1995, the year the Net broke: An insider’s look at the early days of Internet culture

The first 80 some pages of Money, Greed and Risk sketch financial history as it developed in 19th century America, with special emphasis on speculative frenzies. This history was also covered beautifully last year in Edward Chancellor’s “Devil Take the Hindmost.” Morris takes a middle ground between the kind of Chicago school economic history, which sees speculation as merely a variant of rational decision-making given an array of profit opportunities in the real economy, and Chancellor’s elegant debunking of that school.

In Morris’ view, such figures as Jay Gould, the almost mythically villainous robber baron, were not simply rip-off artists. Yes, Gould’s bear raids and stock manipulation were unethical, but, as Morris points out, the railroads which Gould manipulated were often in a market in which railroads in general were overbuilt, burdened by intolerable debt structures designed by the government, and badly run. Gould did a decent job, when he actually ran the Union Pacific instead of using it as a marker in an investment position. This background allows us to understand current trends in the financial markets.

The life cycles of financial products form the best parts of the book. He breaks the pattern down into phases. Typically, what happens is some financial instrument, due to characteristics inherent in the way it structures its return, becomes less profitable in competition with other financial instruments, given the larger factors which govern the market at the time (interest rates, inflation, etc.). This problem is then solved by re-constituting the financial instrument in such a way that it regains competitive profitability.

Take mortgages, for example. Because mortgages are relatively illiquid, the growth in mortgages slowed in the sixties, as investors demanded higher yield. Congress responded by creating Ginnie Maes, which led to mortgage pools. Mortgage pools were still hampered, however, by the variables within the normal mortgage package. Mortgages are pegged to monthly coupons, in contrast to treasury and corporate bonds. Mortgages also contain a prepayment risk – that is, the option homeowners have to pay off the mortgage at any time. In the eighties, these variables were countered by developing a new mortgage backed structure, divided into different tranches, called Collateralized Mortgage Obligations, or CMOs.

Morris explains the mechanics of this in more detail than I can reproduce here. We then shift into a second phase, during which the financial market gradually becomes aware of the profit opportunity created by the new financial instrument. A profit opportunity is always, however, conditioned by risk. Remember that any financial instrument (stock, bond, CMO, derivative) operates against the larger factors in the economy, such as interest rates, productivity growth, technological innovation, and the direction of prices. The flow of money to the new instrument, which, in the Street lingo, is called “chasing yield”, becomes speculative when these larger factors are not calculated against. The conditions are then ripe for a correction, which is entailed by some disturbance, such as a rise in the interest rate, which collapses an excessive investment position in the financial instrument.

This happened with Junk bonds, CMOs, and the kind of “relative values” trading Long Term Capital Management engaged in. The fourth and final phase is the normalization of the financial instrument. Junk bonds are a good example. After the collapse of that market in the early nineties, high yields returned to giving a positive return, becoming, by 1998, a means by which a portfolio manager, incorporating in his portfolio different kinds of risk, can hedge against other risks. In the case of CMOs, the exotic slicing and dicing that produced “125+ tranches” is cleared away and a standardized financial product becomes the norm.

As Morris points out, many of these financial products involve such terrifically complex mathematical matrixes that they were impossible to design prior to the advent of the computer.

Morris’ book possesses a nice usefulness for anyone seeking to understand the current financial market, in spite of his adherence to the often gnarly jargon of the Street. Morris tries to do more, however. He also wants to defend the current financial market. Here, the book operates as a counterweight to James Grant’s contrarian views, expressed in Grant’s The Trouble with Prosperity (Times Book, 1998). The contrarian position which Grant espouses basically has two legs: first, it encourages skepticism as to the real economic purpose served by innovations in the design of financial products; and second, it holds to the opinion that interventions by the US Government, in the form of bailouts of banks and the extension of insurance on deposits, systematize moral hazard.

“Netscape’s management was too swayed by hacker culture, with its inveterate dislike of Microsoft, to think strategically about Windows and about thwarting Microsoft’s opportunities.”

Morris’defense of these innovations does not seem to meet Grant’s case. As we reach the end of the nineties, many economic historians are beginning to group the eighties and the nineties together, reading the eighties successes and failures as a concomitant of the nineties long boom. Both decades have witnessed de-regulation in the financial markets, and both decades have seen a resulting, spectacular growth in the financial sector. But Morris is too ready to accept take the correlation between what is happening on Wall Street and what is happening in the real economy as evidence of cause. It seems to me that the restructuring of corporations and the increase in productivity which are driving the nineties economy are due to fundamentals which have driven booms before, such as the effect of technology, the introduction of entrepreneurial features in management organization, and the continuing flexibility in the labor market (or, to be blunt, the low wages of the American worker), and are not due to LBOs, or derivatives trading, or other such flash goods.

One can argue that the collateral effect of overburdening a business with takeover debt is to force it to restructure, but that is surely a long, hazardous detour to get to a rational goal which is required, anyway, by market forces. In fact, Morris’ financial products may indeed divert capital from real investment. If that is so, government interventions as, for instance, the Fed designed bailout of Long Term Capital Management (which Morris defends) are not in the interests of the public but, as the populists would say, in the interests of the speculators. And that is bad for business.