The 2008 meltdown originated 30 years earlier with the government creations of Ginnie Mae and Freddie Mac, mortgage-backed securities. Institutional investors, such as pension funds, bought in “because even though they were extremely safe, they paid more in interest than Treasury bonds.’’
 
Then JP Morgan, holding a $4.8 billion loan to Exxon for its 1989 oil spill, created the credit default swap—paying a third party a fee to assume risk of Exxon defaulting. Morgan extended the swap concept to its $9.7 billion in commercial loans and freed $512 million in reserves formerly needed to cover the cost of default. Swaps became the rage.

Nations says the 2008 crash, propelled by “a frantic search for yield on the part of investors around the world,’’ was caused by ill-conceived adjustable rate mortgages; credit default swaps failing when housing prices dropped, overly leveraged mortgage-backed securities, subprime lending and the Fed’s failure to set realistic interest rates. When insurance giant American International Group (AIG) embraced credit default swaps, its $79 billion exposure in mortgage derivatives caused its collapse and it needed a government bailout to survive.

“It was easy to stand behind the false belief that complex and sophisticated means accurate,’’ Nations writes, saying that “fiber-optic lines and microwave towers that banks and trading firms installed are intended to transmit messages at nearly the speed of light.”

“But one hedge algorithm confused volume with liquidity in 2010 and the illusion of liquidity would cause the flash crash of 2010.’’

The contraption: Believing the collapse of Greece’s economy imperiled its assets—87 percent in stocks—a Kansas asset management company sold 75,000 futures worth $4.1 billion on May 6. The “weaponized algorithm,’’ selling in spans of a few milliseconds, caused the Dow to drop more than 1,000 points in minutes, with three million shares trading 90 percent below previous day prices; more than 200 securities lost 100 percent of value before the algorithm finished its wreckage. Order was restored.

“Crashes might not repeat themselves, but they rhyme. It’s not about money or numbers or individual stocks but about fear and greed. There is almost always too much greed. There is rarely enough fear,’’ Nations concludes.

A History of the United States in Five Crashes, by Scott Nations. William Morrow. 336 pages. $35.99.

Eleanor O’Sullivan is an award-winning freelance journalist who writes for Financial Advisor magazine.

First « 1 2 » Next