Economics Financial Crisis

Theories of the Financial Crisis: Hubris of the Bankers

[digg-reddit-me]No list of theories of causes of the financial crisis that almost destroyed the fabric of the world economy (as opposed to the slow-motion disaster unfolding now) would be complete without listing hubris, that most Greek-mythical of faults.

Hubris clearly isn’t the only reason. There was greed – we all know that. There were various incentives that distorted the system as a whole. There was an enormous imbalance between East Asian countries and America that assisted in producing unmooring our financial industry. There was government intervention. There was a shift in the animal spirits. There was a profound miscalculation of risk. There were assets bubbles, Goldman Sachs, deregulation, new financial instruments, and a subservience of politics to finance.

But how can one explain how far out on this limb all of these venerable institutions went – how they thought they would be able to leverage themselves 33 to 1 – how they took on so much risk they almost brought down the financial system built over centuries in a week. Bankers didn’t take to calling themselves “Masters of the Universe” because they were being ironic. No – at the heart of this crisis – and reasserting itself now as they try to restore “normalcy” to their profession – was hubris.

Michael Lewis – who worked on Wall Street as a young man – described this hubris brilliantly in an essay published in the immediate aftermath of the financial collapse for Portfolio. He described how countless warning signs were ignored – because the money and the success had gone to the heads of these titans of Wall Street. (He steers away from the more high profile Cassandras from Nassim Nicholas Taleb to Nouriel Roubini to Brooksley Born.) After all, how had they gotten so much money if they didn’t know what they were doing? Lewis, unable to make that “logical” leap himself, had left Wall Street in the late 1980s, expecting the whole house of cards to fall at any moment:

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue…

In [the past two decades], I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?

At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.

Michael Osninski – who wrote programs creating derivatives – explained his rationalization for why he was able to make so much money:

[E]ven then, I was wondering why I was making more than anyone in my family, maybe as much as all my siblings combined. Hey, I had higher SAT scores. I could do all the arithmetic in my head. I was very good at programming a computer. And that computer, with my software, touched billions of dollars of the firm’s money. Every week. That justified it. When you’re close to the money, you get the first cut. Oyster farmers eat lots of oysters, don’t they?

Everyone seeks to claim credit for the successes that they benefit from – so, as the money flowed into Wall Street and all together people who didn’t quite understand what they were doing worked together and together inflated the prices of assets they didn’t know enough about to value – everyone got rich.

Contributing to this sense of unreality – and this hubris – was the culture that grew up around these people. They learned how to manipulate the programs written by the lowly programmers that created derivratives and other complex assets – and created a language that was opaque to those outside the club – of super senior risk, of CDS, CMS, and sundry other financial products. They sealed off their world from outside inspection, blocked regulation at every turn – and came to believe they understood the system. Though many must have understood their ignorance going in – as Lewis did – their success washed away their concerns. A gambler doesn’t need to know how roulette works if everyone who is playing the game is winning.

But hubris always leads to a downfall – and so, in the fall of 2008 2009, the house of cards created by these “Masters of the Universe” collapsed – and with it, the life savings of millions who trusted the brash bankers.

In the end it seems, no rational analysis or argumentation could convince these titans of Wall Street that their success was based on luck rather than knowledge or skill. And they ignored or marginalized who demonstrated otherwise – until it was too late. Too many seemed to have believed their own hype. It was as if they truly thought they were “Masters of the Universe.”

And now that the financial system has gotten back on its feet – and as the rest of the economy is still suffering – this hubris, which seemed to have fallen with the stock market, has reinflated. As a top Goldman Sachs official said commenting on the high levels of risk the firm was taking on – and the best-ever profits they were generating from that:

Our model really never changed, we’ve said very consistently that our business model remained the same.

The near-collapse of the financial industry is apparently no match for the hubris of bankers.

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[Image by thehutch licensed under Creative Commons.]

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