reading about the financial crisis: a twenty- one-book review

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Reading About the Financial Crisis: A Twenty-One-BookReview

Citation Lo, Andrew W. "Reading about the Financial Crisis: A Twenty-One-Book Review." Journal of Economic Literature, 50(1): 151-78 (2012).

As Published http://dx.doi.org/10.1257/jel.50.1.151

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Journal of Economic Literature 2012, 50:1, 151178http:www.aeaweb.org/articles.php?doi=10.1257/jel.50.1.151

151

1. Introduction

In Akira Kurosawas classic 1950 filmRashomon, an alleged rape and a mur-

der are described in contradictory ways byfour individuals who participated in variousaspects of the crime. Despite the relativelyclear set of facts presented by the differ-ent narratorsa womans loss of honor andher husbands deaththere is nothing clearabout the interpretation of those facts. Atthe end of the film, were left with severalmutually inconsistent narratives, none of

which completely satisfies our need forredemption and closure. Although the movie

won many awards, including an AcademyAward for Best Foreign Language Film in1952, it was hardly a commercial success inthe United States, with total U.S. earnings of$96,568 as of April 2010.1This is no surprise;

who wants to sit through 88 minutes of vividstory-telling only to be left wondering who-dunit and why?

Six decades later, Kurosawas messageof multiple truths couldnt be more rel-evant as we sift through the wreckage of

the worst financial crisis since the GreatDepression. Even the Financial CrisisInquiry Commissiona prestigious biparti-san committee of ten experts with subpoenapower who deliberated for eighteen months,

1 See http://www.the-numbers.com/movies/1950/0RASH.php. For comparison, the first Pokemon movie, released in1999, has grossed $85,744,662 in the United States so far.

Reading About the Financial Crisis:A Twenty-One-Book Review

A W. L*

The recent financial crisis has generated many distinct perspectives from variousquarters. In this article, I review a diverse set of twenty-one books on the crisis,eleven written by academics, and ten written by journalists and one former TreasurySecretary. No single narrative emerges from this broad and often contradictorycollection of interpretations, but the sheer variety of conclusions is informative, and

underscores the desperate need for the economics profession to establish a singleset of facts from which more accurate inferences and narratives can be constructed.(JEL E32, E44, E52, G01, G21, G28)

*MIT Sloan School of Management and AlphaSimplexGroup, LLC. I thank Zvi Bodie, Jayna Cummings, JanetCurrie, Jacob Goldfield, Joe Haubrich, Debbie Lucas, BobMerton, Kevin Murphy, and Harriet Zuckerman for help-ful discussions and comments. Research support from theMIT Laboratory for Financial Engineering is gratefullyacknowledged. The views and opinions expressed in thisarticle are those of the author only, and do not necessarilyrepresent the views and opinions of MIT, AlphaSimplex,any of their affiliates or employees, or any of the individualsacknowledged above.


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Journal of Economic Literature, Vol. L (March 2012)152

interviewed over 700 witnesses, and heldnineteen days of public hearingspresentedthree different conclusions in its final report.Apparently, its complicated.

To illustrate just how complicated it canget, consider the following facts that havebecome part of the folk wisdom of the crisis:

1. The devotion to the Efficient MarketsHypothesis led investors astray, causingthem to ignore the possibility that secu-ritized debt2was mispriced and that thereal-estate bubble could burst.

2. Wall Street compensation contracts weretoo focused on short-term trading prof-

its rather than longer-term incentives.Also, there was excessive risk-takingbecause these CEOs were betting withother peoples money, not their own.

3. Investment banks greatly increasedtheir leverage in the years leading upto the crisis, thanks to a rule changeby the U.S. Securities and ExchangeCommission (SEC).

While each of these claims seems perfectlyplausible, especially in light of the events of200709, the empirical evidence isnt as clear.The first statement is at odds with the factthat, prior to 2007, collateralized debt obliga-tions (CDOs),3the mortgage-related bonds atthe center of the financial crisis, were offering

2 Securitized debt is one of the financial innovations atthe heart of the crisis, and refers to the creation of bondsof different seniority (known as tranches) that are fixed-

income claims backed by collateral in the form of largeportfolios of loans (mortgages, auto and student loans,credit card receivables, etc.).

3 A CDO is a type of bond issued by legal entities thatare essentially portfolios of other bonds such as mort-gages, auto loans, student loans, or credit-card receiv-ables. These underlying assets serve as collateral for theCDOs; in the event of default, the bondholders becomeowners of the collateral. Because CDOs have differentclasses of priority, known as tranches, their risk/rewardcharacteristics can be very different from one trancheto the next, even if the collateral assets are relativelyhomogeneous.

much higher yields than straight corporatebonds with identical ratings, apparently forgood reason.4 Disciples of efficient markets

were less likely to have been misled thanthose investors who flocked to these instru-ments because they thought they had identi-fied an undervalued security.

As for the second point, in a recent studyof the executive compensation contractsat 95 banks, Fahlenbrach and Stulz (2011)conclude that CEOs aggregate stock andoption holdings were more than eight timesthe value of their annual compensation, andthe amount of their personal wealth at riskprior to the financial crisis makes it improb-

able that a rational CEO knew in advance ofan impending financial crash, or knowinglyengaged in excessively risky behavior (exces-sive from the shareholders perspective, thatis). For example, Bank of America CEO KenLewis was holding $190 million worth of com-pany stock and options at the end of 2006,

which declinedin value to $48 million by theend of 2008,5and Bear Stearns CEO JimmyCayne sold his ownership interest in his com-panyestimated at over $1 billion in 2007for $61 million in 2008.6 However, in thecase of Bear Stearns and Lehman Brothers,Bebchuk, Cohen, and Spamann (2010) haveargued that their CEOs cashed out hundredsof millions of dollars of company stock from2000 to 2008, hence the remaining amount

4 For example, in an April 2006 publication by theFinancial Times, reporter Christine Senior (2006) fileda story on the enormous growth of the CDO market in

Europe over the previous years, and quoted Nomurasestimate of $175 billion of CDOs issued in 2005. Whenasked to comment on this remarkable growth, CianOCarroll, European head of structured products at FortisInvestments replied, You buy a AA-rated corporate bondyou get paid Libor plus 20 basis points; you buy a AA-ratedCDO and you get Libor plus 110 basis points.

5 These figures include unrestricted and restrictedstock, and stock options valued according to the Black-Scholes formula assuming maturity dates equal to 70percent of the options terms. I thank Kevin Murphy forsharing these data with me.

6 See Thomas (2008).


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153Lo: Reading About the Financial Crisis

of equity they owned in their respective com-panies toward the end may not have beensufficiently large to have had an impact ontheir behavior. Nevertheless, in an extensiveempirical study of major banks and broker-dealers before, during, and after the finan-cial crisis, Murphy (2011) concludes that the

Wall Street culture of low base salaries andoutsized bonuses of cash, stock, and optionsactually reduces risk-taking incentives, not

unlike a so-called fulcrum fee in whichportfolio managers have to pay back a portionof their fees if they underperform.

And as for the leverage of investmentbanks prior to the crisis,figure 1 shows muchhigher levels of leverage in 1998 than 2006 forGoldman Sachs, Merrill Lynch, and LehmanBrothers. Moreover, it turns out that the SECrule change had no effect on leverage restric-tions (see section 4 for more details).

Like World War II, no single account ofthis vast and complicated calamity is suffi-cient to describe it. Even its starting date isunclear. Should we mark its beginning at thecrest of the U.S. housing bubble in mid-2006,or with the liquidity crunch in the shadowbanking system7 in late 2007, or with thebankruptcy filing of Lehman Brothers and

7 The term shadow banking system has developed sev-eral meanings ranging from the money market industry tothe hedge fund industry to all parts of the financial sectorthat are not banks, which includes money market funds,investment banks, hedge funds, insurance companies,mortgage companies, and government sponsored enter-prises. The essence of this term is to differentiate betweenparts of the financial system that are visible to regulatorsand under their direct control versus those that are outsideof their vision and purview. See Pozsar, et al. (2010) for anexcellent overview of the shadow banking system.

Assets-to-equity ratio

35 to 1

30 to 1

25 to 1

20 to 1

15 to 1

10 to 1

5 to 1

0 to 1

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

Year and quarterGoldman Sachs

Merrill Lynch

Lehman BrothersMorgan Stanley

Figure 1. Ratio of Total Assets to Equity for Four Broker-Dealer Holding Companies from 1998 to 2007

Source: U.S. Government Accountability Office Report GAO09739 (2009, figure 6).


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the breaking of the buck8by the ReservePrimary Fund in September 2008? And wehave yet to reach a consensus on who theprincipal protagonists of the crisis were, and

what roles they really played in this drama.Therefore, it may seem like sheer folly

to choose a subset of books that econo-mists might want to read to learn moreabout the crisis. After all, new books arestill being published today about theGreat Depression, and that was eightdecades ago! But if Kurosawa were alivetoday and inclined to write an op-ed pieceon the crisis, he might propose Rashomonas a practical guide to making sense of

the past several years. Only by collectinga diverse and often mutually contradic-tory set of narratives can we eventuallydevelop a more complete understandingof the crisis. While facts can be verifiedor refutedand we should do so expedi-tiously and relentlesslywe must alsorecognize the possibility that more com-plex truths are often in the eyes of thebeholder. This fact of human cognitiondoesnt necessarily imply that relativ-ism is correct or desirable; not all truthsare equally valid. But because the par-ticular narrative that one adopts can colorand influence the subsequent course ofinquiry and debate, we should strive atthe outset to entertain as many interpre-tations of the same set of objective factsas we can, and hope that a more nuancedand internally consistent understanding ofthe crisis emerges in the fullness of time.

8 This term refers to the event in which a money mar-ket fund can no longer sustain its policy of maintaining a$1.00-per-share net asset value of all of its client accountsbecause of significant market declines in the assets heldby the fund. In other words, clients have lost part of theirprincipal when their money market fund breaks the buckand its net asset value falls below $1.00.

To that end, I provide brief reviews oftwenty-one books about the crisis in thisessay, which I divide into two groups:those authored by academics, and those

written by journalists and former TreasurySecretary Henry Paulson. The books in thefirst category are:

Acharya, Richardson, van Nieuwerburgh,and White, 2011, Guaranteed to Fail:Fannie Mae, Freddie Mac, and theDebacle of Mortgage Finance. PrincetonUniversity Press.

Akerlof and Shiller, 2009, AnimalSpirits: How Human Psychology Drives

the Economy, and Why It Matters forGlobal Capitalism. Princeton UniversityPress.

French et al., 2010, The Squam LakeReport: Fixing the Financial System.Princeton University Press.

Garnaut and Llewellyn-Smith, 2009,The Great Crash of 2008. MelbourneUniversity Publishing.

Gorton, 2010, Slapped by the InvisibleHand: The Panic of 2007. OxfordUniversity Press.

Johnson and Kwak, 2010, 13 Bankers:The Wall Street Takeover and the NextFinancial Meltdown. Pantheon Books.

Rajan, 2010, Fault Lines: How HiddenFractures Still Threaten the WorldEconomy. Princeton University Press.

Reinhart and Rogoff, 2009, This Time IsDifferent: Eight Centuries of FinancialFolly. Princeton University Press.

Roubini and Mihm, 2010, CrisisEconomics: A Crash Course in the Futureof Finance. Penguin Press.

Shiller, 2008, The Subprime Solution:How Todays Global Financial CrisisHappened and What to Do About It.Princeton University Press.

Stiglitz, 2010, Freefall: America, FreeMarkets, and the Sinking of the WorldEconomy. Norton.


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and those in the second category are:

Cohan, 2009, House of Cards: A Tale ofHubris and Wretched Excess on WallStreet. Doubleday.

Farrell, 2010, Crash of the Titans: Greed,Hubris, the Fall of Merrill Lynch, and

the Near-Collapse of Bank of America.Crown Business.

Lewis, 2010, The Big Short: Inside theDoomsday Machine. Norton.

Lowenstein, 2010, The End of WallStreet. Penguin Press.

McLean and Nocera, 2010,All the DevilsAre Here: The Hidden History of the

Financial Crisis. Portfolio/Penguin. Morgenson and Rosner, 2011, Reckless

Endangerment: How Outsized Ambition,Greed, and Corruption Led to Economic

Armageddon. Times Books/Henry Holtand Company.

Paulson, 2010, On the Brink: Inside theRace to Stop the Collapse of the GlobalFinancial System. Business Plus.

Sorkin, 2009, Too Big to Fail: The InsideStory of How Wall Street and WashingtonFought to Save the Financial System

from Crisisand Themselves. Viking. Tett, 2009, Fools Gold: How the Bold

Dream of a Small Tribe at J.P. MorganWas Corrupted by Wall Street Greed andUnleashed a Catastrophe. Free Press.

Zuckerman, 2009, The Greatest TradeEver: The Behind-the-Scenes Story ofHow John Paulson Defied Wall Streetand Made Financial History. Broadway

Books.

I didnt arrive at this particular mix of booksand the roughly even split between aca-demic and journalistic authors with any par-ticular objective in mind; I simply includedall the books that Ive found to be particu-larly illuminating with respect to certainaspects of the crisis. Reviewing the booksauthored by our colleagues is, of course,

natural. The decision to include other booksin the mix was motivated by the fact that,as economists, we should be aware not onlyof our own academic narratives, but also ofpopulist interpretations that may ultimatelyhave greater impact on politicians and pub-lic policy. Whereas the academic authorsare mainly interested in identifying under-lying causes and making policy prescrip-tions, the journalists are more focused onpersonalities, events, and the cultural andpolitical milieu in which the crisis unfolded.Together, they paint a much richer pic-ture of the last decade, in which individualactions and economic circumstances inter-

acted in unique ways to create the perfectfinancial storm.

Few readers will be able to invest the timeto read all twenty-one books, which is all themore motivation for surveying such a widerange of accounts. By giving readers of the

Journal of Economic Literaturea panoramicperspective of the narratives that are avail-able, I hope to reduce the barriers to entry tothis burgeoning and important literature. Insection 2, I review the books by academics;in section 3, I turn to the books by journalistsand former Treasury Secretary Paulson; andI conclude in section 4 with a brief discus-sion of the challenges of separating fact fromfantasy with respect to the crisis.

2. Academic Accounts

Academic accounts of the crisis seem toexhibit the most heterogeneity, a very posi-

tive aspect of our profession that no doubtcontributes greatly to our collective intelli-gence. By generating many different narra-tives, were much more likely to come up

with new insights and directions for furtherresearch than if we all held the same con-

victions. Of these titles, Robert J. ShillersThe Subprime Solution: How TodaysGlobal Financial Crisis Happened, andWhat to Do about Itwas the first out of the


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gate. Written for the educated layperson, itappears from internal evidence that Shillersshort book was completed by April 2008, andpublished in August of that year. This bookcaptures the view, which became current atthe time, that the crisis was principally aboutthe unraveling of a bubble in housing prices.Shiller ought to know about such things:

years ago, he and his collaborator Karl E.Case pioneered a new set of more accuratehome-price indexes based on repeat salesrather than appraisal values, now known asthe S&P/CaseShiller Home Price Indicesand maintained and distributed by Standard& Poors. Thanks to Case and Shiller, we can

now gauge the dynamics of home prices bothregionally and nationally.

Much of Shillers exposition on real estatebubbles will be familiar to readers of the sec-ond edition of Irrational Exuberance. Ratherthan scarcity driving up real estate pricesa theory that he demonstrates is incompleteat besthe postulates a general contagionof mistaken beliefs about future economicbehavior, citing Bikhchandani, Hirshleifer,and Welchs (1992) theoretical work on infor-mational cascades to support this notion, butalso John Maynard Keyness famous conceptof animal spirits. Overall, Shillers discus-sion of underlying causes is rather thin,perhaps due to his writing for a general audi-ence. Shiller would expand more fully on histheory of animal spirits in his 2009 book withGeorge Akerlof (reviewed below), as Shillermentions in his acknowledgements, so per-haps a little intellectual crowding out took

place as well.With the benefit of three short years

of hindsight, Shillers policy prescriptionsappear laudable but almost utopian. Past thenecessity of some bailouts, Shiller proposesdemocratizing financeextending theapplication of sound financial principles to alarger and larger segment of society (115).This follows from his theoretical premise:if bubbles are caused by the contagion of

mistaken beliefs about economic outcomes,then the cure must be inoculation againstfurther mistaken beliefs and eradication ofcurrently mistaken ones. Much as the gov-ernment plays a vital role in public healthagainst the spread of contagious disease,Shiller recommends government subsidiesto provide financial advisors for the less

wealthy, and greater government moni-toring of financial products, analogous tothe consumer product regulatory agenciesalready in existence in the United States.More speculatively, he also suggests usingfinancial engineering to create safer financialproducts and markets. Finally, since bubbles

represent a failure of the correct informa-tion to propagate to the public, Shiller callsfor greater transparency, improved financialdatabases, and new forms of economic mea-surement made more intuitive for the gen-eral public.

Shillers stylized description of the hous-ing bubble largely passes over how itsbursting transmitted ill effects to the rest ofthe economy. In August 2008, however, atthe same time that his book was released,a much more detailed account of themechanics behind the crisis in short-termcredit markets was presented at the annualJackson Hole Conference sponsored by theFederal Reserve Bank of Kansas City. Thepaper by Gary Gorton, simply titled, ThePanic of 2007, quickly became a hot topicof discussion among economists and policy-makers, andsomething new under thesuna samizdat for interested laypeople on

the Internet. This paper was republished inMarch 2010 with additional material andanalysis on the shadow banking system asSlapped by the Invisible Hand: The Panicof 2007.

Much of Gortons account is descriptive.Among other things, its a crash course (nopun intended) in several specialized areasof financial engineering. Gorton begins

with the basic building block, the subprime


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mortgage,9describing each of the layers of atall layer cake that we call securitized debt:how those subprime mortgages were usedto create mortgage-backed securities, howthose securities were used to create CDOs,

why those obligations were bought by inves-tors, who those investors were, and why theirspecific identities were important.

What Gorton describes is a machine dedi-cated to reducingtransparency. Even today,its still striking how the available statistics inhis account dwindle as one gets to the upperlayers of the cake. There are estimates,guesstimates, important numbers with onesignificant figure or less, and admissions of

complete ignorance. Even the term sub-prime represents a reduction of transpar-encyGorton details at some length theheterogeneity of the underlying mortgagesin this category, a term that wasnt part of thefinancial industrys patois until recently.

With this description in hand, Gortonwalks us through the panic of 2007. It beginswith the popping of the housing bubble in2006: house prices flattened and then beganto decline. Refinancing a mortgage becameimpossible and mortgage delinquency ratesrose. Up to this point, this account parallelsShillers basic bubble story. Here, however,Gorton claims the lack of common knowl-edge and the opaqueness of the structuresof the mortgage-backed securities delayedthe unraveling of the bubble. No one knew

what was going to happenor rather, manypeople thought they knew, but no single

9 The term subprime refers to the credit quality ofthe mortgage borrower as determined by various con-sumer credit-rating bureaus such as FICO, Equifax, andExperian. The highest-quality borrowers are referred to asprime, hence the term prime rate refers to the inter-est rate charged on loans to such low-default-risk individu-als. Accordingly, subprime borrowers have lower creditscores and are more likely to default than prime borrow-ers. Historically, this group was defined as borrowers withFICO scores below 640, although this has varied over timeand circumstances, making it harder to determine whatsubprime really means.

view dominated the market. As a device foraggregating information, the market was

very slow to come up with an answer in thiscase.

When the answer came to the market,it came suddenly. Structured investment

vehicles and related conduits, which helda sixth of the AAA CDO tranches,10 sim-ply stopped rolling over their short-termdebt. This wasnt due to overexposure inthe subprime market: Gorton estimatesthat only two percent of structured invest-ment vehicle holdings were subprime.Rather, as Gorton states, investors couldnot penetrate the portfolios far enough to

make the determination. There was asym-metric information (125). At each step inthe chain, one side knew significantly morethan the other about the underlying struc-ture of the securities involved. At the toplayer of the cake, an investor might knowabsolutely nothing about the hundredsof thousands of mortgages several layersbelow the derivative being tradedand innormal situations, this does not matter. Ina crisis, however, it clearly does. The ratio-nal investor will want to avoid risk; but asGorton analogizes, the riskier mortgagesin mortgage-backed securities had beenintermingled like salmonella-tainted frost-ing among a very small batch of cakes thathave been randomly mixed with all theother cakes in the factory and then shippedto bakeries throughout the country.11 Tocontinue Gortons analogy, the collapse ofthe structured investment vehicle market,

and the consequent stall in the repurchase

10 The term AAA refers to the bond rating of theCDO, which is the highest-quality rating offered by thevarious rating agencies.

11 Gorton actually uses the analogy of E. coli-taintedbeef in millions of pounds of perfectly good hamburger.Ive exercised poetic license here by changing the refer-ence to tainted frosting to maintain consistency with mylayer-cake analogy, but I believe the thrust of his argumentis preserved.


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(repo) market, represented the marketrecalling the contaminated cakes.

Here the story becomes more familiarto students of financial crises. Dislocationin the repo market was the first stage of amuch broader liquidity crunch.12 Short-term lending rates between banks rose dra-matically, almost overnight, in August 2007,as banks became more uncertain about

which of their counterparties might beholding the cakes with tainted frosting andpossibily shut down by food inspectors, i.e.,

which banks might be insolvent because ofdeclines in the market value of their assets.Fears of insolvency will naturally reduce

interbank lending, and this so-called runon repo (Gortons term) caused temporarydisruptions in the price discovery systemof short-term debt markets, an importantsource of funding for many financial insti-tutions. In retrospect, the events in August2007 were just a warm-up act for the mainevent that occurred in September 2008

when Lehman failed, triggering a muchmore severe run on repo in its aftermath.Gorton believes that the regulatory insis-tence of mark-to-market pricing,13 even in

12 The term repo is short for repurchase agreement,a form of short-term borrowing used by most banks, bro-kerage firms, money market funds, and other financialinstitutions. In a typical repo transaction, one party sellsa security to another party, and agrees to buy it back at alater date for a slightly higher price. The seller (borrower)receives cash today for the security, which may be viewedas a loan, and the repurchase of the same security fromthe buyer (lender) at the later date may be viewed as the

borrower repaying the lender the principal plus accruedinterest.

13 Mark-to-market pricing is the practice of updat-ing the value of a financial asset to reflect the most recentmarket transaction price. For illiquid assets that donttrade actively, marking such assets to market can be quitechallenging, particularly if the only transactions that haveoccurred are firesales in which certain investors are des-perate to rid themselves of such assets and sell them atsubstantial losses. This has the effect of causing all otherswho hold similar assets to recognize similar losses whenthey are forced to mark such assets to market, even if theyhave no intention of selling these assets.

a market with little to no liquidity, exacer-bated the crisis. Certainly there was a sub-stantial premium between mark-to-market

values and those calculated by actuarialmethods. These lowered asset prices thenhad a feedback effect on further financing,since the assets now had much less value ascollateral, creating a vicious circle.

Gorton strongly disagrees with theoriginate-to-distribute explanation ofthe crisis. This term, which became com-mon in the summer of 2008, contrasts theprevious behavior of financial institutions,

which retained the loans and mortgagesthey approved, i.e., originate-to-hold, to

the relatively new behavior of creating andpackaging loans as products for further sale.The originate-to-distribute explanationplaces the blame on the misaligned incen-tives of the underwriters, who believedthey had little exposure to risk; on the rat-ing agencies, which didnt properly repre-sent risk to investors; and on a decline inlending standards, which allowed increas-ingly poor loans to be made. Here Gortonbecomes much less convincing, especiallyin light of later information, and he arguesas if proponents of the originate-to-dis-tribute explanation are directly attack-ing the general process of securitizationitself (which may have been the case atthe Jackson Hole conference). But there islittle in Gortons accountor for that mat-ter, the recent historical recordto suggestthat the originate-to-distribute explanationis excludedby the asymmetric information

hypothesis. Simply because many lenderswent under after the fact doesnt mean thattheir incentives were necessarily alignedcorrectly beforehand. However, there issome anecdotal evidence to suggest that anumber of the most troubled financial insti-tutions ran into difficulties in 200708 pre-cisely because they did notdistribute all ofthe securitized debt they created, but kepta significant portion on their own balance


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sheets instead.14Perhaps with the benefit ofmore hindsight and data collection, we canget to the bottom of this debate in the nearfuture.

With asymmetric information in the air,one might have expected Akerlof and Shillers

Animal Spirits: How Human PsychologyDrives the Economy, and Why It Matters forGlobal Capitalism, released in January 2009,to have touched on the topic, especially sinceAkerlofs classic 1970 paper, The Market forLemons, launched this entire literature.Instead, Animal Spirits, which Akerlof andShiller began writing in 2003, attempts torehabilitate John Maynard Keyness concept

of animal spirits into a broad interpretiveframework for studying less quantitative eco-nomic phenomena, among them confidence,fairness, corruption, the money illusion, andstories, i.e., the power of narrative to shapeevents. Like Shillers The Subprime Crisis,this is also meant for the advanced generalreader, although earlier drafts were used inShillers course on behavioral economics atYale. As a result, the book is variegated, butsometimes unfocused. While the insertionof material pertaining to the economic crisisisnt an afterthought, in some places, it feelslike a ninety-degree turn away from the mainthrust of their argument.

Akerlof and Shiller clearly hold to theoriginate-to-distribute theory. Tellingly,they describe the run-up to the financial cri-sis in their chapter on corruption and badfaith in the markets. Where Gorton seesopaqueness dictated by the structure of the

securities in question, Akerlof and Shillersee concealment, deception, and willful

14 These were presumably the troubled assets that thegovernments $700 billion Troubled Asset Relief Program(TARP) were meant to relieve. For example, on October28, 2008, Bank of America, BNY Mellon, Citigroup,Goldman Sachs, JPMorgan Chase, Morgan Stanley, StateStreet, and Wells Fargo received a total of $115 billionunder the TARP program (see GAO 2009).

blindness. In their view, the worst offensestook place at the first link of the chain, amongthe subprime lenders who took advantage ofborrower ignorance. Later links in the chainhad little incentive to investigate, and greaterincentives to overlook or spin away flaws inearlier links.

These are serious allegations, and whilethere is no doubt that certain lenders didtake advantage of certain borrowers, someempirical support would have been par-ticularly welcome at this point, especiallybecause the reverse also occurred. Duringthe frothiest period of the housing market,stories abounded of homeowners flipping

properties after a year or two, generatingleveraged returns that would make a hedge-fund manager jealous. Loose lending stan-dards also benefited first-time homebuyers

who couldnt otherwise afford to purchase,and many of these households haventdefaulted and are presumably better off.Moreover, even among the households

who have defaulted, while many are cer-tainly worse off, there are also those whocan afford to pay their mortgage paymentsbut have chosen to strategically defaultbecause its simply more profitable to doso. Are we certain that predatory lending

was more rampant than predatory borrow-ing, and that the cumulative benefits to allhomeowners are less than the cumulativecosts? Im not advocating either side of thisdebatein fact, its difficult to formulate asensible prior as to which is more likelybut I believe this is a sufficiently important

issue to warrant gathering additional facts tosupport a particular conclusion.

In the end, Akerlof and Shiller believe,there was an economic equilibrium thatencompassed the whole chain (37), whereno one had any incentive to rock the boatuntil housing prices began to drop. As withShillers earlier book, their policy recom-mendations for the financial crisis appearalmost naively optimistic with the passage


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of time. They suggest two stimulus targets.First, the proper fiscal and monetary stimu-lus needed to bring the American economyback to full employment. The proper target,they believed, would be easy to administer:The Federal Reserve, the Congress, andthe Council of Economic Advisers are allexperienced in making such predictions(89). Second, they propose a target for theproper amount of credit needed to keep theeconomy at full employment. In retrospect,thisthe more speculative of their propos-alsis the one that has been most fully real-ized. In January 2009, it wasnt yet clear thatthe political economy of the financial crisis

would favor the rebuilding of the credit mar-kets over the pursuit of full employment.

By the fall of 2009, the outlines of theearly stages of the financial crisis wereclear, although the exact causation (or theblame) remained a point of vigorous con-tention. With the September publication ofThis Time Is Different: Eight Centuries ofFinancial Folly, Carmen M. Reinhart andKenneth Rogoff provided invaluable histori-cal data and context for understanding thecrisis. Among all the books reviewed in thisarticle, theirs is the most richly researchedand empirically based, with almost 100 pagesof data appendices. If all authors of crisisbooks were required to support their claims

with hard data, as Reinhart and Rogoff domost of the time, readers would be consider-ably better off and our collective intelligence

would be far greater.This vast compendium of financial crises

showed that the 2007 subprime meltdownwas neither unprecedented nor extraordi-nary when compared to the historical record.Reinhart and Rogoff briefly document thethis time is different thinking among inves-tors, academics, and policymakers. They linkthe rise of the housing bubble in particularand the rise of the financial industry in gen-eral to the large increase in capital inflows tothe United States. The great size and central

position of the American economythelargest engine of growth in human historydidnt render it immune to basic forms offinancial calamity. Nor, more disappointingly,did the expertise of its financial professionalsor the strength of its financial institutions.Nor did the forces of globalization or inno-

vation prevent the financial crisisin fact,they may have provided it with new channelsthrough which to propagate.

To respond to future crises, Reinhart andRogoff suggest the further developmentof informational early warning systemsand more detailed monitoring of nationalfinancial data, perhaps through a new inter-

national financial institution, similar tothe development of standardized nationalaccount reporting after World War II. Theirdata appendices and analytics pave the

way for such an initiative. They also warnabout the recurrence of this time is differ-ent syndrome, something that observerssince Charles Kindleberger (if not CharlesMackay) have warned against. Moreover,they preemptively dismiss future state-ments of this time is different based on theLucas critique, Robert E. Lucass famousmacroeconomic dictum against historicalprediction because simple linear extrapo-lations of the past dont take into accountthe sophistication of rational expectations.Reinhart and Rogoff argue that because thehistorical record shows that some nationshave graduated from perennial financialinstability to financial maturity, there isreason to hope that improved forms of self-

monitoring and institutional advances cankeep certain types of financial crises fromhappening, despite the implication of theLucas critique that such predictions arefutile.

An unusual perspective of the finan-cial crisis appeared in the United States inNovember 2009 from the Australian econo-mist Ross Garnaut in a book coauthored with

journalist David Llewellyn-Smith. Written


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quantifying the impact seems less obvious.In particular, to determine the effect thatgovernment bailouts might have on cor-porate risk-taking, it matters a great deal

whether the bailouts are intended to res-cue bondholders, equityholders, or both.This is where new economic analysis couldhave added real value. For example, giventhe empirical evidence in Fahlenbrach andStulz (2011) and Murphy (2011) that CEOsincentives seem highly aligned with share-holders, do implicit government guaranteescause shareholders to take on too much risk,in which case we need to focus on reduc-ing the sizes of large financial institutions,

as Johnson and Kwak (2010) propose (seebelow)? Or is this a reflection of deeper con-cerns regarding corporate governance and

whether CEOs should be maximizingstake-holderwealth instead of shareholder wealth?Maximizing shareholder wealth is currentlythe focus of most U.S. CEOs and their exec-utive compensation plans. However, some ofthe rhetoric in this debate suggests an unspo-ken desire for more inclusive policies, which

would be quite a departure from the corpo-rate governance structures of most Anglo-Saxon and common-law countries such asthe United States and United Kingdom.15 Amore detailed fact-based analysis would havebeen particularly valuable in this instance.

The proper solution according to Stiglitzis a wholesale reformation of the Americanfinancial system on a scale not seen since theGreat Depression. Much of Freefalllamentsthe missed opportunity for such a reforma-

tion. Here, however, Stiglitzs account of thepolitical economy behind the stimulus pack-ages and bailouts becomes much too vague.It may fall to the political scientists ratherthan the economists to give us the completestory of what happened. Readers will likelyfind Stiglitzs moral fervor either refreshing

15 See Allen and Gale (2002).

or tedious, depending on their prior beliefs,but at least hes explicit about his convic-tions. However, he sometimes loses clarity

with respect to his assertions of bad faithamong principal players during the crisis.Stiglitz was certainly in a position to hearprivileged information about private policydiscussionshe credits the Obama admin-istrations economic team with sharing theirperspectives with him, despite his often pro-found disagreement with them. Still, manyreaders will have their curiosity piqued aboutthe circumstances behind some of these dis-closures; unfortunately, they may not getmuch satisfaction until Stiglitz publishes his

memoirs.Several attempts to place the financial cri-

sis into a larger framework emerged in thespring of 2010. First published among theseattempts was Simon Johnson and JamesKwaks Thirteen Bankers: The Wall StreetTakeover and the Next Financial Meltdown,released in March. Johnson and Kwak framethe financial crisis as another swing of thependulum of the American political economyand its financial institutions. In their view,the concentration of power by financial elitesin the American systemwhom Johnsonand Kwak characterize as oligarchsleads to governmental financial institutions

with strong private cross-interests and weakregulatory oversight, producing a financialenvironment prone to recurrent crises. Onthe other hand, when the government hasplayed an aggressively hostile role againstthe concentration of financial power (as dur-

ing the Andrew Jackson administration), itsactions have resulted in a fragmented, weak,and vulnerable financial system. In theiropinion, the most successful course has beenthe middle course, taken by Franklin DelanoRoosevelt and his advisors in the early 1930s,

which led to a half-century of strong financewithout major financial crises.

Johnson and Kwak mark the turning pointaway from the older, safer, boring banking


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regime to todays bigger, exciting, morecrisis-prone regime with the election ofRonald Reagan. Financial innovation and a

wave of financial deregulation, made pos-sible in the new political climate, reinforcedeach other, leading to increased profits anda rapid expansion of the financial sector.Banks also grew under deregulationhere,Johnson and Kwaks account doesnt fullyexplain their reasoning behind the resultingconcentration, although the facts are hardlyin dispute. By the 1990s, the American finan-cial sector was able to exert further influenceon the political process in a number of ways:lobbying, campaign contributions, and pro-

viding official Washington with a cadre offinancial professionals who had internalizedmuch of the new, exciting ethos of WallStreet.

According to Johnson and Kwak, thisrenewed regulatory capture by Americasnew masters of the universe set the stage forthe boom and bust cycles of the late 1990sand onward. Moves toward greater finan-cial regulation were actively driven backby the so-called oligarchsin one of theirexamples, Brooksley Born, then head of theCommodity Futures Trading Commission,

was blocked from issuing a concept paperon new derivatives regulation by the thir-teen bankers of Johnson and Kwaks title.Financial institutions became too big tofail, taking additional risk with the implicit(and possibly not-so-implicit) knowledgethat should the worst happen, the UnitedStates government would likely rescue them

from their financial folly. Once again, thisglosses over the critical question of whetherit is the bondholders or equityholders whoget bailed out, and where more careful eco-nomic analysis is needed.

Johnson and Kwak diagnose a systemicproblem of consolidation and influence, notmerely of a small number of large financialinstitutions, but of an entire financial sub-culture. Their solution is quite simple: hard

capitalization limits on the size of financialinstitutions. This, they believe, would causethese problems to unwind, piece by piece,initially by decreasing the threat of too bigto fail banks. As the financial sector becomesless exciting under these new rules, theincentives for pursuing risky behavior willdiminish. Eventually, this virtuous cycle ends

with changes to the institutional culture ofthe financial sector, returning to its earliernorms.

Nouriel Roubini and Stephen MihmsCrisis Economics: A Crash Course in theFuture of Finance was published in May2010, shortly after Johnson and Kwaks

account. Roubini by this point had achieveda certain measure of notoriety outside ofacademia as the prophetic Doctor Doomof the financial media; his early warnings thatthe housing bubble could lead to systemicfinancial collapse led Roubini to become oneof the few financial economists nicknamedafter a comic book super-villain (a nicknamein fact popularized by his coauthor in aNewYork Timesprofile).

Roubini and Mihm give a crisp expositionof the underlying mechanisms of the crisis.In Roubinis view, the financial crisis wasnta rare, unpredictable black swan event,but rather a wholly predictable and under-standable white swan. Comparing it torecent crises in developing economies andhistorical crises in developed ones, Roubiniand Mihm present a short primer on conta-gion, government intervention, and lenderof last resort theory, using them to set up

the heart of the book: its policy prescrip-tions. They propose a two-tier approachof short-term patches and long-term fixes.Most of the short-term proposals have todo with reforms to the financial industry,including increased transparency, changesto compensation structure, and increasedregulation and monitoring of the securitiza-tion process, the ratings agencies, and capi-tal reserve requirements.


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In contrast, Crisis Economicsprescribesmuch stronger medicine for the long term.Bubbles should be actively monitored andproactively defused by monetary authori-ties. Lobbying and the revolving doorbetween finance and government shouldbe severely restricted to prevent regula-tory capture. To prevent what Roubiniand Mihm call regulatory arbitrage bybankswhat lawyers often refer to asjurisdiction shoppinga single, uni-fied national authority should regulate andmonitor financial firms, and strong inter-national coordination is needed to preventbanks from engaging in regulatory arbitrage

on a global scale. Too big to fail institu-tions should be broken up, whether underantitrust laws, or under new legislation thatdefines such institutions as a threat to thefinancial system. Finally, the separationbetween investment banking and com-mercial banking, which had existed underthe GlassSteagall Act, should return in aneven stronger form. Given their premises,these suggestions make sense, but Roubiniand Mihm avoid the difficult political ques-tions of implementation.

May 2010 was also the month in whichRaghuram G. Rajans Fault Lines: HowHidden Fractures Still Threaten the WorldEconomy was released. Rajans argumentson the causes of the financial crisis aremultiple and complicated, but they are all

variations on the same theme: systematiceconomic inequalities, within the UnitedStates and around the world, have created

deep financial fault lines that have madecrises more likely to happen than in thepast. Rajan begins with the United States,

where there has been a long-term trend,he argues, of unequal access to higher edu-cation creating growing income inequal-ity. To address the political effects of thisinequality, leaders from both parties havepursued policies to broaden home owner-ship, e.g., through government-sponsored

enterprises like Fannie Mae and FreddieMac.16Political pressure caused these pro-grams to extend easier credit to less suit-able applicants and private firms followedthe governments lead, culminating in thehousing bubble of 2006 and its aftermath.

Each link in Rajans causal chain is a com-pelling idea worthy of further consideration,characteristic of Rajans method of argument.But does the chain truly hold? As with the

well-known property of probabilities, even ifeach link has a high likelihood of being thecorrect causal relationship, a sufficientlylong chain of independent events may still beextremely unlikely to occur. Of course, Rajan

realizes the solution to this conundrum, anduses multiple chains of reasoning to create astronger cable of analysis. He considers otherfault lines such as the global capital imbal-ance, the traditionally weak social safety netin the United States, and the separation ofbusiness norms in the financial sector fromthose in the real economy, which Rajan wit-nessed firsthand.

He proposes a three-pronged attack againstthe conditions that made the financial crisispossible. First, he suggests a set of strongsocial policies to lower inequality in theUnited States, among them increasing educa-tional access, universalizing health care, anddecreasing the structural risks to personallabor mobility. Second, he recommends thatinternational multilateral institutions developrelationships with the constituencies of theircomponent nations, rather than functioningmerely as a top-down council of ministers.

16 Fannie Mae is the nickname of the Federal NationalMortgage Association, a government-sponsored enterprisecreated by Congress in 1938 to support liquidity, stability,and affordability in the secondary mortgage market, whereexisting mortgage-related assets are purchased and sold.Freddie Mac refers to the Federal Home Loan MortgageCorporation, another government-sponsored enterprisecreated by Congress in 1970 with a charter virtually iden-tical to Fannie Maes. See http://www.fanniemae.com andhttp://www.freddiemac.com for further details.


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More democratic input and greater transpar-ency should, in Rajans opinion, improve thequality of the decision-making process amongthe multilateral institutions on the one hand,and make their policy recommendationsmore palatable to their member nations onthe other. This would allow greater interna-tional and domestic coordination regardingthe global capital imbalance (and other press-ing international issues).

Rajan proposes a complex set of carrotsand sticks to defuse the bad incentives thathave accumulated in the American financialsector. He believes risk was systematicallyunderpriced in large part because of the

financial sectors expectations of govern-ment intervention. Removing the implicitpromise of intervention and the explicitpromise of subsidies would eliminate thisdistortion. The government should espe-cially remove itself from the secondarymortgage market as soon as possible, andreduce its role in the primary mortgagemarket. Even the role of deposit insurance,usually thought of as one of the center-pieces of American bank regulation, shouldbe reconsidered according to him.

Meanwhile, financial corporate gover-nance must reduce the amount of risk takenon by traders and companies. Instead ofimmediate compensation for investmentstrategies that might have hidden tail risk,Rajan proposes that a significant fraction ofthe bonuses generated by finance workersand management be held in escrow subjectto later performance. This would have the

effect of extending the time horizon used tocalculate profit. If the traders and managersare acting rationally, this should, in theory,diminish tail risk.17 At the highest levels,boards should choose prudent financial

17 Its worth noting that AIG had a broadly similar planin place for its top executives during the run-up to thecrisis.

professionals who take an active role in theirfirms operation.

Rajan believes the discipline of the mar-ket will not be enough, however. Othergovernmental regulation must simultane-ously become more comprehensive andless sensitive to political over- or under-reaction. In contrast to Johnson and Kwak,Rajan believes that fixed limits on bank sizeor activity are too crude and easily evaded,creating a new set of misaligned incentivesfor financial institutions. Rajan sees an activerole for bank regulators and supervisors.Public transparency and bank supervision

would serve as a check to excessive risk-tak-

ing by corporate governance. Like Roubiniand Mihm, Rajan favors a modern versionof the GlassSteagall Act and other forms ofasset segregation: this would diminish riskand eliminate a potential channel for a panic.Rajan admits that this would also increase abanks borrowing costs, but he believes thetradeoff might be worthwhile. He also favorsa prohibition against proprietary trading, notfor its increased risks, but because of thepotential abuse of asymmetric informationby the banks.

In May 2010, a third crisis book was pub-lished, authored by fifteen financial econ-omists including Rajan and Shiller: TheSquam Lake Report: Fixing the FinancialSystem. This bipartisan group originallymet in the fall of 2008 at Squam Lake,New Hampshire, to discuss the long-termreform of the worlds capital markets. Thisreport cuts across a representative (but not

necessarily complete) section of the politi-cal and ideological spectrum; as a result,many passages resemble carefully wordedpublic statements released by an ecumeni-cal group on a controversial tragedy. Thisreport doesnt propose any consensus viewamong academic policymakers, but is moreof an extended brainstorming session tofind new policy solutions for an unprece-dented crisis.


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Many of the Squam Lake groups pro-posals will already be familiar to readers ofthis review. The group proposes that eachnation set up a systemic financial regulatoryagency run by the central bank. In terms oftransparency, these regulators should collectmuch broader standardized data on financialinstitutions, and this data should becomepublic after an interval. Capital require-ments should increase with the size, risk, andliquidity of assets. Governments shouldntimpose limits on executive compensation,but they should impose rules that financialinstitutions withhold full compensation fora fixed time period. Simply put, the govern-

ment should be used to universalize regula-tion, but institutions should internalize thecost of their own failures.

Other proposals of the Squam Lake groupare more novel. To maintain bank solvency,the group proposes that the government pro-mote banks to issue a long-term convertiblebond that converts to equity at very specifictriggers during a crisis. In this way, insteadof ad hoc government recapitalization duringa banking crisis, the costs of recapitalization

will be put on the banks investors. To expe-dite a recovery, the group recommends thatfinancial institutions maintain living willsto help regulators restructure them quicklyin worst-case scenarios.

For problems specific to the recent cri-sis, however, the Squam Lake group offersfewer panaceas. The problem of systemicrisk in credit default swaps (CDSs) is a dif-ficult one,18but the Squam Lake Report can

only suggest that the government encourage

18 A credit default swap is an agreement between twoparties in which one party agrees to pay the other party aprespecified amount of money in the event of a default on athird partys bond. Essentially a type of insurance contract,CDSs were used to provide credit protection for variousmortgage-backed securities like collateralized debt obliga-tions (CDOs), which was particularly popular among themost conservative investors in CDOs such as money mar-ket funds.

financial institutions to use a single, stronglyregulated clearinghouse.19 On other ques-tions, such as the problem of runs on largebrokers due to their unsegregated assetstructure, the group cannot decide on a solu-tion based on existing research. Interestingly,the group attempts to walk through howspecific failures during the financial crisis,such as the collapse of Bear Stearns, wouldhave played out had their recommendationsbeen in place. Candidly enough, they see amodest improvement at the firm level, and areduced cost to the taxpayer, but they makeno claims that the financial crisis itself wouldhave been averted.

Finally, in April 2011, Acharya,Richardson, van Nieuwerburgh, and WhitesGuaranteed to Fail: Fannie Mae, FreddieMac, and the Debacle of Mortgage Finance

was published. This is a key contribution toone of the most vexing problems from theepicenter of the crisis: the future of FannieMae and Freddie Mac. The authors tracethe origin of their problems to Fannie Maesflawed privatization during the Johnsonadministration (made largely for account-ing reasons). Fannie Mae, and later FreddieMac, had the ability to participate as a pub-licly traded company on the one hand, butmaintained the privileges granted by its fed-eral charter on the other. Financial marketsbelieved that Fannie Mae and Freddie Machad implicit guarantees on their holdingsfrom the federal government, apparently

with good reason. Following the deregulationof the mortgage industry during the Reagan

administration, investors naturally preferredto invest in them rather than in truly private

19 A clearinghouse is a legal entity that serves as anintermediary between two counterparties so that if eitherone defaults on its obligation, the clearinghouse will fulfillthat obligation. The presence of a clearinghouse greatlyreduces counterparty risk and enhances the liquidity ofthe contracts traded, which is especially relevant for creditdefault swaps.


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mortgage companies. Bipartisan policy goalsmade the enterprises politically untouch-able, even while the evidence of their mis-management grew. In effect, as the authorsof Guaranteed to Failpoint out, Fannie Maeand Freddie Mac were run as the worldslargest hedge funds, and badly at that.

How to unwind this trillion-dollar prob-lem? If much smaller institutions werealready too big to fail, Fannie Mae andFreddie Mac must represent a class untothemselves in terms of sheer size and thedollar-value of their implicit guarantees(estimated to be between $20 to $70 billionin present-value terms according to Lucas

and McDonald (2011), depending on theassumptions used). Drawing on the exampleof the savings and loan crisis in the UnitedStates in the late 1980s and early 1990s,the authors propose that the governmentestablish a resolution trust corporation tomanage the slow liquidation of Fannie Maeand Freddie Mac assetsslow, so as not todestabilize the remaining mortgage-backedsecurities market. As the housing marketimproves, eventually the process can beaccelerated. A similar procedure can takeplace with those Fannie Mae and FreddieMac assets now held by the Federal Reserve.

The other half of this trillion-dollar prob-lem, the authors agree, is to never let a simi-lar situation arise again. The authors believethat the problem is inherent to government-sponsored enterprises with laudable socialgoals, especially in the housing market,and they point to similar but smaller fail-

ures in Germany and Spain. They reject fullnationalization due to its enormous liabil-ityJohnson had partially privatized FannieMae for much lessand for the likely politi-cal capture of its management. In a similarspirit, they are agnostic about full privati-zation, foreseeing that the largest privatemortgage originators would simply induceenough regulatory capture to become gov-ernment-sponsored enterprises in all but

name. The authors attempt to split the dif-ference by proposing a private/public part-nership for the mortgage guarantee businessonly, the lower levels of the mortgage indus-try becoming fully private (although highlyregulated). Finally, the authors believe theroot cause of the mortgage finance debacle,and by extension, the entire global financialcrisis from 2007the American addic-tion to homeownershipshould be treatedposthaste.

3. Journalistic Accounts

While often overlooked by academic read-

ers, the journalistic accounts of the financialcrisis are complementary in many ways totheir academic counterparts. If we return tothe analogy of the financial crisis as a major

war, then in the same way that the academicwriters acted as the strategists, diplomats,and gadflies of the crisis, the financial report-ers were the war correspondents. These

journalists documented the campaigns,battles, and exceptional acts of courage andcowardice among individuals and battalions.Moreover, they describe elements of the cri-sis that, as a scientific discipline, economicshas difficulty capturing: the role of motives,psychology, personality, and strong emotion.

We have seen how Akerlof, Shiller, Stiglitz,Roubini, and others have touched upon therole of greed, fear, and anger in the hous-ing bubble, the financial crisis, and its policyresponses. By breaking down the macro-events of the crisis into many different per-

sonal stories, these accounts are actuallyliterary attempts to make sense of the crisisfrom a micro-foundational level. Its difficultto speak of rational behavior in the aggregate

when major economic decisions are madeby an unrepresentative handful of people.

While journalistic accounts of the crisis havethe flaws of their genrethey are necessar-ily subjective, often moralistic, and they mayattempt to shape a narrative beyond what


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the facts will strictly bearthe accounts ofeconomists and policymakers may have theirown form of biases.

William Cohans House of Cards: A Tale ofHubris and Wretched Excess on Wall Street

was the first major journalistic account out ofthe gates, published in March 2009, almost a

year to the day after the fall of Bear Stearns,which it recounts in great detail. Cohan, a for-mer finance professional turned investigativereporter, documents the harrowing final daysof the firm, and this morbidly fascinating talereminds us that economics has few answersto liquidity crises, thin markets, and other sit-uations where the price discovery mechanism

fails to perform. As the financial analyst A.Gary Shilling (1993, 236) put it, Markets canremain irrational a lot longer than you and Ican remain solvent. In those circumstances,economic actors will necessarily fall backonto procedures which, almost by definition,

will produce suboptimal outcomes, e.g., thefate of Bear Stearns. Cohan is also very strongin his portrayal of economic decision-makingunder stress and decision-making by smallgroups, two areas which have recently begunto receive more scholarly attention.20

Bear Stearns was the first of the majorAmerican banking firms to fall during thefinancial crisis, and its commonly believedthat it was also the weakest in terms of over-sight, incorrectly aligned incentives, andorganizational culture to handle the crisis.

While this might be an example of fallaciouspost hoc reasoning, Cohan presents a casethat Bear Stearnss dysfunctional manage-

ment and aggressive corporate cultureeven by the standards of Wall Streetmadeit particularly vulnerable. Unusually, severalfigures in Bear Stearnss management weretournament-caliber bridge players, includingits last chairman, Jimmy Cayne, one of the

20 For the former, see Kowalski-Trakofler, Vaught, andScharf (2003); for the latter, see Woolley et al. (2010).

best players in the world and notorious forhis presence at tournaments and absence atBear Stearns during the crisis. Cohan makesthe intriguing implication that the cognitiveskills involved in playing world-class bridgemight distort the skills involved in makingfinancial decisions at their highest levels.

The spring of 2009 also saw the release ofGillian Tetts Fools Gold: The Inside Storyof J.P. Morgan and How Wall St. GreedCorrupted Its Bold Dream and Created aFinancial Catastrophein May. Tett, the for-mer global markets editor and current U.S.managing editor of the Financial Times,reconstructs the early history of the develop-

ment of the credit derivatives market, whichplayed a key role in the subprime crisis. IfCohans account was the view from BearStearns, Tetts account is very much the viewfrom J.P. Morgan (now formally JPMorganChase). Tett traces the origin of credit deriv-atives to an initiative of Morgans swaps teamat a Palm Beach resort hotel in 1994 (Tettmentions, in passing, earlier, less success-ful innovations in default-risk derivatives atMerrill Lynch and Bankers Trust). In a headyintellectual atmosphere of Friedrich vonHayek and Eugene Fama, this young teamsought to create a successful derivative prod-uct that would protect against default risk,something all lending institutions have todeal with. This product would combine the

virtuous motive of helping to expand capitalinto the greater economy with the self-inter-ested motive of helping to expand Morgansshare of the derivatives market. Banks for

the first time would be able to make loanswithout carrying the associated credit risks ofthose loans, which would be transferred tothe buyers of the derivative.

At the cutting edge of financial engineer-ing for its time, these new derivatives weretechnically sweet, to borrow J. RobertOppenheimers postwar description of theatomic bomb. As a product, their designprinciples were similar to other consumer


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2009. Despite their eight-hundred year his-tory, bubbles are still rather mysterious eco-nomic phenomena. One deep mystery ofbubbles is their asymmetry. Why do so fewinvestors try to take advantage of an obvi-ous bubble? And why do even fewer inves-tors manage to profit once a bubble bursts?Zuckerman, a reporter for the Wall Street

Journal, tells the riveting story of the largestsingle beneficiary of the collapse of the hous-ing bubble, a previously unknown hedge-fund manager named John Paulson.

Why did John Paulson succeed? Paulsonsrare (but not unique) insight was to purchaseCDS insurance on the most risky slices of

mortgage bonds, the BBB tranches. Thesebonds would be the first to be hit in theevent of default, which Paulson saw as inevi-table in the collapse of the housing bubble.Derivative contracts like CDSs were gen-erally unpopular because they representednegative carry trades, a situation in whichbuyers of such contracts are subject to asteady stream of sure losses. Its payoffs aresimilar to playing a slot machine, constantlyputting in coins in the hopes of an enor-mous but uncertain jackpot some time in thefuture. In a normal market, someone obses-sively buying CDS insurance would have asimilar financial fate as someone obsessivelyplaying the slots. Astonishingly, Paulsonsinitial purchases not only failed to run upthe price of the insurance contracts, but thesellers tried to convince him he was makinga mistake. The information-gathering func-tion of the price discovery mechanism was

clearly awry. Paulsons uniqueness camefrom his conviction, his deep pockets, andhis ability to get out of his position. Withoutany single one of those qualities, Zuckermanimplies, Paulsons record-breaking $4 billionpayout in 2007 would have been much lessspectacular.

Former Secretary of the Treasury HenryM. Paulsons account of the crisisOn theBrink: Inside the Race to Stop the Collapse of

the Global Financial Systemwas releasedin February 2010. At first glance, Paulsonsmemoir appears to be derived from his per-sonal diary of the crisis, revised and editedfor publication. In fact, On the Brink is analmost wholly synthetic day-by-day accountof the escalating series of crises duringPaulsons time at Treasury, based on his pro-digious memory, incomplete phone logs,and personal conversations with many of itsparticipants after the fact (Paulson states hedoes not use email.)

Its become a truism that one should readmemoirs by people at the center of greathistorical events with a careful eye toward

score-settling, self-justification and, morerarely, self-blame; On the Brink would beunique if it lacked those elements. For themost part, however, Paulson presents him-self as a competent man dealing with eventsalmost beyond his control, often mistakenor uncertain about the magnitude of eachimpending phase of the crisis taking place

while he and the Treasury Department man-aged to weather the collapse of Bear Stearns,Lehman Brothers, Fannie Mae, and FreddieMac, and the financial near-apocalypse ofSeptember 2008.

In that respect,On the Brinkis very muchthe Treasury view of the crisis of 2008.Similar memoirs from Timothy Geithner orBen Bernanke will probably be some time incoming. In the meantime, however, policy-minded readers will find much to think aboutregarding the formal and informal constraintson the power of the United Statess monetary

institutions. One striking example is the pol-icy aversion at the time to any cost figure neara trillion dollars or higher. Paulson and hiscolleagues believed that legislators would betoo hostile to a trillion-dollar estimate for theTroubled Assets Relief Program, and insteadchose $700 billion as the least-bad figurethat might accomplish their goals. As it hap-pened, Paulson was still surprised at the hos-tility he received from lawmakers. Was this


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are several economics and finance Ph.D.theses that need to be written to sort out thisone idea.

In November 2010, Greg Farrells bookCrash of the Titans: Greed, Hubris, the Fallof Merrill Lynch, and the Near-Collapse ofBank of America came out. Farrell, a cor-respondent for the Financial Times, has

written a strong narrative business historyof Merrill Lynch in its final months, andthe peculiar merger with Bank of Americathat followed in late 2008. Unlike earlieraccounts described here, Farrells book lacksa strong analytical focus, perhaps becauseby this time the basic narrative of the finan-

cial crisis seemed like well-trodden ground.Farrell employs a personality-driven modelregarding the behavior of firms: personalitiesat the top create incentives (or disincentives)for its employees to follow, rather than thefirm following the dictates of the market. Forexample, Merrills adoption of a heavy loadof CDOs is presented as a consequence of itschief executive Stanley ONeals dismantlingof Merrills earlier corporate culture ratherthan market competition or opportunitiesper se.

If a rising tide lifts all boats, a perfectstorm will sink even the soundest. In Farrellsaccount, once again we see how the financialcrisis exacerbated preexisting dysfunctionsin the management structure, oversight, andcorporate governance of financial institu-tions. According to Farrell, Merrill Lynchsfinal CEO, John Thain, appears to have mis-calculated the length and depth of the storm

of the crisis. Thains guarded optimism thatthe crisis would pass and the market wouldrebound led him to make incorrect deci-sions on the size of the repairs needed by thecompanyalthough Farrell also keeps openthe possibility that Merrill Lynch was anirreparable cause without an outside buyer.In the end, Bank of America, with its insular,regional corporate culture, became Merrillslast resort.

November also saw the publication ofBethany McLean and Joe Noceras All theDevils Are Here: The Hidden History of

the Financial Crisis. McLean is, of course,best-known for her breaking reportage ofthe Enron scandal, and Nocera is currentlyan op-ed columnist at theNew York Times.Their book is an ensemble portrait of thesubprime crisis, clearly of the second (or per-haps third) publishing cycle after the originalevent; in fact, many books mentioned earlierin this article are acknowledged as importantsources of insight. Its strengths, however, arein its grounding in the nuts and bolts of therelevant industries and government organi-

zationsmost notably, in the bond ratingfirms and the mortgage originatorsall the

way up to the actions of the Federal ReserveBoard.

McLean and Nocera tell a story of lead-ing personalities in representative indus-tries responding to incentives, especiallyto changes in the regulatory environment.These changes induced a coarsening in stan-dard business practice. Established firmsbecame corrupt in their pursuit of profit;corrupt firms became criminal. McLean andNocera also tell a parallel story of regula-tory capture, evasion, inundation, and inef-fectiveness. With few exceptions, official

Washington is excoriated for its inaction andcomplicity in this process. Local officials atthe city and state level, on the other hand, arepraised for their attempts to curb or halt theexcesses at the ground floor of the crisisalthough these attempts were often quashed

by active lobbying and federal intervention.Avoiding policy prescriptions, McLean andNoceras account concludes with a series ofopen-ended questions about the future ofthe governments role in mortgage finance.

Gretchen Morgenson and Joshua Rosnersbook, Reckless Endangerment: HowOutsized Ambition, Greed, and Corruption

Led to Economic Armageddon, publishedin May 2011, extends this inquiry into the


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governments past role in mortgage financeand in creating the conditions for the hous-ing bubble to begin. Morgenson, a PulitzerPrize-winning financial journalist at the

New York Times, and Rosner, an indepen-dent Wall Street analyst who spotted earlyproblems among the government-sponsoredenterprises, trace the origins of the crisis toa program of systematic regulatory captureof Fannie Mae and Freddie Mac beginningin the early 1990s. The authors are particu-larly suited to this task: Rosner was an ana-lyst of the industry as the regulations wereimplemented, while Morgenson specializesin financial scandals and conflicts of interest.

In many ways, Reckless Endangerment isa necessary work of regulatory archaeology.The Clinton administrations pursuit of apolicy of low-income home ownership wascaptured, often willingly and far too easily,by profit interests. Fannie Mae and FreddieMac, as government-sponsored enterprises,used their status as quasi-governmentalorganizations to gain business advantage,and used their business profits to gain politi-cal advantage, in a round-robin of influencepeddling. Cronyism became the rule ofthe day, as with the Countrywide Friendsof Angelo program to offer sweetheartloans to influential political figures, a pro-gram whose blatant nature one might expectto see in a developing nation or a corruptmunicipality, rather than at the highest lev-els of the American government. As pairedreading with Acharya et al.s Guaranteed toFail, this is especially illuminating. One sig-

nificant scholarly problem with Morgensonand Rosners account, however, is its lackof sourcing. Major assertions are left hang-ing in the text without an independent wayto verify them. There is no footnote or end-note apparatus, and the index is poorly con-structed. Much of Reckless Endangermentis apparently based on earlier reporting byMorgenson or Rosner dating back to themid-1990s, but the individual articles arent

cited. One hopes that future editions willrectify this glaring omission.

4. Fact and Fantasy

There are several observations to be madefrom the number and variety of narrativesthat the authors in this review have proffered.The most obvious is that there is still signifi-cant disagreement as to what the underlyingcauses of the crisis were, and even less agree-ment as to what to do about it. But what maybe more disconcerting for most economistsis the fact that we cant even agree on all thefacts. Did CEOs take too much risk, or were

they acting as they were incentivized to act?Was there too much leverage in the system?Did regulators do their jobs or was forbear-ance a significant factor? Was the Feds lowinterest-rate policy responsible for the hous-ing bubble, or did other factors cause hous-ing prices to skyrocket? Was liquidity theissue with respect to the run on the repomarket, or was it more of a solvency issueamong a handful of problem banks?

For financial economistswho are usedto dealing with precise concepts such as no-arbitrage conditions, portfolio optimization,linear risk/reward trade-offs, and dynamichedging strategiesthis is a terribly frustrat-ing state of affairs. Many of us like to thinkof financial economics as a science, but com-plex events like the financial crisis suggestthat this conceit may be more wishful think-ing than reality. Keynes had even greaterambitions for economics when he wrote, If

economists could manage to get themselvesthought of as humble, competent people onalevel with dentists, that would be splendid.22Instead, were now more likely to be thoughtof as astrologers, making pronouncementsand predictions without any basis in fact orempirical evidence.

22 Keynes (1932, 373).


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To make this contrast more stark, com-pare the authoritative and conclusive acci-dent reports of the National TransportationSafety Board (NTSB)which investigatesand documents the whowhatwhen

whereandwhy of every single planecrashwith the twenty-one separate andsometimes inconsistent accounts of thefinancial crisis weve just reviewed (andmore books are surely forthcoming). Whyis there such a difference? The answer issimple: complexity and human behavior.

While airplanes often crash because ofhuman behavior or pilot error, the causesof such accidents can usually be accurately

and definitively determined with sufficientinvestigatory resources. Typically there area small number of human actors involvedthe pilots, an air traffic controller, and per-haps some maintenance crew. Also, thenature of accidents in this domain is fairlytightly constrained: an airplane loses aero-dynamic lift and falls to the ground. Whilethere may be many underlying reasons forsuch an outcome, investigators often have apretty clear idea of where to look. In other

words, we have sufficiently precise modelsfor how airplanes fly so that we can almostalways determine the specific causal fac-tors for their failure through relatively lin-ear chains of physical investigation andlogical deduction. Human behavior is justone part of that chain, and thanks to flightdata recorders and the relatively narrowset of operations that piloting an aircraftinvolvesfor example, the pilot must lower

the landing gearbeforethe plane can land,and theres only one way to lower itthecomplexity of the human/machine inter-face isnt beyond the collective intellectualhorsepower of the NTSBs teams of expertinvestigators.

Now compare this highly structured con-text with piloting an investment bank, wherethe instrument panel is the steady streamof news reports, market data, internal

memos, emails, text messages, and vagueimpressions that a CEO is bombarded withalmost 24/7, not all of which is true; wherethe flight controls are often human subor-dinates, not mechanical devices or electronicswitches; and where there is no single flightdata recorder, but rather hundreds of dis-tinct narratives from various stakeholders

with different motivations and intentions,generating both fact and fantasy. If we wantto determine whether or not the failure ofLehman Brothers was due to pilot error,like the NTSB, we need to reconstruct theexact state of Lehman prior to the accident,deduce the state of mind of all the execu-

tives involved at the time, determine whicherrors of commission and omission theymade, and rule out all but one of the manypossible explanations of the realized courseof events.

Given that we cant even agree on a set offacts surrounding the financial crisis, nor do

we fully understand what the correct oper-ation of a financial institution ought to be inevery circumstance, the challenges facingeconomists are far greater than those facedby the NTSB. However, the stakes are alsofar higher, as weve witnessed over the pastfour years. There is a great deal to be learnedfrom the NTSBs methods and enviable trackrecord, as Fielding, Lo, and Yang (2011)illustrate in their case study of this remark-able organization. And one of the most basicelements of their success is starting with asingle set of incontrovertible facts. In other

words, we need the equivalent of the black

box flight data recorder for the financialindustry, otherwise we may never get to thebottom of any serious financial accident.23

23 This was precisely the motivating logic behind theDodd Frank Acts creation of the Office of FinancialResearch, but its future is unclear given the current politi-cal stalemate that has brought a number of important leg-islative initiatives to a standstill.


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An instructive example of the importanceof getting the facts straight is the role thatfinancial leverage played in the crisis, whichis described in Lo and Mueller (2010, 5051).On August 8, 2008, the former director of theSECs Division of Market Regulation (nowthe Division of Markets and Trading), LeePickard (2008), published an article in the

American Bankerwith a bold claim: a rulechange by the SEC in 2004 allowed broker-dealers to greatly increase their leverage,contributing to the financial crisis.24 In par-ticular, Mr. Pickard (2008, 10) argued thatbefore the rule change,

. . . the broker-dealer was limited in the

amount of debt it could incur, to about 12times its net capital, though for various reasonsbroker-dealers operated at significantly lowerratios . . . If, however, Bear Stearns and otherlarge broker-dealers had been subject to thetypical haircuts on their securities positions, anaggregate indebtedness restriction, and otherprovisions for determining required net capitalunder the traditional standards, they would nothave been able to incur their high debt lever-age without substantially increasing their capi-tal base.

He was referring to a change in June 2004to SEC Rule 15c31, the so-called netcapital rule by which the SEC imposes netcapital requirements and, thereby, limits theleverage employed by broker-dealers. Thisstory was picked up by a number of news-papers, including the New York Times onOctober 3, 2008 (Labaton 2008, A1):

In loosening the capital rules, which are sup-posed to provide a buffer in turbulent times,

the agency also decided to rely on the firmsown computer models for determining theriskiness of investments, essentially outsourc-ing the job of monitoring risk to the banksthemselves.

Over the following months and years, each ofthe firms would take advantage of the looser

24 I thank Jacob Goldfield for bringing this example tomy attention.

rules. At Bear Stearns, the leverage ratioa measurement of how much the firm wasborrowing compared to its total assetsrosesharply, to 33 to 1. In other words, for everydollar in equity, it had $33 of debt. The ratios atthe other firms also rose significantly.

The reports of sudden increases in leveragefrom 12-to-1 to 33-to-1 seemed to be thesmoking gun that many had been searchingfor in their attempts to determine the causesof the Financial Crisis of 200709. If true,it implied an easy fix according to Pickard(2008, 10): The SEC should reexamine itsnet capital rule and consider whether the

traditional standards should be reapplied toall broker-dealers.

While these facts seemed straightfor-ward enough, it turns out that the 2004 SECamendment to Rule 15c31 did nothing tochange the leverage restrictions of thesefinancial institutions. In a speech given bythe SECs director of the Division of Marketsand Trading on April 9, 2009 (Sirri 2009),Dr. Erik Sirri stated clearly and unequivo-cally that First, and most importantly, theCommission did not undo any leveragerestrictions in 2004.25He cites several docu-mented and verifiable facts to support this

25 SEC Rule 15c31 is complex, and not simply a lever-age test. The rule does contain a 15-to-1 leverage test witha 12-to-1 early warning obligation. However, this com-ponent of the rule only limits unsecured debt, and did notapply to large broker-dealers, who were subject to net capi-tal requirements based on amounts owed to them by theircustomers, i.e., a customer-receivable or aggregate debit

item test. This test requires a broker-dealer to maintainnet capital equal to at least 2 percent of those receivables,which is how the five large investment banks had been ableto achieve higher leverage ratios in the 1990s than afterthe 2004 rule change (see figure 1). Similarly, their bro-ker-dealer subsidiaries (which were the entities subject tothe net capital rule) had long achieved leverage ratios farin excess of 15-to-1. The historical leverage ratios of theinvestment banks were readily available in their financialreports, and the facts regarding the true nature of the SECnet capital rule were also available in the public domain. Ithank Bob Lockner for decoding the intricacies of the SECnet capital rule.


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surprising conclusion,26 and this correctionwas reiterated in a letter from MichaelMacchiaroli, Associate Director of the SECsDivision of Markets and Trading to theGeneral Accountability Office (GAO) onJuly 17, 2009, and reproduced in the GAOReport GAO09739 (2009, 117).

What about the stunning 33-to-1 leverageratio reported by the press? According to theGAO (Report GAO09739, 2009, 40):

In our prior work on Long-Term CapitalManagement (a hedge fund), we analyzedthe assets-to-equity ratios of four of the fivebroker-dealer holding companies that laterbecame CSEs and found that three had ratiosequal to or greater than 28-to-1 at fiscal year-end 1998, which was higher than their ratiosat fiscal year-end 2006 before the crisis began(see figure 6).

In footnote 68 of that report, the GAOobserves that its 1999 report GAO/GGD003 (1999) on Long-Term CapitalManagement . . . did not present the assets-to-equity ratio for Bear Stearns, but its ratioalso was above 28 to 1 in 1998. The GAOsgraph of the historical leverage ratios forGoldman Sachs, Merrill Lynch, LehmanBrothers, and Morgan Stanley is reproducedin figure 1 (see section 1). These leveragenumbers were in the public domain at the

26 So what was this rule change about, if not aboutchanging leverage restrictions? It was meant to applyonly to the five largest U.S. investment banks which wereat a competitive disadvantage in conducting businessin Europe because they didnt satisfy certain European

regulatory requirements dictated by the Basel Accord.By subjecting themselves to broader regulatory super-visionbecoming designated Consolidated SupervisedEntities or CSEsthese U.S. firms would be on a moreequal footing with comparable European firms. As Sirri(2009) explains: Thus the C

reading about the financial crisis: a twenty- one-book review

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