"Tornadoes are caused by trailer parks." Norm Augustine, former chief executive of Lockheed Martin, coined that aphorism a few years ago after seeing one too many photos of mobile homes that had been devastated by twisters.
A similar misapplication of logic is now evident in discussions of the economic havoc surrounding subprime mortgages. These flimsy loan structures have been splintered by a financial tornado, but they were not the cause of the storm. For that you have to look deeper into the financial system, to the regular pattern of bubbles and binges that has been evident during the past several decades.
A useful compilation of these recurring crises appeared in the Financial Times last week in an article by former Treasury secretary Lawrence Summers. He cited the 1987 stock market crash driven by lockstep "pattern trading"; the rise and sudden collapse of savings and loan institutions in the late 1980s; the frantic borrowing by Mexico that spawned the 1994 peso crisis; the lending binge that led to the 1997 Asian financial crisis; the Russian debt default of August 1998 and the ensuing demise of Long-Term Capital Management; the technology bubble of the 1990s that burst in 2000; and the deflation worries that followed the collapse of Enron in 2002.
These disparate crises share a feature: In each case, capital flooded into assets that were thought to offer higher returns -- only to flood back out when the assets proved to be shaky. Investors overlooked the ordinary risk factors in their hunt for extraordinary profits. Rather than contenting themselves with the average "beta" returns of, say, the Standard and Poor's 500, they sought what a magazine for hedge fund managers last year described as "portable alpha." They were seeking a world like the one at Garrison Keillor's mythical Lake Wobegon, where all the children are above average.
Subprime mortgages are the latest example of the financial world's relentless push for higher yields. As has been widely noted, the term "subprime" was a euphemism for loans that did not meet traditional standards of creditworthiness. The financial wizards believed that by combining these mortgages into large pools that could be turned into securities and then dicing them into pieces that allowed investors to choose their desired level of risk, they could vitiate the underlying problems. A big basket of uncreditworthy loans, in other words, was thought to be safer than the individual loans themselves.
Wiser heads kept warning about the potential for disaster in this "appetite for risk," as the Bank for International Settlements described it in its annual report last summer. But financial bubbles must be lived forward, even if they can be understood only in reverse.
The crackup finally came this summer, as worries spread about the extent of losses from subprime loans and panicky financial institutions rushed to dump anything that might be contaminated. Just as capital knows no borders, neither does fear. The global race for the exit became so frantic that central bankers grew concerned that the payments system wouldn't be able to accommodate all the traffic and would freeze up in a classic financial panic. So the Federal Reserve led a rescue effort, pumping in hundreds of billions of dollars in liquidity and announcing a surprise cut in the discount rate.
People looking at this crisis in isolation expressed relief that the Fed bailout seemed to have worked. But I find greater cause for worry. What we are seeing is a financial addiction -- to ever-more exotic classes of high-yielding assets to tempt global investors and then to the Fed's infusion of liquidity to keep the system from self-destruction. The financial world, you might say, is addicted both to the heroin of high yields and the methadone of the Fed's rehab program.
Investment guru Warren Buffett has been warning for years about the dangers of derivatives -- the complex financial instruments that undergird modern capital markets. The problem is that derivatives, with their interlocking contracts that are often little understood even by financiers, bind the elements of the global system together while obscuring the weakness of the individual pieces. What happened in August's panic was partly that nobody in the markets could be sure how bad the subprime fallout would be, because it was obscured by all the swaps and hedge contracts. The French bank BNP Paribas sent the panic into overdrive when it suspended trading in three of its funds because it couldn't value their losses.
The Fed can keep rescuing the financial markets by providing emergency liquidity to rebuild the flimsy trailer parks. But it's time to look at the tornado itself -- the immense unregulated flows of capital and the new financial instruments that give them such devastating velocity.
David Ignatius