Media Clips
The New York Times
September 20, 2008
Uncharted Territory Led To a New Kind of Crisis
By Nelson D. Schwartz
PARIS -- Just over 100 years ago, J. P. Morgan gathered his fellow financiers at his Manhattan
mansion amid growing financial panic and declared, ''This is where the trouble stops.''
Last weekend, as one of the gravest crises since then accelerated, a similar conclave gathered farther
downtown, at the Federal Reserve Bank of New York.
This time, the Fed chairman and the Treasury secretary summoned the bosses of Wall Street giants
including Citigroup, Goldman Sachs and, yes, JPMorgan. The officials had a similar ultimatum: find an
industry solution to halt the undoing of Wall Street's financial order.
But, different from the action that brought the successful denouement to the Panic of 1907, banks did
not want to gamble their own position to prevent, in this case, the demise of Lehman Brothers.
The troubles did not stop: in the last five days alone, the crisis has changed in unimaginable ways,
with one financial titan filing for bankruptcy protection, another agreeing to a shotgun wedding with a
major bank and a third essentially being nationalized by Washington.
And, for the moment, it looks as if only the full faith and credit of the United States government can
stem the fear.
Why did the magic wrought by J. P. Morgan (the banker, not the bank) not work this time?
Unlike the crisis 100 years ago, today's troubles are far more complicated and widespread. Many of
the creative new instruments that financial players used to rake in money were also among the most
complex ever invented -- so much so that the top managers of the institutions that profited most may
not have fully understood what they owned and traded.
They also may not have fully grasped the speed at which their world had changed since the last
financial flash point a decade ago, when the collapse of Long-Term Capital Management, a giant
hedge fund, seemingly brought Wall Street to the brink.
''I consider myself a serious student of Wall Street history, but history is not going to be a lot of help
here,'' said Byron Wien, a 40-year market veteran who is now chief investment strategist for Pequot
Capital.
"The degree of complexity is so great, the products are new and untested, and the operations are now
global,'' he added. ''This is Long-Term Capital on steroids.''
In some ways, Wall Street suffers from a generation gap. At 62, Richard S. Fuld Jr., the head of
Lehman Brothers, had ridden out events from the oil shocks of the 1970s to the Russian debt default
and Asian economic crisis in 1998.
But in recent years, his firm and other Wall Street giants derived an ever-increasing share of profit
from products that barely existed a decade ago, like credit-default swaps. Essentially insurance on
debt, the market for credit-default swaps has ballooned to a nearly unimaginable $45.5 trillion, from
$900 billion in 2001.
In fact, the insurance giant American International Group, which was effectively taken over by the
government on Tuesday, was one of the largest players in this gargantuan market -- far bigger than
Lehman, which filed for bankruptcy protection early Monday. That was a top reason why A.I.G. got an
$85 billion government lifeline, while Lehman was left to fend for itself.
James Cawley, a veteran player in the credit default swap market, doubts the full understanding of the
older chiefs of the firms who profited from these products and the young traders who specialized in
them.
''Had they understood the implications, we wouldn't be where we are today,'' said Mr. Cawley, founder
and chief executive of IDX Capital. The overriding feeling on Wall Street, he said, was, ''Let's make
money while the sun shines and worry about the details later.''
While Mr. Fuld and other chief executives bear the ultimate responsibility for their firms' fates, it would
take a doctorate in mathematics to untangle the most complex of the derivatives that helped bring
down Lehman or Bear Stearns this year.
And in the boom years, the compensation of Mr. Fuld and other chief executives on Wall Street
followed a similar trajectory -- higher.
''If you're approving things you don't understand, that's not doing your job,'' said Jonathan GS Koppell,
director of the Millstein Center for Corporate Governance and Performance at the Yale School of
Management. ''What are these guys compensated for, if they're checking off things they don't
understand?''
To make matters worse, the financial models underpinning many of the most sophisticated new
products were largely based on trading patterns from a more tranquil time, at least by historical
standards.
Because central banks largely conquered the inflation spike of the 1970s, interest rates have steadily
declined, and emerging markets became more integrated in a world economy that enjoyed relatively
low inflation, said Thomas Mayer, chief European economist for Deutsche Bank.
Despite occasional periods of volatility -- the Wall Street crash of 1987, the failure of Long-Term
Capital, the bursting of the technology bubble in this decade and the economic fallout from the Sept.
11, 2001, attacks -- the markets managed to bounce back each time.
''People were lulled into complacency,'' said Mr. Wien of Pequot Capital.
Yet it was not only the veterans who were caught off guard by the risks lying in wait, but also the
young lions.
This year, a 31-year-old derivatives trader named Jerome Kerviel nearly brought down Societe
Generale, the 150-year-old French financial giant, by making unauthorized bets on the stock market
that cost his bank almost 5 billion euros, or $7.7 billion at that time.
His supervisors had no idea what he had been up to, they said later.
As Wall Street was transforming itself into a more complex place, so was the world economy,
spawning new financial players in corners of the globe whose emergence generated vast new wealth.
This new landscape looks vastly different than only a decade ago -- not to mention when men like Mr.
Fuld and his contemporaries came of age. Maurice R. Greenberg was 80 when he stepped down from
A.I.G. in 2005. James E. Cayne, the former boss of Bear Stearns, is 74.
In earlier eras, Mr. Wien said, a stricken firm like Lehman or A.I.G. would have turned to
deep-pocketed investors in the United States, or failing that, Europe.
This time, banks are turning to the Middle East and especially Asia for capital. Lehman, the
158-year-old investment bank, entered a death spiral when the state-controlled Korea Development
Bank walked away from talks to buy a stake in it.
''The balance of economic power has shifted out of the U.S. and Europe to the Middle East and Asia,''
Mr. Wien said.
At the same time, significant gains in computing power allowed the creation of financial products with
many more variables -- and gave individual traders like Mr. Kerviel much more power to move them at
lightning speed.
''Twenty years ago, it was hard to accurately price a corporate bond, let alone calculate credit
spreads,'' said David Munves, a managing director in the capital markets research group of Moody's,
who spent 10 years at Lehman. Even in the mid-1990s, he said, bond traders would use oversize
calculators at their desks to figure out yields down to one-sixteenth and one thirty-second.
Now, he said, traders can call up databases that feature 400 fields for a single bond.
Once-straightforward features like duration and yield are sliced a multitude of ways. ''As you build
more complex products, you get further away from real-world events, like actually having to sell these
bonds,'' he said.
One result, said Mr. Mayer of Deutsche Bank, is that products were developed for markets that
everyone assumed would be as they were then, with capital freely flowing, rational minds prevailing
and fear largely in check.
''A generation grew up that has been very well trained in this new finance theory, very well educated
to apply it on a broad scale with the necessary computing power, and off we went,'' Mr. Mayer said.
Recent events, he said, have shown that the basic assumptions that have held sway for a generation
or two no longer hold. ''This will leave us with a different paradigm,'' he added. ''If I could give it to you,
I'd win the Nobel Prize.''