Tim Price - Investing Through the Looking Glass: A Rational Guide to Irrational Financial Markets

The financial services industry is unique. No other industry compensates its employees so generously while delivering such modest tangible value to its customers or society at large. Despite the best creative efforts of tens of thousands of extremely well-paid financiers, the former Federal Reserve Chairman Paul Volcker famously suggested that the most important financial innovation of the past 20 years was the ATM machine. In aggregate, investment expectations of even marginal added value from Wall Street and the City are misplaced, because by definition the market cannot beat itself.

But it can blow itself up. Ever since 2008 many investment practitioners have been engaged in something akin to a whodunit. Just how did we get into this mess? This book provides an answer, of sorts. Everybody did it . We all played a part.

As Lord Overstone once remarked, no warning can save people determined to grow suddenly rich. In the run-up to the Global Financial Crisis, accident-prone bankers were only doing what they always do: gambling (badly, it transpired), with other peoples money. There was also no shortage of irrational behaviour by property speculators, or homeowners, as they are sometimes called.

But the rot in the system runs deeper than just the fault lines scattered throughout the property market. After the collapse of Lehman Brothers in September 2008 most banks did not fail, because central bankers did not allow them to. The financial markets are now in thrall to these unelected monetary technocrats. The extraordinary monetary policies that central bankers are now pursuing are destabilising all financial markets and suppressing their natural price signals.

A growing property and banking crisis assumed a new dimension over the weekend of 1314 September 2008. At just past 7am on the Saturday morning, Jamie Dimon, the Chief Executive Officer of JP Morgan, Americas largest bank, walked into his home library and dialled in to a conference call with his management team. Here is what he told them:

You are about to experience the most unbelievable week in America ever, and we have to prepare for the absolutely worst case. Heres the drill. We need to prepare right now for Lehman Brothers filing [for Chapter 11 bankruptcy protection]. And for Merrill Lynch filing. And for AIG filing. And for Morgan Stanley filing. And potentially for Goldman Sachs filing.

There was a collective gasp on the phone.

Lehman Brothers would indeed file for Chapter 11, shortly after midnight on Sunday 14 September 2008. But as the US authorities watched in disbelief as the global financial system started to implode on itself, they decided that the rest of Wall Street would not be allowed to follow in Lehmans footsteps. So Merrill Lynch, the thundering herd , was swept into the welcoming arms of Bank of America. The global insurance giant AIG was rescued. Morgan Stanley was bailed out, with the help of $107 billion in loans from the US Federal Reserve (the Fed). Goldman Sachs, like the other remaining investment banks, was permitted to convert to a bank holding company, and borrow directly from the Fed a privilege denied to Lehman Brothers in its hour of need.

The financial system was saved. For the time being, at least. But at extraordinary cost. Five years after the failure of Lehman Brothers, the Dallas Federal Reserve estimated that the full cost of the financial crisis was as much as $14 trillion very nearly a full year of US gross domestic product.

The financial crisis wasnt triggered by the failure of Lehman Brothers or by a shock reversal in the fortunes of any one individual firm. Lehman Brothers was merely a symptom. So, for that matter, was the decline in value of so-called sub-prime mortgages associated, in popular opinion, with Wall Streets near-terminal collapse. Sub-prime mortgages were merely the first part of a gigantic edifice of debt to fall.