By: Patrick O'Brien
How often have you wondered what exactly happened during the subprime crisis, when the financial system nearly collapsed and trillions of dollars of “wealth” evaporated? I have read numerous articles and attended sessions at risk management conferences, but truly understanding what went wrong has escaped me, until now. Gillian Tett’s splendid book, Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe, has given me a new level of insight into the complex world of financial derivatives and an appreciation for the events that preceded the melt down.
I work in the computer software business and experienced firsthand the dot-com bust of 2000. As VP of Corporate Strategy for a public software company, I was involved in M&A activities, strategic partnerships and large OEM deals with dot-com companies. I rode the wave of going from $15/share to $95 and back down to $5. I understand the difference between client/server, n-tier, and cloud computing, and the subtleties between ISV, OEM and VAR relationships (in this context VAR means “value added reseller” not “value at risk”). I know why the dot-com era was a façade and why the bubble eventually had to burst.
As I read accounts of what was happening during the subprime crisis, I struggled to understand key concepts such as CDS (credit default swap), CDO (collateralized debt obligation) and SPV (Special Purpose Vehicle). I blamed my inability to grasp what was really happening on my lack of experience with complex financial products: I wasn’t “in the business.”
After reading Tett’s book, I now realize that I wasn’t the only one who couldn’t figure out what was going on. “As the pace of innovations heated up,” Tett writes, “credit products were spinning off into a cyber-world that eventually even the financiers struggled to understand. The link between the final product and its underlying assets was becoming so complex that it appeared increasingly tenuous. . . . Most financiers lacked the cognitive skills to truly understand the connections in this new world.” Oh yes, and “even regulators seemed only vaguely aware of what the banks were really doing.”
I highly recommend reading Tett’s book. She is able to decipher Wall Street mumbo-jumbo in terms that a lay reader, or at least a determined lay reader, can understand. Tett provides a rich cast of characters and a storytelling device that helps make this book compelling fun to read. More importantly for risk managers, however, you will also gain a new appreciation for the significance of sound risk management for your organizations. There are lots of reasons why the crisis developed, for example greed, carelessness, and deceptive practices. But across the financial services industry, systemic weaknesses in risk management culture, discipline, and implementation of best practices added fuel to the flame.
In a subsequent blog I will summarize some of the key risk management lessons that Fool’s Gold uncovers.
Fool’s Gold: How the Bold Dream of a Small Tribe at J. P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe. Published by Free Press, 2009.
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