Gillian Tett, Meet William Cronon

On my way back from India, I read Gillian Tett's "Fool's Gold: The Inside Story of J.P. Morgan and How Wall St Greed Corrupted Its Bold Dream and Created a Financial Catastrophe."  [The book's changing subtitles is a topic in itself!]  That awkward subtitle is perfect for the book's quite strange structure.  Tett wants to tell the story of how credit derivatives began (with J.P. Morgan's invention of the BISTRO instrument) but that's not the story her readers will be mostly interested in (that would be the financial crisis).  So she tells the story of the invention of credit derivatives, and then quickly segues into the story of the financial crisis, the prime culprit of which was the use of credit derivative instruments to home mortgages.  The problem is that J.P. Morgan was not a part of this second trend; other banks, however, plunged in with relish, with consequences that we all know about.  Which puts Tett in the strange position that she tells the story from J.P. Morgan's point of view, when all the real action was happening somewhere else.  
 

But no matter.  All that said, Fool's Gold is the best book I've read about the crisis. (To be fair, I've only read three others.)  First, it's about the invention of credit default swaps (CDS), rather than simply mortgage-backed securities (which, if I understand Tett right, were benign instruments dating back to the 1970s).  Second, she gives a really good account of why credit derivatives were invented, and consequently what the "shadow banking" sector is all about.  Moreover, her account convinced me that contrary to what the J.P. Morgan bankers say, the invention of the credit derivative was the key to the financial crisis, not so much because of the instrument itself, but for the reasons for which it was invented.    

Let me explain.  Essentially, the J.P. Morgan bankers invented the CDS to circumvent Basel regulations about capital requirements.  Basel rules required that banks keep a certain amount of liquidity to insulate them from bank runs in the case that their clients default on their loans; this liquidity requirement is in direct proportion to the "risk" that the bank has taken on.  J.P. Morgan's clients tended to be blue-chip corporations, and the risk of default was therefore minimal.  Basel regulations were hindrances that prevented Morgan from making more profits; therefore they had to be subverted.  Morgan accomplished this by creating the swap, it insured the riskiest part of its loans, and thereby shifted the risk off its books.  This meant they required lower liquidity, and could invest the money into higher profits.  (A CDS is a contract the bank makes with another party: the bank pays the party a steady fee in return for which the party agrees to insure the bank in the case of default.)  

Morgan's key innovation, as Tett documents, was that it was able to standardize the credit default swap.  Rather than the slow process whereby the two parties for a CDS contract needed to be found, the Morgan bankers found a way to mass-produce these instruments: their solution was "tranching."  All the loans on the books were bundled together, and separated into portions with different risks.  A key part of this was that the amount of risk needed to be standardized so that the parties to the CDS contract would know exactly the kind of debt that was being insured.  Enter the ratings agencies which were only too happy to do this: for a nice juicy fee, they looked at the debt, applied their models to it and estimated the amount of risk, which they then standardized into levels or tranches.  AAA was the least likely to default, BB was a little more likely and so on.  This worked out well for corporate loans, which could be diversified, but not so well for home mortgages.

 

Reading Tett's account of the invention of BISTRO took me back to William Cronon's story of the grain trade in Nature's Metropolis.  Cronon begins by describing how the grain trade worked prior to the railroads.  The grain would be stored in sacks, and transported manually (across the river and across Lake Michigan) by the traders (who were usually small shop-keepers), who would then sell it in other cities.  The sack in which the grain was stored was crucial to its transportation: it changed boats multiple times during its journey and the sacks of each seller were kept separate.  It was also the key to its exchange value: the grain was examined by a buyer, a mutual price decided on based on the quality of the grain, and then sold.   

The building of the railroads changed this.  Because railroads were built privately, and had a great capital cost, they concentrated on maximizing the shipment of goods from the hinterland to the city (and they could even operate in the winter!).  This meant a rapid turnover – quickly emptying a carriage so that it could be used again for a different trip – and the sack of grains became an obstacle to this.  The railroads solved it by the invention of the steam-powered grain elevator which made the loading of grains from warehouses into the railway cars easy and efficient.  The problem was that there was no room for sacks of grain in this scheme; to maximize profit, all the bins in the elevator needed to be filled with grain, therefore grain from different farmers had to be mixed.  Thus the first step in the chain of standardization took place: the local merchant (or even farmer) was separated from the grain he produced.  

Yet, mixing the grains from different farmers together needed one further step: the creation of different "grades" of grain so that even if mixed together, its price could still be determined.  The Chicago Board of Trade, formed in 1848 and whose membership consisted of Chicago grain traders came up with such a classification and over time, this classification started to be widely used.  Thus a further distancing of the grain from its trade took place.  Traders no longer had to sell grains physically.  Instead an elevator receipt – which showed that a certain quantity of a certain kind of grain had been sold – could itself be traded amongst traders.  The receipt could be used to buy grain from a warehouse but this was not the grain that was actually sold; instead, it was a functionally equivalent substitute.

A final step was the role of the telegraph in setting the prices of grain.  The telegraph allowed communication between, say, Chicago and New York markets, which meant that the price of grain in New York markets could affect Chicago's.  The standardization of the grain also helped here: it was no longer necessary for a buyer in New York to manually inspect the grain that he was being sold; instead he would know of its quality because it had been "rated" as being of a certain category.      

    

All of these trends – the standardization of the grain into grades, its effective separation from the particulars of its production i.e. its commoditization, and the fact that it was now easy for buyers and sellers to make contracts over long distances – culminated in large volumes in futures trades of grains and sometimes led to “Corners,” artificial shortages created by speculators.  Cronon sees the increase in the grain trade due to standardization as responsible for the change in the landscape around Chicago.  

I will stop here, but the parallels between the grain trade and the derivatives trade are clear.  Just as the grain becomes effectively separated from its producer, the loan issued by the bank became separated from the party that the loan was given to.  And just as the grains of farmers were now mixed together in standardized bins of different "grades" of grain, so also debt from different parties was mixed together and labeled along a standardized spectrum of risks.  And this standardization helped along a further trade in these instruments themselves... Cronon calls this the "logic of capital."  And so it is.  But the commoditization of the grain trade grew from the railroads' insistence on maximizing turnover: this was the only way they saw of making profits to offset their high capital costs.  The banks too wanted higher profits, but their obstacle was not the movement of goods but capital regulations.  Credit derivatives, it is very clear from Tett's story, were created to make a run around regulations.    

All of which is not to say that standardization is a bad thing, per se.  But rather to say that standards need regulators.  When the standardization doesn't work, when the standards stop reflecting what's "inside," then we all pay a price.