Actually, there is. Wayne Angell, the taciturn former Federal Reserve governor who now tells the future at Bear, Stearns, puts a name on it: “Speculation.” Not that speculation is a new phenomenon. But Feb. 4, 1994, the day the Fed abruptly ended five years of easy money, made it dangerous. Billions of dollars of wealth disappeared almost overnight; if you’d been a long-term-Treasury-bond millionaire on Feb. 3, you’d have had only $870,000 three months later as higher rates decimated bond prices. Far more than fast-moving global markets or derivatives trading, which has taken the rap in the Barings case, it is the end of that speculative excess that lies behind the past year’s headfines. What sounds like collapse, says a veteran hedgefund manager, is just the hiss of “all these markets in financial assets having the air taken out of em.”
Any investor can be a genius when interest rates are falling. Stocks go up, bonds go up, everything goes up. Rate hikes separate the geniuses from the gamblers, the careful strategists from the people whose only strategy was borrowing to the hilt. People like Orange County Treasurer Robert Citron, who’d seemed so brilliant riding the rate curve down, can only look on pathetically as higher rates wipe $1.7 billion off the county’s books. Entire countries like Mexico, which had seemed so successful as short-term money flooded in, can become disaster areas overnight when that borrowed money becomes dear. Even Barings felt the shock waves. It wasn’t paying U.S. rates. but it was heavily leveraged in a stressful environment. One shock -in this case, literally, an earthquake 10,000 miles from home - was enough to put it under.
Is this just a simple story of interest rates? Not exactly. The truth is, crises are endemic to the financial system, any financial system, We used to call them “panics.” For the first century and a half of U.S. history, one big mistake by a bank or a bond trader could devastate the economy for years on end. If crises seem more common now than after World War it, that’s because the Great Depression purged hundreds of weak banks and brokers, and the heady prosperity of the 1950s gave the survivors plenty of margin for error. Observes economic historian Barry Eichengreen, “When you’re growing fast and profits are high, a lot of sins can be disguised.”
The first big postwar disaster was probably the collapse of the over-indebted Penn Central Railroad in 1970. Financial tremors have been the norm ever since. Exchange rate crises were constant from 1971 to 1973. In 1974, the unrelated failures of New York’s Franklin National Bank and of Germany’s Bankhaus Herstatt set the world trembling. “Everyone was talking about how weak the financial system was,” recalls Brookings institution scholar Ralph Bryant. High fliers didn’t need computers to get into trouble on a very large scale. When Nelson Bunker Hunt lost a billion the oldfashioned way in 1981, trying to corner the silver futures market, hand signals and paper trading tickets were perfectly adequate.
These days, computers usually take the rap when crisis strikes. “Technology and mathematical models are outstripping the knowledge of senior management of these institutions,” worries one Treasury official. Granted: without computers, the derivatives that hurt Gibson and P&G and destroyed Askin would never have been created, and Kidder government-bond trader Joseph Jett would have been hard pressed to bide the $210 million he lost. But even today, computers are by no means the essential ingredient in crisis. The gravest threat to the world economy in the 1990s, the near collapse of Japan’s entire banking system, came from old-fashioned real-estate loans, not newfangled, computer-generated trading techniques. Baring’s problems, fatal as they were, pale before the ongoing woes of the staggering French banking giant Credit Lyonnais, which last week sought yet another mulibillion-dollar government bailout. Its sin: bad lending.
Computers can help investors panic, causing an otherwise isolated problem to reverberate in financial markets around the world. But computers have also become the essential tools for keeping risk under control. Any trading room can afford programs that constantly measure risk, recalculating the odds with each move in the dollar and each change in the portfolio. It’s not foolproof, and never can be; in January, Chemical Bank’s technology couldn’t avert a $70 million currency-trading fiasco. By and large, though, the systems work. “All of these problems are preventable and are being prevented prevented every day by hundred and hundreds of other institutions,” says Rob Merrilees, president of G-bar, a Chicago options house.
That, of course, assumes that management is intent on preventing them. Often, as at Barings, executives talk a good game about risk control but act differently. “You see lots of securities firms that give $5 million bonuses to traders. You’ll have to look very hard to find a securities firm that pays a $5 million bonus to it’s internal auditor,” says Richard Breeden, the former chairman of the Securities and Exchange Commission. Look behind a financial crisis and you’ll see not computer failure but management failure.
No regulation can bar management incompetence any more than tighter rules could have kept Henry Ford II from building the Edsel. Letting a firm like Barings fail sends out an important message: the job of regulators is to keep collapse from becoming contagion, not to make up for bad financial judgment. The trick is making sure that the trouble is contained. Careful examination and quick diagnosis are more vital than ever, given the speed with which crises can spread. But they’re no substitute for the Fed’s unpopular rate hikes. The speculation virus will never disappear altogether. Every so often we need a booster shot.
