e•

lfSt•

ISaster 0 etemet

Alan Greenspan lit the fuse of the credit crisiswhen he extolled the revolutionary virtues of the

'Net-and redefined risk and responsibility_

By PAUL KEDROSKY

OMETIMES A BRIEF EXCHANGE CAN CAP­

ture an essential truth better than reams of

explanation. That happened recently when a

Financial Times reporter suggested to an in­

vestment banker that the credit crisis had snuck up on

investors and regulators because of how hard people

like him made it to get good information. The banker,

with evident irritation, pointed out that all the infor­

mation you needed was widely available. Why should

he be blamed if nobody paid attention?

It was an eye-opening comment. Financial mavens

have long had access to comprehensive data on credit

markets and subprime mortgages. It apparently didn't

ILLUSTRATION BY E.\llLIAi\'O PONZI FOR NEWSWEEK 25

WORLD AFFAIRS

Collision Course I Therise of the Internet and complexfinancial derivativesturned out to be a toxic combination.

1982: MichaelBloombergsellsan electronicdesktop terminalfor trading insecurities.Merrilllynch,his first cus­tomer, buys20.

1988: MCIMailgets hitched tothe Internet,the firstcommercialinroad intothe .government­run researchnetwork.

1993:ThefirstWebbrowser,Mosaic,makesnavigatingtheInternet as easyas pointingandclicking.AIGorepushed throughthe financing.

1983: FannieMaeissues the firstcollateralizedmortgage obligation,makingthe secondarymortgage marketmuchmore attrac­tive to investorsand lenders.

1989: TimBerners-lee,aphysicist, createsthe WorldWideWeb,whichuseshypertext, orlinks,to connectelectronicdocuments.

1994:CharlesBowsher,the U.S.comptroller,warns that de­rivatives tradingneeds oversight;the Fed'sGreenspan disagrees.

cross this banker's mind that the averageLCD-TV-buying consumer can't afford toshell out $1,700 a month for a Bloomberg.But in a sense, he was right. The informa­tion is out there-free, on the Internet.

The Internet has broadly delivered onits promise to bring information to themasses. All the information needed todiagnose the current credit crisis-the lat­est and best information about the collaps­ing prices of mortgage securities, balloon­ing numbers in the subprime mortgagemarket, bizarre behavior on the part ofbond rating firms and so forth-has beenfreely available to anybody who knowshow to use Google. But what good is it allif the data went unnoticed?

For more than a decade the Internet

has been hailed as the great democratizerof information. It was supposed to em­power individual investors, make murkyfinancial markets more transparent, andcreate a new generation of citizen in­vestors who were free to put their savingsin everything from the S&P 500 to palm oilfutures. It was supposed to shrink theworld and turn it into a village, whereeverything happened in the public squareand corruption and greed would have noplace to hide. As the 1990s mantra goes,"information wants to be free." The 21st

century was supposed to be the culmina­tion of this philosophy.

One of the biggest proponents of this

o Whichbankshavebeenhithardest?Viewour listat xtra.Newsweek.com

At the peak of thedotcom bubble,Greenspan saw anInternet 'revolution'in finance.

view was Alan Greenspan. Most econo­mists now agree that Greenspan, as chair­man of the u.s. Federal Reserve, kept in­terest rates too low for too long. What'sless widely appreciated is his role as atechnology booster. In March 2000, at thepeak of the dotcom bubble, he gave aspeech about a revolution being built onthe Internet. It was transforming finance,he said, making it possible to "reallocaterisk" via the "creation, valuation and ex-

change of ... complex financial productson a global basis." In short, Greenspansaw that the tandem of the Internet andfast computers were perfect for splittingmortgages into tiny pieces, repackagingthem and then shunting them to yield­hungry investors across the country andaround the world. But he should haveknown it would create what his felloweconomists call an "agency problem": Re­mote owners of teensy mortgage piecesdidn't police loans, didn't worry enoughabout loan quality, and were impossible tonegotiate with should a loan become trou­bled. They just wanted cash flow. And sothe fuse for a future credit crisis was lit.

To be clear, the Internet has donemany important and useful things for theworld financial system. Earnings calls areavailable to all comers, not just analysts;electronic trading has driven commis­sions to near zero; trading can happenwirelessly from anywhere at any time. In­vestors can track stock picks and stockpickers on Web-based scoreboards. Theseinnovations were long overdue. But byaccident, the Internet was also an enablerof the current credit crisis. It brought ustogether, but it also did the reverse, creat­ing communities with narrow affinities.These are often echo chambers wherepeople can find others like themselves­scrapbook makers or train-spotters orbuilders of exotic new products for thenow $668 trillion (not a misprint) deriva­tives market.

At the same time, in making informa-

26 LEFTTO RIGHT: 1'1;'1'1BOYLE-GETTY J:'IIAG~:.s,AP, LARRY DO\VNIl\'G-REUTERS.LANDOV, CATRINA GENOVES~:­GETTY Ii\IAGES. GETTY IM.-\GES, LARRY DOWNING-CO RBIS, TERRY ASHE- T1J\IE LIFE P1Cl'URES-GE'ITY IMAGES

--_..

2007: BradyDouganbecomes the first deriv­atives trader to reachthe top spot of a majorbank.Whenhe becameCEOof Credit Suisse,thecompanymade eighttrades about every fourseconds.

2003: Respond­ingto a recessionbrought on by theaftermath of theterrorist attacks of9/11,Greenspan low­ers short-term in­terest rates to 1per­cent, a 50-year low.

2000: Green­span persuadesU.S.legislators tostrip the federaloversight agencyofthe power toregulate the grow­ingmarket forderivatives.

2001: Country­wide begins its raceto the top of themortgage-lendingmarket bydesigningnew securities un­der looser guide­lines. Its revenuesstart to soar.

1995: BlytheMasters ofJ.P. Morganinvents creditdefault swaps,a method ofinsuring againstloan defaults.

1999: The

dotcom bubble,fueled by 'irrationalexuberance,'bursts, spellingdoomfor manyhigh-flyingtechcompanies.

tion free, the Internet has buried us indata, keeping most people from seeing thebuilding credit storm. Rather than turningthe world into a global village of empow­ered investors, the resulting data foghelped some Wall Street wiseguys hijackthe global economy as easily as playingvideogames-with instant messages andtrillions of dollars in complex derivatives.

The dotcom crash of 2000 and 2001

may have involved Internet stocks, butthe underlying cause was old-fashioned"irrational exuberance" (at least Green­span got that one right). It was a kind ofadolescence period for the Internet. Now,by contrast, we are in the midst of the firstfinancial crisis of the mature Internet

age-a crisis caused in large part by thetightly coupled technologies that now un­dergird the financial system and our soci­ety as a whole.

The fiasco raises important questionsabout how to regulate financial markets. Ifinformation is freely available, does thatmean the onus is no longer on WallStreeters to tell the rest of us what's goingon? What role do regulators play in keep­ing tabs on all these complex financialshenanigans?

The Internet has made it possible foranybody with an online brokerage accountand a broadband connection to become aglobal investor, but with that freedom hascome a great responsibility: to know whatyou're doing without relying on govern­ment oversight. And in a world where ourability to trade exotic financial instru-

ments vastly exceeds our ability to under­stand and value them, that is a very dan­gerous thing indeed. It behooves us topause and take a look at the forces that ledus here, and what we might do to preventanother occurrence.

The information was out there, andthis problem had been building for years,so why did no one notice? Part of the prob­lem is that the relevant data, while avail­able on the Web, is spread around in a zil­lion places. You can go to Yahoo Financeto check the recent share price of Wal­Mart, its market capitalization and its cur­rent sales. There is no one free place where

Perhaps $1 trillionin electronic swapsare undocumented,unseen, like virtualPost-it notes.

you can do the same thing across subprimemortgages, asset-backed securities, creditswaps and all the other arcana inherent intaking the temperature of modern globalmarkets. Instead, you have to wander fromsite to site, sort of like building a jigsawpuzzle from disguised pieces strewnaround an entire city. It is part treasurehunt and part puzzle- building.

That's not the end of the problems. In­formation about financial time bombs,

like derivatives, is veiled in acronyms thatmake you want t{) gouge your eyes out.(Consider two different measures of theperformance of mortgage securities:ABX.HE.AA.06-2 and ABX.HE.AA.06­I-such lovely and lyrical names!) Thereis an entire language required to under­stand this new generation of financialtechnologies, from credit default swaps tocollateralized debt obligations to residen­tial mortgage-backed securities, not tomention the corresponding three- andfour-letter abbreviations. There's also dataon current account deficits and yieldspreads. Most people, faced with thistsunami of data, do the only rationalthing: they give up.

The trouble with giving up, however, isthat the world goes on without you. Andone of the obligations of being a citizen ina free society is vigilance-watching whatis happening in your neighborhood,whether it's financial or physical. A lack ofregulatory oversight certainly played a rolein the current crisis, but over-relying onregulators is a dangerous practice. Citi­zens need to take responsibility. Apathyand indifference in the face of a complexand fast-changing world is a path to ruin.

Nevertheless, if the Internet's datasmog has bludgeoned the average con­sumer into indifference, it has also enabledtraders to act more swiftly and decisively.Traders, bankers and financial engineershave built up the mental shortcuts neededto keep track of a hundred credit defaultswap spreads, or 10 favorite bonds to

J.EFTTO RIGHT: RICHARD SHEINWALD-BLOOL\IBERG NEWS·U.NDOV. CHRIS HONDROS-GETTY 1i\IAGES,

STEPHEN J. CARRERA-AP, SIGGl BUCHER-REUTERS-L-\.!"'DOV, ROBERT GIROUX-GEm" IMAGES 27

WORLD AFFAIRS

The Pathways of the New Con1

a smart and savvy quantitative financeguru, the site's forums have long been ahotbed of discussions about engineeringfinancial instruments. Back in 2005,when swaps were newer and reallybooming, if you wanted to get in on theaction you could just post a messagethere and wham, within hours, if notminutes, you'd have a host of peoplesteering you to working papers, re­sources and all the latest information onbuilding your own bomb. There's noth­ing wrong with hosting an online discus­sion forum about finance. But without

the help of forums and related resources,

~ # ---~---~- - " ------

VENEZUELA

- ~~- - -~------DUBAI

~-~-~-~--~~~RUSSIA

i'­

Dubai was a standout among Ithe newly disciplined emerg-'

~~gc~ea;t~e~i~~~~~~il::~O~I~~;, ·..•.••••1Dubai took on debts that now •••.

~:~::~u~~:~~nd the emirate ~'able to a Year-to.- ~.slowdown as date decline "

m~~~~r~;s• ,'.are cooling,and the U.A.E. has announced

plans to inject $30 billion into

local banks to avert a real I"crisis. For now though,$25,000-a-night rooms at the !new Atlantis resort are still

getting customers.

Russia wins the prize for theemerging market worst hitby the financial crisis. Thestock market has lost two

thirds its value since May.When things

Year-to- turned seri-date decline ous, the

~. Kremlin of-0' .' 0 fered $70 bil-

lion in softloans to the banking sectorand pledged governmentmoney for stock buybacks.Those attempts were sabo­taged by declining oil prices,which fell below $70 a barrellast week. The impact showsjust how dependent thecountry really is on oil.

'STOCK INDEX FOR

THE UNITED ARAB

E.\IIRATES:\SA WHOLE

Venezuela looks particularly vulnerable as the creditcrunch spreads. As oil demand slackens, the price ofcrude is plummeting, and it closed at a one-year lowlast week. That has a huge impact on this oil-dependenteconomy. Inflation is the highest in the region (morethan 20 percent), and president Hugo Chavez's popu­larity, already at a low ebb, could fall further.

--- --- ~~~-~-~~~~ ---BRAZIL

A month ago, Brazil's presi­dent predicted the crisiswould produce only "aripple" in Brazil. He waswrong. On Oct. 16, the Boves­pa index lost more than 11percent, its biggest single­day drop in a decade. The

real has slidYear-to- 30 percent

date decline against the

•' dollar since

o 0' 0 Aug. 1. But thebanking systemis shielded by

ultraconservative lendingpractices (credit accountsfor just 34 percent of GDP),and inflation is pinned byhawkish interest rates. Brazil

may still be the emergingmarket best positioned toweather the crisis.

Gauging the Damage:

swaps. While it would make for boringtelevision, the race is terrifYing as hell ifyou're part of it.

While the Web reduces economy­wracking derivatives to the level of aquick 1M chat about baseball, it also al­lows people to find and support one an­other, whether they are history buffs orfinancial engineers. Just as it's easier tofind fellow fans of the Flying Banana, itis easy to find someone who can quicklysteer you through creating a collateral­ized debt obligation. Just head on over tothe forums at financial engineering siteslike Wilmott. com. Run by Paul Wilmott,

There was once talk of "decoup ling, " the idea that thegrowing surpluses of emerging markets made themnew bastions of stability, protected from financialstorms in the West. Not now. From Russia to South

Korea, emerging -market stocks have plunged, oftenfurther than Wall Street, as recessionfiar spreads.

watch, or myriad structured-mortgage fi­nance product prices. This generation ofbankers is the first to be truly Web aware,and they use the technology to the maxi­mum. That's meant lower costs and fastertrading, but it has also helped aid and abetthe current crisis. We have used the Inter­net and modern communications tech­

nologies to create a shadow-banking sys­tem, an unregulated lending network that .was, by 2007, as large as the traditionalbanking system. It is now shrinking, butits remnants must be dragged intothe light, with over-the-counterderivatives pushed onto centralclearinghouses.

Consider that many unregu­lated financial transactions arecarried out over instant messag­ing. Want to set up a $100-mil­lion credit default swap on thebank of your choice? No problem. Just1M a few trader friends at other hedgefunds or banks, propose the idea, andthen seal the deal with whoever likesyour terms. No phone conversations, nomessy paperwork, just a few quick mes­sages and it's done. This kind of easy ac­cess to peers has turned trading into ahigh-stakes, low-documentation video­game, and in doing so it has encouragedand facilitated many risky behaviors, likehaving too many overlapping trades tokeep straight. "I bought credit protectionon Wells Fargo, and sold it on AIG, soI'm now hedged! Or did I do both twiceand accidentally double up? Ooooh!" Bysome estimates close to a trillion dollarsin credit default swaps out there werecreated electronically and are now un­documented and little understood.Think of them as virtual Post-it notessomewhere in the ether, waiting forsomeone to notice.

The trend toward treating derivativesas a cross between gossip and videogamesis insidious. Trivial conversations over in­stant messaging can mutate into trades.Everything gets flattened, with chatterabout the weather right alongside settingup a $100 million default swap. Whatmatters when everything looks the sameand is bookended with a happy face?

In recent months most firms have raced

to get this derivatives mess under control.Company CEOs and boards have all readthe stories about there being in excess of$50 trillion in credit default swaps outthere, and they are in blind panics to un­derstand their financial risks. They rightlysee it as a race between them getting theirderivative exposure straight, and owingbillions on defaulting companies to whichthey are overexposed because of ill-hedged

28 NEWSWEEK I OCTOBER 27, 2008

SOURCES: YEAR-YO-DATE STOCK MARKET PERFORMANCE BASED ON MSCI BARRA'S COUNTRY INDICES

SOUTH KOREA at least make sure you know enough notto be surprised.

Instead of gwmg everyone aBloomberg workstation, we can ask thatour personal-finance providers build us abetter dashboard over the Web. We need

something that lets us know more thanthe balance of our 401(k)s, somethingthat connects us to the ebb and flow oflive financial markets around the world.It wouldn't be hard. No new technology isrequired-people just need to demand it(loudly). All that is required is our activeinterest in making sure that the worlddoesn't come down around our ears. Weare part of this system, and we need awindow into it.

One window must look in on what

goes on between traders-including in-

Without the Net,many of these creditinnovations wouldnever have launched

so quickly.

KEDROS KY is Senior Fellow at the KauffinanFoundation and an adviser to institutional

monq-management firms. He edits the blog

Infectious Greed (paulkedrosky.com).

stant messages. By all means let the 20­something traders set up derivative tradesvia 1M-just make sure all the trades takeplace in full view. Compliance regulationsfrom the SEC and the exchanges alreadyforce messages to be archived, but firmsneed to do a better job of making trades,however they happen, go straight fromprivate electronic channels onto publicexchanges. We simply can't have opaquefinancial instruments traded via 1Mturn into trillion-dollar markets that noone understands or can see. No more"whoops!" should be allowed. Instead, thesolution is to use the Web to force the out­comes of traders' actions into the open,even if their private conversations them­selves remain private.

Instead of helping cause a financial cri­sis, next time around the Internet needs tobe part of the solution. And it's up to us­engaged citizens, at least as much as gov­ernment and flawed regulators-to makesure change happens long before the nextinevitable financial crisis breaks. We canuse technology to make financial marketssafer. And that includes making them saferfrom the collateral damage of AlanGreenspan's irrational exuberance forrisky financial technologies.

Year-to­datedecline

AN

•', ,, ,

Japan showshowAmerica'ssubprime credit is takingdownevenmarkets that hadlittle exposure to subprime.Mostbanks still boast solidbalance sheets thanks to thedisciplinelearned after Year-to-the Asianfi- datedeclinenancialcri­sis. Unfound­ed fear forthe financialsector is nowmorphingintomore realistic fear about the"real economy,"whichwillbehurt bya globalslump. OnOct.16,the Tokyomarket sawits biggest one-day drop in20years-11.4 percent.

on. What if, instead, you saw somethingakin to the dashboard of a car-with dials

and knobs corresponding to what's goingon in credit markets, derivatives, com­modities and stocks. Instead of givingendless tables-the sort ofthing that usedto clutter newspapers-imagine heatcharts (red is bad, green is good) andsimple graphs. The financial dashboardwould interpret information: here is whatis currently working properly in financialmarkets, here is what isn't, and here iswhat you should be terrified about. Ifyou want to know more you can click andfind out. A well-designed dashboard will

South Koreansthought it couldn't happen again.Theyhad workedso hard at reform after the collapse oftheir currency in1998.But last monththe wonfell20percent, as Koreansbegan hoardingU.S.dollars in theirhomesafes, fearful ofthe globalmar-

"ket swoons.Thefirst current accountdeficit in a decade nowlookscertain.Andthe ghosts of '98are back.

I'

most of which never really see the lightof day, the credit innovations (and I usethat word advisedly) that helped spur thecurrent crisis would never have gottenoff the ground so quickly.

The Internet, of course, is just a tech­nology, to be used for good or ill. Is therea technological fix that would help pre­vent a similar mess? One of the ways ofaverting the next crisis is to make the In­ternet better at consolidating informa­tion. Right now when you go to financialsites you are deluged with informationabout stocks and major market indices,plus some news headlines, and on and

Year-to­datedecline

Indiafigured it was immune,too, before the foreignersstarted fleeingand the layoffsbegan. Firedemployees

of GrazianoTrasmissionimurdered theCEO.Jet Airwayshired back 1,900workers after stewardesses stagedrallies in stiletto heels. Prime MinisterManmohanSinghurged the Westtoconsider the developingworld in itsrescue plans.

NEWSWEEK I OCTOBER 27, 2008 29