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What (and Who) Got Us Into This Mess?—A Q&A With Michael Lewis, Editor of Panic: The Story of Modern Financial Insanity

If there’s one lesson to be learned from <i>Panic</i>, it’s that investors should be terrified by combinations of the words “fundamentals,” “economy” and “strong.”

If there’s one lesson to be learned from Panic: The Story of Modern Financial Insanity, it’s that investors should be terrified by combinations of the words “fundamentals,” “economy” and “strong.”

One phrase should sound familiar: Republican presidential candidate John McCain essentially doomed his bid for the White House with the famous assessment that “the fundamentals of our economy are strong.” His pronouncement has deep historical roots. In 2000, then-Treasury Secretary Lawrence Summers—on the heels of the dot-com bubble and the stock market meltdown on April’s Black Friday—announced that he was “confident the economy will continue to grow … our fundamentals are strong.” But the great originator of the phrase, portentously, was Herbert Hoover, who declared on Oct. 25, 1929: “The fundamental business of the country … is on a very sound and prosperous basis.”

Financial crises have much more than phrases in common. That this is especially true for contemporary finance is the gist of Panic, edited by author Michael Lewis. For this insightful, entertaining anthology, Lewis chose newspaper and magazine articles, book excerpts and other writings from immediately before, during and after four recent financial meltdowns: the crash of ’87, the foreign market collapse in the late ’90s, the burst of the dot-com bubble and the current subprime mortgage crisis. Panic, then, serves as a condensed history of contemporary finance, amplifying the echoes of financial irresponsibility from our recent past.

Lewis, author of Moneyball, The Blind Side and the New York Times bestseller Liar’s Poker (based in part on his experience as an investment banker), spoke with AARP Bulletin Today about where we went wrong, who’s to blame and what to expect next.

Q. You write that the recent financial panics have been cyclical. How are they all connected?

A. The period since the early ’80s has been characterized by people behaving in ways that are financially unsustainable.

Most of your readers are probably bewildered by the subprime mortgage crisis because what happened is so bizarre. How did trillions of dollars get lent to people who had no creditworthiness? It took incredible financial complexity to generate this idiocy. That complexity is what marks this period, and what marks all these crises. At the bottom of each is some new, complicated instrument that has been invented by really smart people—and it’s a tool that gets misused. The complexity of these tools essentially allows people to disguise the risks they’re running. The risks become bad risks, the situation becomes unsustainable, and panic ensues. This thing we’re going through now, though, is a different beast, for all sorts of reasons.

Q. How so?

A. For one thing, this crisis is on a much greater scale than the previous ones. I mean so much bigger. Instead of billions, or even tens of billions, we’re talking trillions of dollars of mistakes.

Q. So why haven’t we learned more from the past?

A. Well, what’s weird about the panics and crashes that led up to this one is that they didn’t have any serious consequences for most ordinary people. They were these self-contained financial events that only had consequences in little pockets of the financial world, largely because the Federal Reserve got really clever in responding to them. So people just ignored them and assumed that Wall Street knew what it was doing.

Q. In each of these crises, people were counting on unlikely events not to occur, and when they did, they caused a panic. It seems that “unlikely” events aren’t that unlikely at all.

A. Yes. The risk models they used on Wall Street were pretty good in estimating the risk of stocks and bonds and derivatives in normal times, but dramatically underestimated the risks of rare events.

Q. Meaning?

A. Let me give you an analogy: Say you are an insurance company and you sell lots of very cheap hurricane insurance to people who live on Miami Beach. You don’t get paid as much as you really should for this insurance, but you might make [out] like a bandit if no hurricane hits. If a hurricane comes, everyone’s doomed because you don’t have enough money to pay for everyone’s losses. But either way, the mere fact that you sold that insurance doesn’t make a hurricane more likely.

On the other hand, if those in the financial markets create lots of crash insurance, and lots of banks that had crash insurance begin selling it off because they don’t think they need it, people know that you’re going to lose a fortune if the crash happens. So in a way, it creates pressures for the crash to happen because investors become concerned that financial institutions aren’t going to be viable. This leads to runs on banks. So, yes, there has been a systematic underestimation of the likelihood of disaster, but I also think that this underestimation has actually led to some of the disasters.

Q. What holds the financial market together?

A. At its core, it’s a productive enterprise. In the end, capital is basically rational, and you hope it finds its way to the people who can put it to the most use—and that they then turn it into more capital. For example, you invest in a business, the business makes profits and you get your little slice of those profits. If you want to get right down to it, economic growth comes from innovation—from people finding better ways to do the same things.

Q. What can be done to protect against panics?

A. The government could do a much better job of regulating and preventing big firms from taking catastrophic risks—risks that will cause the stock market to go down 50 percent, for example.

Q. For starters. What else?

A. The government could also regulate the agencies that assign credit ratings to governments, companies and individual piles of securities. Those ratings agencies have become totally unreliable. Moody’s and S&P are the two agencies that put gold seals of approval on big piles of subprime mortgages because they were paid to do so. They were completely unregulated by the government. It’s outrageous that they did what they did. We need an objective ratings agency that people know they can trust.

Q. What surprised you while compiling this anthology?

A. It surprised me how clearly some people were able to express and predict what was going to happen. John Cassidy wrote a piece in the New Yorker in 2002 saying that we’re in the beginning of a housing bubble that’s going to be much, much worse than the Internet bubble and that it was going to create financial catastrophe. But it didn’t matter. Nobody paid any attention.

Q. What are your thoughts on the bailout plan?

A. I think they’ve attacked the problem from the wrong end—they see it as a top-down problem. They seem to think that if they feed huge sums of money into these giant failed institutions, somehow these institutions will turn around, stop failing and be engines of economic growth. But they failed for a reason. They were run badly by people who didn’t know what they were doing and who shouldn’t be given an opportunity to prove they don’t know what they’re doing all over again.

Q. Strong words.

Those institutions are at the mercy of events that they have no control over, namely what’s going on in the larger economy. If markets continue to collapse, if people lose jobs, lose their homes and renege on credit card debt, it doesn’t matter how much money is pumped into Citigroup at the top—it’s still going to be a mess.

Q. What would you recommend?

A. The bailout needs to start from the ground up. Much of what’s going on is driven by the falling real estate prices. Falling house prices are driven by people who are having their houses foreclosed upon, which increases the supply of houses on the market. The bailout money should be used to stabilize the economy at the individual level and keep those people in their homes.

Q. Do you think it’s likely that another panic will occur?

A. Well, we’re having panics every day now. The markets are doing the weirdest things, and they’re going to continue to do the weirdest things for a long while—probably nine months, maybe more. This is the long panic. Do I think that U.S. financial markets will get themselves in a whole new problem in the next decade? Yeah, probably. But I think it will take a while because it requires people to be willing to take risk in the first place. People are going to be very unenthusiastic about risk for a while. It will take some years before we forget this experience.

Krista Walton is an assistant editor of Preservation magazine.

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