Monday, February 2, 2015

After the Music Stopped

There are many books about the 2007-2009 financial crisis, but what sets Alan S. Blinder’s After the Music Stopped apart is that it is “less of a whodunit and more of a why-did-they-do-it?” Where other books focus on the spectacle of Wall Street CEOs madly rushing around to emergency meetings, Blinder gives the reader a better understanding of what went wrong.

One striking chart early in the book is U.S. house prices adjusted for inflation. It is very flat for nearly a century and suddenly doubles in less than a decade. Then prices drop back down to previous levels even faster.

On 2007 July 8, then CEO of Citigroup, Chuck Prince, said “When the music stops ... things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” While the music played, house prices rose fast, and when the music stopped, house prices dropped like a stone.

In a 2005 survey of San Francisco home buyers, on average they expected house price increases of 14% per year for the next decade. In Los Angeles, they expected 22% per year. These insane numbers reminded me of the crazy expectations during the tech boom where I heard people talking about retiring and making 15% or 20% per year on their investments.

Wall Street firms were leveraged 30-1 to 40-1. This means that “a mere 2.5 percent decline in the value of your assets wipes out all shareholder value.” As long as they sold the risk of mortgage defaults and institution defaults to others, this wasn’t a problem for them. But they were caught holding toxic assets themselves when the music stopped.

Rather than selling long-term bonds, investment banks accessed cheaper debt using overnight loans called “repos.” This means they had to “return to the capital markets to borrow every single day.” A loss of confidence in a bank would cause problems immediately. “The inability to roll over short-term borrowing is the modern version of a run on the bank.” Blinder concludes that “we need a financial system with much less leverage.”

Blinder explains that derivatives were complicated by design. Standardizing derivatives and trading them on organized exchanges would make it easier for traders to understand what they were trading. Creating non-standard and opaque derivatives “enables sharpies to take advantage of suckers.” Also, the fees embedded in non-standard derivatives are much higher than they would be in standardized derivatives.

Why did the ratings agencies fail to see mortgage-backed securities should have been given low ratings? One answer is that ratings agencies are paid by “the issuer of each security.” It’s not hard to see a conflict there. The tendency of ratings agencies to only reduce ratings after problems are obvious to all is summed up by “the markets’ jaundiced view that the agencies show up at the battlefield after the fighting is over and shoot the wounded.”

Blinder doesn’t find the phrase “too big to fail” precise enough. He says that the real problem is that some financial institutions are “too interconnected to fail,” or that they are too interconnected to be allowed to fail messily.

AIG actions leading up to the financial crisis “must have been one of the greatest, if not the greatest, failures of risk management, and of corporate governance more generally, in history.” Blinder describes AIG FP as “a giant, casinolike hedge fund hiding inside an insurance company.” However, “the loan to AIG now looks likely to be paid back in full, with a profit to the government.” In fact, “the $700 billion TARP cost the taxpayers almost nothing in the end.”

Blinder and Mark Zandi performed some modeling to simulate the U.S. economy with and without the government actions to deal with the financial crisis. “By 2011, we estimated, real GDP was about 6 percent higher, the unemployment rate was nearly 3 percent lower, and 4.8 million more Americans were employed because of the financial-market policies (as compared with sticking with laissez-faire).”

After giving a short version of the elementary school lesson of “How a Bill Becomes a Law,” Blinder gives colourful insight into the real process: “Now forget most of that. In practice, many bills originate in the White House. House and Senate committees (and members’ offices) are typically choked with lobbyists making ‘suggestions,’ cutting deals, and even drafting legislative language.”

Public perception is that while the U.S. government gave massive amounts of money to banks, little was done to help homeowners. In fact, there many programs created to help homeowners, but they all operated too slowly to help prevent many foreclosures. So, the public perception is not too far off the mark.

Blinder devotes considerable effort to summarizing events to set up his prescription for reducing the odds and severity of similar problems in the future. This includes political actions as well as regulatory changes.

Overall, Blinder delivers on his promise to give insight into why the financial crisis unfolded as it did rather than just describing events. I recommend this book to anyone with an interest in a better understanding of the U.S. Federal Reserve System and macroeconomics in general. Others will likely want to pass on this book, despite the fact that Blinder went to some trouble to make it accessible to non-specialists.


  1. Sounds like an interesting book. Is this quote correct? :

    “By 2011, we estimated, real GDP was about 6 percent higher, the unemployment rate was nearly 3 percent higher, and 4.8 million more Americans were employed because of the financial-market policies (as compared with sticking with laissez-faire).”

    Seems like the UNemployment rate should have been lower.

    1. @Greg: Good catch. I'll fix that. Thanks.