How did it happen that the hedge fund managers, bankers, and big-league brokers made the kinds of mistakes that precipitated our dizzying financial crisis and, in turn, a world-wide recession?
These were, on the whole, highly educated people. Their educations prepared them to act as they did. Many of them learned in business school that the path to wealth and success was, in effect, high-stakes gambling with other people’s money. They learned that “value” is a fiction that can be created by manipulating symbols. They learned to measure success not by the real world consequences of their actions but by comparing their illusions to other illusions.
Blame for the financial crisis, of course, can be served up in heaping portions to a great many people. We don’t lose “more than $50 trillion in stocks, real estate, commodities and operational earning within 15 months” as the economist Hernando de Soto summarized it, without a lot of help. De Soto puts the new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) at the center of the crisis, and complains that the deep problem is that these instruments represented “property” outside the body of legal norms that make property meaningful. What exactly is a collateralized debt obligation? A credit default swap? While it isn’t hard to find technical definitions of one or the other, both are a bit like string theory in physics: theoretically elegant, but remote from any possible human experience. They represent notional property—not anything you can walk on or pick up, eat or drink, or even conceive as having a local existence, like a time-share condo. Money itself may be an abstraction, but the new derivatives are abstractions of abstractions. They are a kind of perfected nothingness, and they reside in an international realm above even the rule of law.
That’s not to say they lack consequential reality. We know all too well they share that part of our earthly existence.
No Underlying Reality
When I first heard about these derivatives they struck a chord. It sounded as though Wall Street had wandered into a contemporary English department and gotten drunk on postmodernism. Don’t worry about the underlying reality of things; there is no so-called “underlying reality.” Everything is radical contingency. We make up our lives as we go along; and we make-up our institutions too! Improvise! That’s the only rule. If one improvisation grows stale, improvise another on top of it, and another and another. The bills, so to speak, never come due once we realize that bills, like everything else, are just more fictions.
In this imaginary universe, Bernie Madoff’s failure seems to be only insufficient effrontery. If his pyramid had been a bit larger and his fictions more grand and abstract, he might have been another A.I.G.
Although we now know that much of the “value” that our financial institutions had conjured up in the last decade by means of exotic instruments has vanished, it is hard to understand where it went. Was it pure mirage? Perhaps not, but it definitely had a quality of shimmering-on-the-edge-of-reality. Pauline Wallace, a partner at PriceWaterhouseCoopers LLP, told Bloomberg.com that she regarded the off-balance-sheet accounting behind these instruments “as a bit of a magic trick. Magicians come to parties, and they make things seem to disappear. The risk is somewhere, but you never knew where.'
Mirage-central is the American Securitization Forum, which describes itself as “a broadly-based professional forum through which participants in the U.S. securitization market can advocate their common interests on important legal, regulatory and market practice issues.” The word “securitization” is itself a bit of postmodern irony. It sounds like it has something to do with security, that happy state where anxiety is quieted and threats have been banished. But “securitization” has nothing to do with that. It is, rather, the bundling together of various financial instruments already at one level of abstraction from the underlying property to create a new financial instrument at a second level of removal from the underlying property. InvestorWords.com defines securitization as, “The process of aggregating similar instruments, such as loans or mortgages, into a negotiable security.”
These second order securities are “derived” from the original assets, and in the process those assets are divided into small pieces and spread around. The new second-order securities are supposed to create cash flows, and they have no fixed value: their “value” shifts as the market assesses what they might be worth.
Among other things, ASF runs the ASF Securitization Institute in Manhattan where “securitization industry professionals” can take courses from “senior industry practitioners.” The topics covered in “Securitization Fundamentals” don’t sound all that much like Mephistopheles whispering in Faust’s ear:
- Basic securitization concepts and vocabulary
- Overview of market participants and their roles
- Introduction to securitization analytics
- Legal, regulatory, and accounting frameworks
- Factors in structuring a deal
- Mechanics of bringing a deal to market
- Trading and evaluating seasoned securitizations
- Management of a portfolio of securitization investments
- Outline of international securitization market concepts
But it is best to keep in mind that these are lessons in how to build palaces out of pure and unregulated risk.
Last October, when word spread among “securitization professionals” that the Financial Accounting Standards Board (FASB) was considered a rule that would require bankers to put trillions of dollars of these off-balance sheet financial improvisations onto balance sheets, the American Securities Forum held a meeting in Charlotte, North Carolina to decide how best to fight it. As Bloomberg.com reported at the time, ASF executive director George Miller then went to a U.S. Senate hearing to inveigh against the FASB proposal. His pitch was pitch-perfect irony. Speaking for an industry that reveled in creating mammoth and literally unaccountable risk, he warned, “There are great risks to the financial markets and to the economy of moving forward quickly with bad rules.”
The industry preference was for no rules, since it was the possibility of free-form invention that had allowed the U.S. banks, as Bloomberg.com put it, to “export toxic debt around the world.” The absence of specific regulation of derivatives was the loophole that swallowed the global economy. The key to the crisis is that the banks, hedge funds, and other financial institutions were able to operate in a universe of their own make-believe.
But, of course, the hedge fund geniuses weren’t introduced to postmodernism in its English department instantiations. They got it instead in business school.
$50 Trillion Mishap
Before I continue with that thought, I want to plant myself firmly in reality. American higher education is not a precipitating factor in our $50 trillion mishap. It takes many cooks to brew something this rotten. The repeal of the Glass Steagall Act under President Clinton in 1999 was crucial. Glass Steagall Act, passed in 1933, separated investment and commercial banking, and was intended as a brake on the kind of speculation that would put banks at risk. President Clinton led the effort to repeal it. The “investment community”—we use the term lightly—sought the change because the restriction was seen as a “relic,” and something that impeded investment opportunities. It now looks like this was a relic worth preserving. Without Glass Steagall to prevent them, banks loaded up on trillions of dollars of bad investments.
Blame also reposes, like a rotting albatross, on the shoulders of those who imagined that the housing market could endlessly expand on the basis of subprime mortgages. The beginning of this folly dates all the way back to the Community Reinvestment Act of 1977, signed by President Carter. CRA created the basic structure for making home mortgages to people who did not meet the ordinary criteria for those loans. During the 1980s, community activists lead by ACORN launched a strategy of suing banks and otherwise intimidating them into making more and more such loans. Banks initially resisted but with pressure from Congress began to get with the game. We know what follows: the banks ameliorated the risk by cutting the sub-prime loans into millions of little pieces and spreading them, via mortgage-backed securities, everywhere. Once upon a time, people thought the best way to deal with poison was to isolate it. The new idea was to spread it around as much as possible.
When it was late in the day but perhaps not too late to do something about the impending collapse of the housing market, we had Congressional leaders including Christopher Dodd, chairman of the Senate Banking Committee, and Barney Frank, chairman of the House Financial Services Committee, firmly and, as it happens, decisively standing in the way of any attempt to curb the profligate Fannie Mae or in-over-their-heads lenders such as Countrywide. Meanwhile, chairman of the Federal Reserve (1987-2006) Alan Greenspan had helped to inflate the housing bubble by keeping interest rates too low too long.
Mighty Big Attitude
I rehearse this list of malefactors and poorly conceived policies to avow that the Great Financial Crisis of our times cannot be placed entirely at the feet of greedy bankers and hedge fund managers, and their educations therefore are only one thread in great tapestry of folly. But it is nonetheless a thread worth following. It means something. The indirect contributions to the financial crisis are worth bearing in mind. They help us understand what didn’t happen. Why smart, educated people didn’t say, “Look at this loophole. We had better persuade the authorities before some unscrupulous person finds it and makes a real mess of things.” Or, “We could make some fast returns doing this, but it would screw things up for everybody in a few years—including us.” Or, “This way of proceeding pushes the problem out of sight. Neither the government nor the public will see it, but we can’t do it. It is wrong.”
Those things didn’t happen because business students weren’t educated to see the world in such terms. Harvard Business School, for example, has spent decades glorifying a mole’s eye view of the world. The “case study” approach emphasizes the skills needed to advance your business—an approach that makes ethics a mere externality. Harvard is now alert to the problem and is now developing—you guessed it—a case study in “whether the school is failing to teach students to understand and manage risk.” That’s how Oliver Staley, writing on Bloomberg.com puts it.
The topic of what might be called MBA complicity is suddenly in the open. Last week, The New Republic carried an essay titled “MBA Frayed” byBradford Plumer that opened with a re-hash of the story of Andrew Lahde. He was the hedge-fund manager who last year cashed out on top strewing derisive comments about the MBA grads “who were (often) truly not worthy of the education they received (or supposedly received) [yet] rose to the top of companies such as AIG, Bear Stearns and Lehman Brothers and all levels of our government."
Plumber serves up some other fine comments, including an admission by an Indiana University-Bloomington professor of finance who acknowledges that the financial tools at the heart of the crisis were “taught and developed in business schools without, often, a full appreciation for how they could go sour.”
Lists of alumni implicated in the financial crisis are making the rounds. On “Magna Cum Lousy” Joe Weisenthal presents a slideshow of “Where Today’s Bad CEOs Went to School.” Weisenthal’s premise: “Most of the bankers, politicians and regulators who got us into this mess went to a handful of elite universities and business schools.” He starts with the University of Chicago:
-- John Meriwether (LTCM hedge fund manager)
-- Robert Steel (Former Wachovia CEO)
-- Rob Levin (Former Fannie Mae CFO)
-- Clifford Asnes (Hedge fund manager)
-- Mark Carhart and Ray Iwanowski (Goldman)
-- Peter Peterson (Blackstone)
-- William Conway (Carlyle Group)
-- Brady Dougan (Credit Suisse CEO)
-- Jon Corzine (NJ Senator, Goldman Sachs)
NYU, Columbia, Wharton, Princeton, Dartmouth, MIT, Yale, and Harvard round out the lists. Weisenthal is offering mockery, but his explanation is perfectly accurate: “These schools obviously helped frame [the] philosophies [of their graduates], while providing the networking opportunities needed to climb the highest rungs of the corporate and political ladders. It turns out, of course, that those ladders were planted in mud, rather than solid earth.”
“Magna Cum Lousy” is home-made parody, but as Staley says on Bloomberg, even Harvard Business School has been “stung by criticism that it hasn’t prepared alumni to cope with the economic meltdown.” That criticism is cropping up in respectable quarters. In November, Business Week ran a forum titled “Business schools are largely responsible for the U.S. financial crisis. Pro or con?" The pro side, argued by two Harvard Business School professors, went straight at it: “Ideas and tools—exotic financial instruments, poorly designed compensation plans, models of corporate leadership that value leaders’ charisma over substance, an uncritical embrace of laissez-faire models—were taught to MBA and executive-education students without considering whether these idea and tools would contribute to a firm’s long-term well being or endanger the legitimacy of the U.S. capitalist system.”
They called for “business leadership” to be defined “in terms of value creation, not value extraction.” That’s bracing, but the jargon is a little bit worrisome. “Value creation” presumably means increasing the value of assets, but it sounds a bit like the idea that “value” itself can be created, and isn’t that the core illusion of the world of derivatives?
Last month, the Financial Times (London) pointed another arrow in the same direction, in “Harvard’s Masters of the Apocalypse: If his fellow Harvard MBAs are all so clever, how come so many are now in disgrace?” In it Harvard MBA Philip Delves Broughton politely suggests that the “jargon-spewing, value-destroying financiers and consultants have done more than any other group of people to create the economic misery we find ourselves in.” Many of the critics of B-school fecklessness stop with the roll call of disgraced U.S. executives such as Stan O’Neal and John Thain (Merril Lynch CEOs) but Broughton reminds us of the worldwide reach of this kind of training. The Royal Bank of Scotland executives, Andy Hornby and Fred Goodwin, for example, were other Harvard MBAs who led their company over the cliff. And not so long before Harvard Business School had been featuring The Royal Bank of Scotland in not one but two case studies as an exemplar of good organizational architecture and excellent “human capital strategy.”
Broughton captures what I take to be a crucial component of the whole phenomenon of business education as preparation for economic and social disaster:
“During my time at the school, 50 students were chosen to participate in a detailed survey of their development. Scott Snook, the professor who ran it, reported that about a third of students were inclined to define right and wrong simply in terms of what everyone else was doing.
‘They can’t really step back and take a critical view,” he said. “They’re totally defined by others and by the outcomes of what they’re doing.’”
Of course, that’s only a third; and it may not apply equally to other schools grading the 150,000 MBAs produced in the U.S. each year. Still, the number seems roughly consonant with the results.
The “Real World”
The connection between higher education and the financial calamities of our times, however, is not merely a matter of what happens in business schools. It goes deeper. The hedge fund D.E. Shaw, for example, used to advertise regularly in the Chronicle of Higher Education. The ads were little masterpieces of intellectual snobbery. They didn’t identify what D.E. Shaw actually does. They just offered a word-picture of a place where really, really bright college graduates with the right touch of sophistication could thrive in one another’s company. The ads allowed that “many employees feel that the firm combines some of the most attractive features of academia.” The D.E. Shaw website still lists job opportunities in the same hushed tone mahogany-paneled privacy: “The firm is extremely selective in its hiring, and can give serious consideration only to individuals having extraordinary intellectual capabilities, communication skills, and general ‘real world’ competence.” The genteelly skeptical quotation marks around “real world” are a nice touch.
None of this of course proves a deep connection between the financial catastrophe and the tenor of contemporary higher education. I offer it simply as informed intuition of what has happened. We could call it simply a failure to provide a foundation in the liberal arts—not as they are now but as they once were. What’s missing is the capacity to comprehend the world as a whole thing, in which our actions have potentially far-reaching, yes, real world consequences, and we experience the moral weight of what we do. I don’t mean “moral weight” as served up by contemporary ideologies that dwell on identity groups and carbon footprints, but the moral weight of knowing that life isn’t simply a trip to the casino.
Harvard Business School now seems to think that it can set matters right in its curriculum by teaching students to understand and manage risk better than before. That may be a good step but it seems to come nowhere near the problem of students who define right and wrong simply in terms of conformity to those around them. Those students will obviously follow the safe course and take the risks that others take. Not just Harvard business students, but students everywhere these days are saturated in a rhetoric of leadership that paradoxically seems to stifle both independent thinking and moral gravity. Perhaps that is because leadership without a sense of the hard-edges and tragic quality of life can never be more than a style.
Style without content, or content reduced to expertise in applying clever formula—that’s the stuff out of which the hollow men who have brought us this catastrophe are made. The crisis of financial derivatives was brought to us by human derivatives—people who are abstractions of abstractions, and no moral substance at all. They are bought to us, in no small part, by a university that has placed its own bets on an unsound philosophy.