What Cooked the World's Economy?

It's 2009. You're laid off, furloughed, foreclosed on, or you know someone who is. You wonder where you'll fit into the grim new semi-socialistic post-post-industrial economy colloquially known as "this mess."

Ezra Clayton Daniels

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James Lieber is a lawyer whose books on business and politics include Friendly Takeover (Penguin) and Rats in the Grain (Basic Books). This is his fifth article for the Voice.

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You're astonished and possibly ashamed that mutant financial instruments dreamed up in your great country have spawned worldwide misery. You can't comprehend, much less trim, the amount of bailout money parachuting into the laps of incompetents, hoarders, and miscreants. It's been a tough century so far: 9/11, Iraq, and now this. At least we have a bright new president. He'll give you a job painting a bridge. You may need it to keep body and soul together.

The basic story line so far is that we are all to blame, including homeowners who bit off more than they could chew, lenders who wrote absurd adjustable-rate mortgages, and greedy investment bankers.

Credit derivatives also figure heavily in the plot. Apologists say that these became so complicated that even Wall Street couldn't understand them and that they created "an unacceptable level of risk." Then these blowhards tell us that the bailout will pump hundreds of billions of dollars into the credit arteries and save the patient, which is the world's financial system. It will take time-maybe a year or so-but if everyone hangs in there, we'll be all right. No structural damage has been done, and all's well that ends well.

Sorry, but that's drivel. In fact, what we are living through is the worst financial scandal in history. It dwarfs 1929, Ponzi's scheme, Teapot Dome, the South Sea Bubble, tulip bulbs, you name it. Bernie Madoff? He's peanuts.

Credit derivatives-those securities that few have ever seen-are one reason why this crisis is so different from 1929.

Derivatives weren't initially evil. They began as insurance policies on large loans. A bank that wished to lend money to a big, but shaky, venture, like what Ford or GM have become, could hedge its bet by buying a credit derivative to cover losses if the debtor defaulted. Derivatives weren't cheap, but in the era of globalization and declining American competitiveness, they were prudent. Interestingly, the company that put the basic hardware and software together for pricing and clearing derivatives was Bloomberg. It was quite expensive for a financial institution-say, a bank-to get a Bloomberg machine and receive the specialized training required to certify analysts who would figure out the terms of the insurance. These Bloomberg terminals, originally called Market Masters, were first installed at Merrill Lynch in the late 1980s.

Subsequently, thousands of units have been placed in trading and financial institutions; they became the cornerstone of Michael Bloomberg's wealth, marrying his skills as a securities trader and an electrical engineer.

It's an open question when or if he or his company knew how they would be misused over time to devastate the world's economy.

Fast-forward to the early years of the Clinton administration. After an initial surge of regulatory behavior in favor of fair markets, especially in antitrust, that sort of behavior was abandoned, and free markets triumphed. The result was a morass of white-collar sociopathy at Archer Daniels Midland, Enron, and WorldCom, and in a host of markets ranging from oil to vitamins.

This was the beginning of the heyday of hedge funds. Unregulated investment houses were originally based on the questionable but legal practice of short-selling-selling a financial instrument you don't own in hopes of buying it back later at a lower price. That way, you hedge your bets: You cover your investment in a company in case a company's stock price falls.

But hedge funds later diversified their practices beyond that easy definition. These funds acquired a good deal of popular mystique. They made scads of money. Their notoriously high entry fees-up to 5 percent of the investment, plus as much as 36 percent of profits-served as barriers to all but the richest investors, who gave fortunes to the funds to play with. The funds boasted of having genius analysts and fabulous proprietary algorithms. Few could discern what they really did, but the returns, for those who could buy in, often seemed magical.

But it wasn't magic. It amounted to the return of the age-old scam called "bucket shops." Also sometimes known as "boiler rooms," bucket shops emerged after the Civil War. Usually, they were storefronts where people came to bet on stocks without owning them. Unlike their customers, the shops actually owned blocks of stock. If customers were betting that a stock would go up, the shops would sell it and the price would plunge; if bettors were bearish, the shops would buy. In this way, they cleaned out their customers. Frenetic bucket-shop activity caused the Panic of 1907. By 1909, New York had banned bucket shops, and every other state soon followed.

In the mid-'90s, though, the credit-derivatives industry was hitting its stride and argued vehemently for exclusion from all state and federal anti-bucket-shop regulations. On the side of the industry were Federal Reserve Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and his deputy, Lawrence Summers. Holding the fort for the regulators was Brooksley Born, who headed the Commodity Futures Trading Commission (CFTC). The three financial titans ridiculed the virtually unknown and cloutless, but brilliant and prophetic Born, who warned that unrestricted derivatives trading would "threaten our regulated markets, or indeed, our economy, without any federal agency knowing about it." Warren Buffett also weighed in against deregulation.