“Exotic financial instruments,” you say?

missionsOver at The New Yorker, John Lanchester provides just about the pithiest summary of Our World of Hurt. Even if you don’t pick up any of the books he’s reviewing, this piece is essential reading for a full understanding of the outrageous irresponsibility of investment bankers.

Primarily, he answers the biggest question left remaining on the whole mess: what are credit-default swaps?

“SAY YOU’RE IN THE GROCERY BUSINESS, and feel gloomy about your prospects. Your immediate neighbor is in the stationery business, and he feels gloomy about his prospects, less so about yours. You get to talking, and one of you hits on a brilliant idea: why not just swap revenues? You take his earnings for the year, and he takes yours. The actual business doesn’t change hands, making the swap, in banking terminology, ‘synthetic.’

…But competition was making those swap deals less profitable. The quest was for a new, and therefore newly lucrative, product to sell. What got the J. P. Morgan team rolling was this thought: instead of swapping bonds or currency or interest rates, why not swap the risk of default? In effect, it could sell the risk that a borrower won’t be able to pay back his debt. Since banking is based on making loans to customers, the risk of default by those customers is a crucial part of the business. A product that made it possible to reduce that risk—by selling it to somebody else—had the potential to create a gigantic new market…

The new financial instruments, as clever as they were, had an unfortunate side effect: they broke banking. At its heart, banking is a simple business. Customers deposit money at a bank, in return for interest; the bank lends that money to other people, at a higher rate of interest. This isn’t glamorous or interesting, but banking is not supposed to resemble skydiving or hip-hop; what recommends it is that it’s a good way of making steady money (and of creating credit in the economy), as long as the bank is careful about whom it lends money to. The quality of the loans is critical, because those loans are the bank’s earning assets.

This isn’t some incidental issue; it’s the very core of what banking is. But the model of packaging plus securitization spurned the principle that a bank had to individually assess and monitor every loan. The mathematics of valuation models—horrendously complex equations to assess probabilities and correlations, cooked up in mad-scientist style by the firms’ ‘quants’—took on the burden of assessing statistical risk. The idea that a banker looks a borrower in the eye and takes a view on whether he can trust him came to seem laughably nineteenth-century. As for the risks? Well, as Lawrence Summers said when he was Deputy Secretary of the Treasury, ‘The parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies.'”

As I said, ESSENTIAL READING.

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