporate bond gages, auto loans, student loans, or credit-card receiv- you get paid Libor plus 20 basis points; you buy a AA-rated ables. These underlying assets serve as collateral for the CDO and you get Libor plus 110 basis points.” CDOs; in the event of default, the bondholders become 5 These figures include unrestricted and restricted owners of the collateral. Because CDOs have different stock, and stock options valued according to the Black- classes of priority, known as “tranches,” their risk/reward Scholes formula assuming maturity dates equal to 70 characteristics can be very different from one tranche percent of the options’ terms. I thank Kevin Murphy for to the next, even if the collateral assets are relatively sharing these data with me. homogeneous. 6 See Thomas (2008). Lo: Reading About the Financial Crisis 153 Assets-to-equity ratio 35 to 1 30 to 1 25 to 1 20 to 1 15 to 1 Year and quarter 10 to 1 Goldman Sachs Merrill Lynch Lehman Brothers 5 to 1 Morgan Stanley 0 to 1 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Figure 1. Ratio of Total Assets to Equity for Four Broker-Dealer Holding Companies from 1998 to 2007 Source: U.S. Government Accountability Office Report GAO–09–739 (2009, figure 6). of equity they owned in their respective com- Like World War II, no single account of panies toward the end may not have been this vast and complicated calamity is suffi- sufficiently large to have had an impact on cient to describe it. Even its starting date is their behavior. Nevertheless, in an extensive unclear. Should we mark its beginning at the empirical study of major banks and broker- crest of the U.S. housing bubble in mid-2006, dealers before, during, and after the finan- or with the liquidity crunch in the shadow cial crisis, Murphy (2011) concludes that the banking system7 in late 2007, or with the Wall Street culture of low base salaries and bankruptcy filing of Lehman Brothers and outsized bonuses of cash, stock, and options actually reduces risk-taking incentives, not unlike a so-called “fulcrum fee” in which portfolio managers have to pay back a portion 7 The term “shadow banking system” has developed sev- of their fees if they underperform. eral meanings ranging from the money market industry to And as for the leverage of investment the hedge fund industry to all parts of the financial sector banks prior to the crisis, figure 1 shows much that are not banks, which includes money market funds, investment banks, hedge funds, insurance companies, higher levels of leverage in 1998 than 2006 for mortgage companies, and government sponsored enter- Goldman Sachs, Merrill Lynch, and Lehman prises.
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