What the Pope knew, and the investment bankers didn't

By Phil Lawler ( bio - articles - email ) | Jun 04, 2010

Late in the summer of 2008, the price of shares in Lehman Brothers went into a terminal decline. Richard Fuld, the chief executive of the investment bank, was desperately working the phones, looking for new investors to shore up his supply of working capital. The firm was fundamentally sound, Fuld insisted; the stock price would recover once the panic-selling stopped.

Fuld was wrong. When Lehman Brothers plunged into bankruptcy, the panic had just barely begun. The company was not sound, nor were any of the other investment banks that dominated Wall Street. Huge financial empires had been built on a shaky foundation of speculative investments, and in September 2008 the entire system toppled.

How did it happen, and why? Two eye-opening books--Too Big to Fail, by Andrew Ross Sorkin, and The Big Short, by Michael Lewis--offer useful perspectives for a reader unaccustomed to travel in the world of high finance.

Sorkin's book follows the principal actors in the drama, the investment-bank executives and their chief regulators at the Treasury Department and the Federal Reserve, during those frantic days of September. A beat reporter for the New York Times, Sorkin had an amazing degree of access to these powerful individual, and he provides detailed accounts of their feverish efforts to stave off disaster.

Every major financial institution on Wall Street wobbled during those frightening days, and more than a few of them collapsed. Every major executive felt compelled to rush into deals, often without adequate understanding. And that compulsion affected federal regulators as well as private investors. It is astonishing to learn that major investment banks were offered for sale at virtually any price the buyer cared to name. It is equally astonishing to know that the Secretary of the Treasury, Henry Paulson, essentially ordered investment-bank executives to accept government bailout funds whether they wanted them or not--and made his demand stick. Accounting proprieties and legal niceties both were tossed aside in the rush to do something--anything--that might avert a catastrophe.

An ordinary reader will find it difficult to sympathize with any of the leading figures in Sorkin's book. They are headstrong, ambitious, and arrogant, inordinately confident that their views are right, accustomed to having their way, dismissive of the cautions that a few prudent observers issued. Some analysts have blamed the entire financial collapse on greed, and there greed is certainly evident throughout the story. But greed is never absent from the finance industry. There was something else at work in this case. The overweening hubris of the Wall Street tycoons was certainly a factor. But there was more to it. The collapse took place because speculative investments suddenly lost their value. Although he recounts how that happened, Sorkin does not adequately explain why.

Michael Lewis, who began his professional career as a bond trader, offers a much more understandable explanation in The Big Short. Lewis introduces the reader to the complex financial instruments-- derivatives, collateralized debt obligations, credit swaps-- that fueled an era of artificial wealth and then led to the debacle.

Traditional stocks and bonds supply firms with necessary capital, so that businesses can grow, hire employers, and produce valuable goods and services. Derivatives are an entirely different sort of investment. They do not create jobs, support production, or generate economic growth--except for the few wealthy individuals who trade in them. For all practical purposes, derivatives are bets.

Worse still, as Lewis points out, the investment bankers who placed these bets were gambling with other people's money. If their bets paid off the bankers added bonuses to their already high salaries. If they lost, the shareholders picked up the tab. But for years the bets did not lose. So the bankers made more and more gambles, using one derivative as collateral for another, piling up tin towers of paper "assets" that held value only if someone else was willing to pay for them. Finally in September 2008 no one was willing to pay, the firms' obligations greatly exceeded their shareholders' equity, and now the American taxpayers were stuck with the trillion-dollar bill.

Didn't anyone see this disaster on the horizon? Yes. Michael Lewis tells the story from the perspective of a handful of eccentric investors who predicted the collapse in the real-estate market and the subsequent rout of the derivatives. They were ridiculed by mainstream investors but in the end they were proven right, and their accurate predictions earned them millions. Still, as The Big Short ends, these few investors are not altogether happy with their work. Yes, they brought in spectacular returns. But their success was the result of a horrible systemic failure; they won because so many others lost. In their case, too, the profits came not as the result of productive enterprise-- creating jobs and products and services--but from a successful bet.

But there was one other analyst who predicted the collapse--predicted it as far back as 1985, actually--and to his credit Lewis mentions him: Cardinal Joseph Ratzinger, the future Pope Benedict XVI. In his encyclical Caritas in Veritate, the Pope repeats the warning that he issued 25 years ago: a system guided only by the desire for profit will ultimately devour itself.

The fatal flaw of the investment banks is not that they sought profit; it is that they pursued profit without productivity. They were not providing capital to drive the economy. The billions of dollars invested in derivatives might have been used instead to set up new firms, hire new workers, furnish new products--to make life better for millions of people. Instead the market in derivatives enriched a few thousand elite financiers-- while it lasted.

The lesson to be learned is that capital should work for people; people should not work for capital. That lesson applies not only to high-level bond traders, but also to ordinary families with their modest stock portfolios and retirement-savings plans. With wealth comes responsibility. Capital should be invested in ways that benefit others as well as the investor himself. The Pope knew that. The investment bankers didn't.