If you have spent a fair amount of time reading about the financial crisis, you are unlikely to be surprised by the broad outlines of McLean and Nocera’s book. But this book should still be required reading. First, the author’s are masters of the storytelling craft. Many scholars can examine the institutional and economic causes of the crisis, but McLean and Nocera can make these explanations vividly understandable. At the same time, they weave together a tapestry of stories of captains -- among them Angelo Mozilo, the management of AIG, executives at Fannie Mae, various regulators -- who sailed their institutions and the international economy straight onto the blackest of shoals.
However, what interested me most was not the treatment of the usual suspects, but how the juxtaposition of the various stories – the invention of mortgage-backed securities, the rise of Countrywide, the development of AIG’s credit derivative business – reveals subtler villains and difficult puzzles. Much of what I find interesting below may not strike you as novel, but the value of this book may be in getting us to look once more with fresher eyes at patterns that tend to submerge back into the vastness of the big picture of the crisis. The book still has me mulling over the following:
Making the numbers: the poorest decisions by financial institutions and regulators were driven by a monomaniacal focus on managing according to a single measure of success: Countrywide’s management was obsessed with market share, policymakers fixated on homeownership percentages, and, of course, short term share price preoccupied any number of firms. Perhaps the subtlest but most telling examples of management by numbers – both stupid and smart -- is the contrasting attitudes that Wall Street firms took towards measures of risk like “value-at-risk” (“VaR,” which measures the maximum loss that a firm could expect in its portfolio from specified kinds of risk with say a 95% confidence interval). The book contrasts banks such as Merrill Lynch, on the one hand, and their more sophisticated competitors like JP Morgan and Goldman, on the other. McLean and Nocera portray Merrill’s CEO, Stanley O’Neal, as being obsessed with massively and crudely increasing his firm’s risk solely to earn the same profits as Goldman. At the same time, the authors describe how banks that used raw VaR numbers as a lodestone failed to understand the limitation of VaR models – such as the fact that the model says nothing about the level of losses in the remaining 5% of cases (to use the above confidence interval). This created incentives for traders to game models by making investments that would not be captured in VaR figures – for example making trades with a low probability but high magnitude of potential losses to fit into that unknown 5%. Contrast this with the attitude towards VaR of both the metric’s creators at JP Morgan and the senior executives at Goldman; at these firms, the firm’s VaR number – which was often recalculated at the end of each trading day -- was seen as the beginning of the conversation on appropriate levels of risk for the firm, and not the end.
Most readers will likely be less interested in the limitations of risk management tools than I’ve been, but the more general lesson on the dangers of managing according to simple numbers has broader implications. Americans seem hardwired for lists and rankings (with the end-of-the-year bacchanalia of lists now upon us). The danger of making decisions based solely on “hard numbers” has dangers not only for industry, but also for government and statecraft. Think of how many Presidents set goals for increasing not only homeownership, but also for goals such as levels of college education or exports. What nasty tradeoffs, for example, irresponsible oversight of student lenders, are made in order to meet brute goals? Academics are not immune from this fixation with navigating according to simple numbers – witness the games played with school rankings (or even the obsession – heaven forbid – with law review placements and citation and download counts).
Bully cultures and dissent: it is also striking to see how the firms that fared the worst – like AIG and Merrill – suffered more because of a culture of bullying, in which risk management was not only marginalized, but dissent was squelched with screaming and naked power plays. Contrast this again with the portrayal of Goldman, which, by no means a warm and fuzzy place, nevertheless encouraged active discussion and debate on levels of risk-taking and potential threats to the firm. There is also a direct parallel to the tale of how Bob Rubin and Larry Summers responded to Brooksley Born’s concerns on the regulation of OTC derivatives during the Clinton Administration. I can be reflexively skeptical every time an academic brings up the fuzzy concept of “culture,” but the book makes a powerful case for institutional cultures in which dissent is allowed and ego is channeled.
Accounting scandals were the smoke, the fire came later: the experiences of both AIG and Fannie Mae may surprise in that accounting and regulatory scandals did not chasten behavior and risk-taking. Instead, they seem to have merely pushed risk-taking, as if hydraulically, to other parts of the organization. This may perplex many lawyers – wouldn’t you think that being called to the mat by the government would sober up a client and increase the leverage of the in-house compliance chaperones?
Instead, it appears that the competitive and cognitive dynamics of a continuing bubble dominate – something I examined in 2006. These dynamics radically alter decisions to comply with law and can far outweigh the effects of scattershot prosecutions and enforcement actions. Regulation through litigation seems a rather quaint idea after reading this book.
CEOs with J.D.s: speaking of in-house compliance guys, it is also striking to consider again how many of the ceos of financial institutions had j.ds – Rubin and Blankfein at Goldman, O’Neal at Merrill, Prince at Citi, Raines at Fannie Mae. I’m not sure what this means other than to explode the myth that going to law school makes one automatically risk averse. Might having a law degree counterintuitively mean that an investment banker has to take a convert’s attitude towards financial risk: become more Catholic than the Pope?
Where were the lawyers?: This question has been asked many times by many others, and unfortunately this book does little to answer the question. Lawyers and their role in the many fateful decisions of firms and agencies are largely degree absent from the book. But there are certainly clues. The book provides many examples of “siloing,” in which different groups within a firm did not share valuable information on risk – for example, the level of “stated documentation” mortgages being made – with other groups. This explains to a large degree how the build up of risk both inside a firm and system-wide was missed. Were lawyers unable to play the siren role because they were stuck in a silo or marginalized? Or was it their lack of understanding about finance and economics?
Or is perhaps the inherent conservatism of our profession also counterintuitively to blame? Think about how precedent works for transactional lawyers. If a model agreement has worked many times before, it may be less likely to be questioned anew. If a lawyer were to suggest new risk factors for securities disclosure what might happen? Likely there would be pushback and a request for an example of someone else using that language – in other words, a request for precedent.
Did lawyers fail to apply enough pressure on the brakes due to reluctance to displease or lose clients? Or was a broader shift in professional norms at work, in which lawyers saw their role as helping clients develop work-a-rounds for regulations rather than as counselors counseling compliance with the law. At a conference earlier this year, a friend of mine phrased the distinction as the difference between a role of “transaction cost engineer” (borrowing from Gilson) and one of “protecting the franchise” of law.
Answering the question of “where were the lawyers” has profound implications not only for scholarship, but moreover for legal education. Will the crisis cause legal educators to re-think what we do in the classroom? If so, I hope we move beyond simplistic calls for more ethics classes? Business schools (my apologies, David) have a patent on rolling out new ethics programs as a clockwork response to each new wave of scandal. Excuse my hearty skepticism about whether those courses really change the behavior of future bankers, or whether they are more window dressing to make donors and universities feel better. Ethics courses may help the conscientious be aware of difficult questions, but only rules – whether imposed by law or a community – will deter the true “bad man.”
So All the Devils was a welcome read, even in a busy season, because of all the thinking it has forced me to do. On a more abstract level, it has also made me think about my own scholarship as I continue to plow away on my own book. One limitation of McLean and Nocera’s journalistic account is that it focuses much on the individual decisionmakers – a version of a Great Man account of history. The reader may be left thinking “if only these individuals had made these particular choices differently.” Focusing too much on the trees misses the systemic forest of failures. Had Angelo Mozilo not pushed Countrywide deeper into riskier mortgages, some other firm would have taken its place. To McLean and Nocera’s credit, they do provide brief and accessible accounts of some of the scholarship on the meltdown – such as Gary Gordon and Andrew Metrick’s account of a “bank run” on the repo market. Still, the lion’s share of the book is devoted to the personal.
Yet the personal and narrative approaches can serve as a tonic for scholarship, my own included, that emphasizes economic and institutional forces and downplays individual decision-making. One limitation of this latter approach is that it may – although not by necessity – lead to giving short shrift to “softer” factors that contribute to crises, such as changing norms. Moreover, a focus on economic and legal changes may be misread to suggest that human agency has no part in the equation. For all the justified reluctance to inject morality into financial crises – and I do reject the idea that human nature changes from age to age or that greed was an invention of the last ten, twenty, thirty years -- downplaying the human element can lead to the trap of believing that all was pre-ordained by iron laws of history.
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